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Executives

Marcy Brand

Gary C. Kelly - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Robert E. Jordan - Chief Commercial Officer, Executive Vice President and President of Airtran Airways

Laura H. Wright - Chief Financial Officer, Chief Accounting Officer and Senior Vice President of Finance

Ginger Hardage - Senior Vice President of Corporate Communications

Analysts

John D. Godyn - Morgan Stanley, Research Division

Helane R. Becker - Dahlman Rose & Company, LLC, Research Division

Daniel McKenzie - Rodman & Renshaw, LLC, Research Division

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Michael Linenberg - Deutsche Bank AG, Research Division

Raymond Neidl - Maxim Group LLC, Research Division

Jamie N. Baker - JP Morgan Chase & Co, Research Division

Savanthi Syth - Raymond James & Associates, Inc., Research Division

Glenn D. Engel - BofA Merrill Lynch, Research Division

Hunter K. Keay - Wolfe Trahan & Co.

Jeffrey A. Kauffman - Sterne Agee & Leach Inc., Research Division

Southwest Airlines (LUV) Q2 2012 Earnings Call July 19, 2012 12:30 PM ET

Operator

Welcome to the Southwest Airlines Second Quarter 2012 Conference Call. My name is Tom, and I'll be moderating today's call. This call is being recorded, and a replay will be available on southwest.com in the Investor Relations section. At this time, I'd like to turn the conference over to Ms. Marcy Brand, Director of Investor Relations. Please go ahead, ma'am.

Marcy Brand

Thank you, Tom. Good morning, everyone, and welcome to today's call to discuss our second quarter results. Joining me on the call today is Gary Kelly, Southwest Chairman, President and Chief Executive Officer; Bob Jordan, Executive Vice President and Chief Commercial Officer and President of AirTran Airways; and Laura Wright, Senior Vice President, Finance and Chief Financial Officer.

Today's call will begin with opening comments from Gary, followed by Bob providing an update on the AirTran integration and operations, and then followed by Laura providing a review of our second quarter results and current outlook.

As a quick reminder, prior-year consolidated results include AirTran results beginning May 2, the date of the acquisition. In order to provide what we believe to be a more meaningful year-over-year comparison on today's call, we will also be discussing specified current results and providing outlook commentary on a combined basis as defined in this morning's press release.

Please be advised that today's call will include forward-looking statements. Because these statements are based on the company's current intent, expectations and projections, they are not guarantees of future performance, and a variety of factors could cause actual results to differ materially.

As this call will include references to non-GAAP results such as combined results and results excluding special items, please reference this morning's press release in the Investor Relations section of southwest.com for further information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results.

And with that, I'll turn the call over to Gary.

Gary C. Kelly

Thank you, Marcy, and good morning, everyone, and thank you all for joining us. We are very pleased with our second quarter financial performance. Excluding items, second quarter profits of $273 million is an all-time quarterly record. It's up 126% year-over-year. Earnings per share of $0.36 is also an all-time record and it's up 140% year-over-year, and also $0.03 ahead of Wall Street estimates.

The sluggish economy was no help. High fuel prices were no help, although they at least were lower than the first quarter. But I give all the credit to our people at Southwest and AirTran. And once again, they did a great job of running a very high-quality airline with solid on-time performance, excellent baggage handling, outstanding schedule reliability. And at the same time, our people at both airlines are doing an exceptional job of integrating AirTran, and our people have done an extraordinary job of rolling out a lot of new initiatives like our All-New Rapid Rewards program, the Boeing 737-800, the Evolve seating retrofit for our 700s and a number of other initiatives.

And in particular, as we outlined in the release today, the AirTran integration is very much on track. The AirTran business was a significant contributor to our second quarter profit record. A couple of things to note there: First, I'm very proud of our team's efforts to get a deal with Delta and Boeing to replace all of the Boeing 717s and retire them from our fleet by the end of 2015. The operational and cost benefits are obvious with an all-Boeing-737 fleet. But the revenue benefits are huge, given that we've got 26 more seats with the 737 at essentially the same trip cost as the 717. So after gathering up all the one-time accounting charges for this deal in 3Q, the ongoing rental expense versus sublease income is essentially awash once we start delivering the 717s to Delta. And Laura is going to cover all of that in more detail in a few moments.

And further, we have significant technology work underway related to the AirTran integration. Our top priority is an international reservation system implementation that's on track for a 2014 deployment. Next is the systems capability at both airlines to connect the networks and the itineraries, and that work is on track for our first quarter 2013 deployment. In addition to core AirTran profits, that acquisition is contributing profit synergies in line with our expectations, and we continue to target $400 million in synergies from that for 2013, which is more than double the current run rate that we have.

Still related to AirTran, each airline continues to make aggressive but prudent schedule changes. International cities are being added in AirTran. Small cities that don't fit the Southwest model in this high-fuel-cost environment are being closed.

During the second quarter, Southwest picked up additional slots at Washington Reagan. We received authorization from the City of Houston City Council to proceed with an international facility at Hobby Airport, and that's targeted for 2015.

And work at Dallas Love Field is on target, on schedule and on budget, and all of that is in anticipation of the full Wright Amendment repeal in October of 2014.

So needless to say, there's a lot going on at Southwest. It is already bringing significant shareholder value, and there's a lot more to come over the next several years.

I want to thank our Board of Directors for their hard work and their devotion to driving shareholder value. In May, they increased our authorization to repurchase shares to $1 billion, of which half of that repurchase has been completed. And they also more than doubled the quarterly dividend to $0.01 a share.

Our strong cash flow, our leverage is low, our annualized return on invested capital for this quarter actually exceeded our 15% requirement. And so you can see why the board took these actions by all of these strong positions and strong performances.

And then finally, while we remain cautious about the domestic economy, our business seems to be holding up well. Fuel prices, at least right now, are no higher than they were in the second quarter and hopefully, they will be lower this quarter. But we're keeping our capacity roughly flat this year and next until we're comfortable with our earnings performance hitting our 15% return on invested capital target. And of course, this quarter's results were a great step forward in that regard.

So Bob, without further ado, I'll turn it over to you.

Robert E. Jordan

Well, thank you, Gary, and thanks, everyone, for joining us. I'm really pleased to give you a report on AirTran. We continue to make great progress on the integration front. Five AirTran 737s have been converted to the Southwest delivery, and we've got another one in progress. We plan to transition 11 737 this year, and the majority of the remaining 41 we will transition in 2014 once international capabilities are in place in Southwest.

As Gary mentioned, the recent agreement with Delta and Boeing Capital to transition out of the AirTran 717s is a great deal for us. While that was not anticipated at the start of the acquisition, the opportunity to replace 717 flying with 737 flying offers -- that offers significantly more seats. And therefore, of course, revenue opportunity at essentially the same trip cost makes just perfect economic sense for us. The first 717s will transition in August of 2013, with the entire fleet exiting by the end of 2015.

On the labor front, the majority of our unions have seniority integration agreements in place, and we're making really good progress on the 2 that remain. We continue to transition AirTran employees to Southwest. The first groups of AirTran pilots and flight attendants have completed their moves, and over 1,000 AirTran employees have transitioned to Southwest and that number is rising each and every month.

Airport transitions continue, with ground operations folks beginning that transition at 6 stations last month. And AirTran's operations in Seattle and Des Moines fully convert to Southwest this quarter. Of course, optimizing the combined networks continues to be a major focus. We added several new AirTran international markets to the roadmap during the second quarter, and those were primarily funded through redeploying capacity from closed small cities.

And I'm just very pleased with the performance of those new markets. They all look very strong. And I'm extremely pleased and thrilled that the Houston City Council cleared the way for Southwest to build a new 5-gate international terminal at Hobby Airport. Construction there is planned to begin next year, with flying to destinations such as Mexico, the Caribbean and cities in Central and South America beginning in 2015.

We're making great progress towards implementing connecting capabilities during the first quarter of 2013, as Gary mentioned, and that, of course, opens up significant opportunities in the combined Southwest-AirTran networks ahead of full integration.

On the operation front, the AirTran operation continues to perform very, very well. They are posting stellar DOT results in all 3 categories. For example in May, which is the most recent month of results published, AirTran ranked first in the category of customer complaints, second in mishandled bags and third in on-time performance overall. So I'm just extremely pleased with the operation at AirTran and cannot be more proud of our people there.

Overall, AirTran's business continues to improve solidly year-over-year. And while still underperforming Southwest revenues on a nominal unit basis, positive RASM and yield trends continue. We realized net synergies in the first half of this year of approximately $80 million and our plan continues to call for reaching $400 million total pretax synergies in 2013 based, of course, on our current network and fleet plans.

So in summary, I am very pleased with our integration progress and timing. Our synergies are on track, the 717 deal is a great long-term deal for the company. And the AirTran folks are posting stellar operational results. And I think that's pretty darn good, and I'm very proud of our AirTran folks and their excellent work.

And with that, I'm going to turn it over to Laura Wright to walk us through the details.

Laura H. Wright

Thank you, Bob, and good morning, or afternoon, everyone. Excluding special items, our second quarter operating profits was an all-time record quarterly performance of $485 million. Revenue was solid throughout the quarter, producing record revenue results, and our nonfuel operating costs came in better than expected.

Although fuel prices on average were still very high, we benefited from the decline in market prices that occurred during the quarter, as evidenced by a roughly $60 million decrease in our economic fuel cost compared to both the second quarter of last year as well as to our expectations back in May.

We also have a $28 million year-over-year reduction in our non-operating expenses, excluding special items, and all-in, this led to a net income of $273 million, excluding special items, or $0.36 per diluted share, both quarterly records.

For the 12 months ended June 30, our pretax return on invested capital was 8%. And as Gary pointed out, our June quarter as stand-alone results exceeded the 15% annual target.

And overall, I would reiterate Gary and Bob's comments that we're very pleased with the second quarter results, particularly the improvements from a year ago.

Our passenger revenues increased over $400 million or 11.5% from last year's $3.9 billion. And on a combined basis, our passenger revenue is still a solid 5.1%.

On a unit basis, passenger revenues were up 6.4% versus combined results, and total unit revenues grew 6%. Our PRASM strength came primarily from our yields. They were up 6.7% on a combined basis. And as Bob noted, we continued to significantly improve AirTran's year-over-year revenue performance. However, on a nominal unit basis, we still have significant synergy opportunities yet to be realized on AirTran's network.

Southwest's mix of full-fare passengers was 17%, which was slightly down from first quarter's 18%. However, business traffic indicators that we monitor suggest that our business traffic has remained steady.

Our Business Select fare product contributed approximately $25 million in incremental revenues in the quarter, and our Wright Amendment revenues also continue to contribute significantly. We had $74 million of incremental revenues in the second quarter from Wright Amendment.

Our 800s and Evolve flights, which were just introduced in the second quarter, are already producing great results and they contributed millions collectively in 2Q '12.

All-New Rapid Rewards continues to perform well. We had approximately $75 million incremental cash sales from our business partners compared to the second quarter of last year. And cumulatively, our business partner cash sales from our frequent flyer program increased in excess of $300 million for the 12 months ended June 12 compared to the 12 months ended June 2011.

While the vast majority of this is still being deferred from a P&L perspective, thereby increasing our air traffic liability, we did recognize about $50 million additional incremental passenger revenue from the frequent-flier business partner sales in the second quarter '12 over last year.

Thus far, our July passenger unit revenue growth was solid. We do not expect our July passenger unit revenues to be up as much as June's 6% year-over-year increase due to softer July 4 holiday traffic, which is to be expected when July 4 falls in the middle of the week.

Our bookings in place thus far for the quarter look good and overall, we expect another solid third quarter unit revenue performance but do not expect the year-over-year growth to exceed second quarter's 6%.

Our freight and other revenues were in line with our expectation. And we currently expect that our third quarter freight and other revenues will decrease slightly from the third quarter 2011 freight and other revenues, primarily due to AirTran's fees trending lower year-over-year as their capacity is moved over to Southwest.

Our second quarter economic fuel price per gallon was $3.22, and that was down a $0.05 from the prior year combined. The $3.22 includes a net $0.04 unfavorable cash settlement from the lock-in losses from our legacy hedging portfolio. Our premiums in the quarter were $12 million, that's down from $26 million in the prior year. And our economic fuel costs were up $0.13 per gallon better than the last guidance that we provided in mid-May of $3.35. And that was really due to the $6 drop in oil prices since that time.

At current market prices, we expect that our third quarter economic fuel price, including taxes, will be in the $3.05 to $3.10 per gallon range. That's based on the July 17 forward pricing. This estimate includes an estimated $0.03 per gallon fuel hedging penalty and again, this relates to the lock-in losses from the legacy hedging portfolio.

Our third quarter hedge does provide protection if WTI prices average above $100 per barrel, as illustrated in this morning's press release. However, we also participate in the third quarter fully and following prices until we reach WTI prices below $75 per barrel. Again, this is illustrated in this morning's press release.

Our third quarter premium expense is also expected to be about $17 million, and that's down from $36 million last year.

For the fourth quarter of 2012 and looking out into 2013, our current hedge portfolio provides a meaningful protection in the rising fuel price environment, again with that protection kicking in at $100 of WTI oil price and above. In the event prices drop from current forward levels, we will continue to participate in lower fuel prices fully until we hit at $75 per barrel WTI price in the fourth quarter as well as 2013.

Our second quarter unit costs, excluding fuel and special items, were up 4.3% year-over-year on a combined basis. And excluding profit-sharing, we're up 2.7%. This was better than we expected, and that was primarily due to lower maintenance, airport, depreciation and advertising costs. Maintenance was less than expected, due to fewer Evolve seating conversions and fewer heavier maintenance events than planned. Our airport costs benefited more than we anticipated from airport settlements we received during the quarter. And depreciation came in lower due to some of the changes we had in our aircraft retirement schedule. And finally, advertising was under planned as we deferred some of the spend that we had previously planned for the second quarter to the back half of 2012.

For the third quarter of 2012, we're currently anticipating our nonfuel unit costs, excluding special items and profit-sharing, will increase in the mid to high single-digit range compared to third quarter 2011's $0.0727. While we've had more modest cost increases in the first half of this year than expected, we do anticipate higher costs in the back half, primarily from maintenance, including Evolve, airport costs, depreciation and the deferred advertising.

We remain focused on controlling our core costs with significant opportunities ahead with our fleet modernization plans. On the non-operating cost side, we have significant year-over-year improvement. Our net interest expense for 2012 is expected to be down by $70 million on a combined basis due to paying down about $1 billion of debt. And as noted in the fuel discussion, our 2012 fuel hedging premiums, which are recorded in other gains and losses, are expected to be down approximately $65 million from 2011.

Let me provide a quick recap of our balance sheet and cash flow. Our cash and short-term investments at quarter end were $3.3 billion, and as of yesterday were $3.7 billion. For the first 6 months of the year, we had $1.4 billion of cash flow from operations and over $800 million of free cash flow. Our leverage, including our off-balance sheet aircraft leases, is approximately 45% and is expected to decline at the low 40% range by year end.

And from August of 2011 through the end of the second quarter, we purchased approximately 500 million or 59 million shares of Southwest common stock under our current $1 billion authorization at an average price of $8.44.

I'll move to fleet and capacity. We had 14 737 Classics retirements during the second quarter, 3 of these were lease returns and the remainder owned aircraft, ending the quarter with 695 active aircraft. Of the 34 800 deliveries planned this year, there are 15 remaining. And we're still planning for 40 total Classic retirements this year, which will put our fleet count around 692 at year end.

In terms of our capacity plans, our 2012 available seat miles will be comparable to 2011's combined ASMs.

For 2013, we don't plan to grow the fleet, and we're planning for modest capacity growth compared to 2012.

Although we are increasing the aircraft gauge in 2013 with 800s and the additional 6-seats on our 700s, we have capacity offsets with planned Classic and 717 retirements. And currently, our capacity for the first quarter is expected at 2013 is expected to be relatively flat to slightly down year-over-year.

I will end with an update on the current status of our fleet modernization initiative. Back in January, you'll remember that we provided estimates for EBIT contribution over the next 3 years as a result of our fleet initiatives. Since then, we've made a few changes. We announced a $1 billion of deferral of capital spending in new airplanes. And most recently, we announced that we will sublease or lease all 88 of AirTran's 717s to Delta. Replacing AirTran's 717 flying with 737s as they transition to Delta is expected to benefit our annual pretax results by approximately $200 million after all of the 717s are transitioned to Delta and replaced with 737s flying.

The primary source to the benefits from a revenue contribution of more seats as a nominal trip cost of the 717 compared to our 737s is approximately the same. And as a result of this opportunity to retire the 717s from our fleet earlier than the head lease obligations, we have made adjustments to our retirement schedule of our Classic fleet to be able to replace the 717s flying as they transition to Delta.

Because we're replacing the 717 flying with adjustments to our Classic retirement schedule, this agreement does not increase our near-term capital spending plans for future aircraft needs.

Collectively, the 717 deal and the aircraft deferrals announced in May have not changed our EBIT estimates for 2012 through 2014, which were $70 million in '12, more than $300 million in 2013 and more than $500 million in 2014.

For 2015, however, we're expecting that the EBIT contribution from our fleet initiatives will exceed $700 million, and the $200 million increase in 2015 is largely the result of the replaced 717s line.

Overall, the improvement in EBIT by replacing the 717s with 7-3s coupled with the reduction in our invested capital that comes from the aircraft deferrals as well as the early retirement of the 717 leases, significantly improves the return on investment of the collective fleet modernization plan.

In the third quarter, we expect to record an accounting charge of approximately $140 million. It's primarily associated with the costs that were contractually assumed by Southwest to convert the AirTran aircraft to Delta's labor and configuration. The charge will be included in our AirTran acquisition an integration costs, which are treated as non-GAAP special items.

With respect to these aircraft transition costs, we expect to only spend approximately $100 million in net costs. And the difference between that expected $100 million net costs and the $140 million GAAP third quarter special charge is a result of financial assistance that is being provided by the manufacturer that will be recorded on our financial statements as a reduction in aircraft basis on future deliveries.

The $100 million of net conversion costs are about $50 million higher than we expected to incur if we would've integrated the 717s directly into Southwest. So as a result, this will increase our estimate of total acquisition and integration costs from $500 million to approximately $550 million.

In regards to the net rent expense, as aircraft are transitioned from Southwest the Delta, our book rental expenses is eliminated, and the sublease income basically offsets that.

So in summary, we're very excited about the opportunity to retire the 717s from the fleet early. And we're confident that the net economics of the transaction better support our strategic, our operational, as well as our financial goals.

And with that, Tom, I believe we are ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] We will now begin with our first question from John Godyn with Morgan Stanley.

John D. Godyn - Morgan Stanley, Research Division

I just wanted to follow up on your comments about third quarter RASM likely being solid. It definitely helps put some boundaries on it to know it won't exceed the second quarter, but I think investors are still a little bit confused at how to interpret it, just given the tough comps throughout the quarter. If July isn't as good as June and comps get a lot tougher in August and then again in September, it seems possible that PRASM might go negative in September. Is this the sort of ramp throughout the quarter that would be reasonable? Or am I missing something about how the months shape up from here?

Laura H. Wright

Yes, I think -- I'm looking for the comps, John. But certainly we think July, the fact that we had July 4 on a Wednesday produces a tougher year-over-year comp than what we expect in August and September. I think we also have July, as you say, a very optimal month, and I think we've noted in the past that some of the suboptimal months, and we just have more room to grow revenues than we do in the peak periods like July. But overall, our bookings for the quarter look solid, and we don't see anything for August or September. But I would admit that July is impacted by Fourth of July.

John D. Godyn - Morgan Stanley, Research Division

Okay. And Gary, when we think about Southwest historically, capacity growth demand stimulation, solid returns have gone hand-in-hand. But as you've gone through this tougher phase here, the answer has been still in capacity growth until returns improve, and that makes sense. But as we look forward, and you mentioned that you're going to keep 2013 capacity flat, is the flat or minimal capacity growth the sort of new normal? Or do you envision getting back to a world where you see capacity growth, demand stimulation as again sort of aligned with maintaining solid returns from here?

Gary C. Kelly

Well, we definitely have some opportunities to stimulate demand. But I think that it will be perhaps a bit more tactical in the future than it has been in the past. And also, it has to be at a revenue production level that hits our 15% return requirement. So I think step one is just restoring our profitability to those levels, number one. Number two is to make sure that we have the capabilities in place to pursue expansion opportunities, which we are doing, that's adding the 737-800, that's investing in international capabilities, those kinds of activities. We'll have access to airplanes to be able to grow the airline. So all of those necessary pieces will be in place. And then it's just a matter of, again, making tactical decisions about what new markets we might want to add. Because it's tactical, I think we just have to wait and see when we're ready to add aircraft, what opportunities are available, and that'll be a function of capacity in the market and the price in the market. So Bob Jordan and I both highlighted Houston Hobby and the international opportunity there, which is a perfect example to your question. I'm hopeful that we will be hitting our return requirements so that we can add aircraft, because there is a significant opportunity to lower fares and grow the market in Houston Hobby internationally, as one example. And there are plenty more examples like that, but I think we just don't want to get the cart before the horse. So the first thing is we need to hit our profit targets, and then we'll be in the position to make those kind of choices.

Operator

And we'll take our next question from Helane Becker with Dahlman Rose.

Helane R. Becker - Dahlman Rose & Company, LLC, Research Division

So my first question, Laura, is my usual Wright Amendment question. Can you just update us on the Wright Amendment revenues year-to-date? And then the other question that kind of goes along with that is I've noticed that some of your -- some of the other airlines are adding service to Love Field from their hubs using 50-passenger jets. So can you just talk about the opportunity that you have to -- as 2014 approaches, to do a lot of that service with larger aircraft and the potential for revenue benefit?

Laura H. Wright

Okay, I'll take the first one. So in the quarter, Wright Amendment revenue was $74 million. That was versus $63 million a year ago. Year-to-date, it's $1.34 billion versus the second quarter. So very strong. And Gary, I will let you talk about...

Gary C. Kelly

Well, Helane, I'll try to answer your question here. I think first of all, by federal law, Love Field will be limited to 20 gates. I guess it is limited now. But certainly, the new airport construction will be 20 gates. We have ample access to those 20 gates to support our operation. We'll be able to grow from here. We have a very strong business in Dallas, as Laura just reported to you. That is very nice growth in what is a pretty tough economic environment. So we're very pleased with our business here out of Dallas. We always take the competition seriously, but I think we would be delighted to compete head-to-head against regional jets every day. So in the grand scheme of things, our big competition out of Dallas is coming from DFW Airport, not Love Field.

Operator

And we'll go next to Dan McKenzie with Rodman & Renshaw.

Daniel McKenzie - Rodman & Renshaw, LLC, Research Division

Bob, I appreciate the AirTran commentary. But the one thing that stands out is the $2 million operating loss at AirTran. So it does look like roughly 15% of Southwest business is losing money, at least prior to the synergies. And I guess as I look at the operating costs, individual line items seem pretty much the same, if not better than AirTran's stand-alone historically. So...

Gary C. Kelly

Dan. Hey, Dan. Let me just interrupt you there. That is the 2011 required presentation. So that, first of all, that's not this year, that's last year. And I'll defer to Marcy as to what we'll have on our IR website for AirTran, if anything, separately. But we're having a harder time separating the profits between AirTran and Southwest as time goes by because they just -- they begin to blend more and more together. But again, I'll defer to Investor Relations over the next several days or weeks. But there was a significant operating profit from AirTran in the second quarter, that's fact number one. Of the $485 million operating profit, which was an all-time record, x items, I don't recall off the top of my head, but as Bob Jordan mentioned earlier, the operating margins at AirTran lags Southwest's margins some. But they're not far off. So they were a substantial portion of that $485 million.

Robert E. Jordan

And they're better year-over-year.

Gary C. Kelly

And they're better year-over-year.

Robert E. Jordan

There's progress along the way here.

Gary C. Kelly

So I apologize for the misinterpretation there, but the -- but that was a 2011 chart that was required at the time for combining financial statements. I think it's because it was split between -- there was AirTran standalone for a month and Southwest owned it for 2 months, and that's the only reason that's in there. But I agree with you that it is somewhat confusing.

Daniel McKenzie - Rodman & Renshaw, LLC, Research Division

Okay. So thank you for clarifying that, and I apologize for the confusion on my part. And then I guess if I could just ask the -- my next question. If I can just focus on productivity, perhaps a little differently than what's stated in the press release. I didn't see block hour stats in the press release. So I guess I'm wondering, first, what that average block hour time was in the second quarter? And then how does that compare to second quarter block hour time historically? And if you can just talk a little bit about the potential productivity improvements there?

Gary C. Kelly

Well for the most part, our utilization is still very high and especially in relation to prior years. Since 2007, we've concentrated more of the flying into the meat of the day, sort of 7 a.m. to 7 p.m. And the block hours per day are down somewhat year-over-year, but I think that probably suggests, Laura, that maybe we have some opportunities to add more flights outside of the mean part or the meaty part of the day. But...

Laura H. Wright

Yes, and then there's [ph] 2Q '12 11 hours and 24 minutes was the block time average for the quarter. Last year was 11.41, but at '10, it was 11.11, so it's some. And I think we peaked at around 11.50 back in '07. So it's still very, very high.

Operator

And we'll take our next question from Duane Pfennigwerth with Evercore Partners.

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Can you give us an update on the Evolve project, how many aircraft have been completed and the rate at which you're converting those over and when you think that's done?

Laura H. Wright

We can do that, Duane. We have 50 converted through June. We expect to convert about 200 more, about 100 in the third quarter and 100 in the fourth quarter. And we will be done in the second quarter of 2013 with all of the 700s.

Duane Pfennigwerth - Evercore Partners Inc., Research Division

And then just on fuel efficiency, I guess, as we think about whatever that line is in the model, ASMs per gallon, it kind of feels like that should accelerate a bit as you do this Evolve program and as you layer in more of these 800s. Can you give us any sense for the sort of year-to-year gains we can expect going forward?

Laura H. Wright

When you're talking about the fuel efficiency and all the economics, we haven't provided anything in 2013. As you know, the Evolve seats we're actually expensing. They're not being capitalized, so that's actually adding to some of the cost pressure and why you're not seeing net improvement in the 2013 time frame. But certainly – or 2012 time frame. But certainly as we get into 2013, we have the majority of the fleet, we'll see some nice gains on the fuel efficiency and just the overall CASM from those, but we haven't provided any 2013 guidance yet.

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Okay. And if I could just sneak one more in, could you clarify your comment about capacity growth next year?

Laura H. Wright

Yes. So we expect capacity growth in 2013 to be modest. That's going to become as a result of the extra seats from the 800 and Evolve. First quarter will be flat to relatively down, but full year will be a modest increase.

Operator

And we'll take our next question from Mike Linenberg with Deutsche Bank.

Michael Linenberg - Deutsche Bank AG, Research Division

I guess 2 quick ones. Back to capacity growth, Laura, you gave us next year. Did you give us the third and fourth quarter of this year?

Laura H. Wright

I did not. I think I told you that for the full year we're going to be relatively flat with last year.

Gary C. Kelly

I think we reached down about 1 point, 1 percentage point. So we're down about 1 point, Mike, here in this second quarter. I think it's pretty...

Robert E. Jordan

1.2, I think.

Laura H. Wright

Yes, 1.2, I think there.

Gary C. Kelly

Pretty consistent in the third and fourth quarter.

Michael Linenberg - Deutsche Bank AG, Research Division

Okay, good. And then my second question. On the $1 billion of CapEx that you saved 2012 to 2014, Laura, how does that break out per year? Is it evenly across the 3 years or is it front-end loaded?

Laura H. Wright

No, it's actually weighted towards 2013 and 2014. The 2012 estimates are about $1.3 billion, so it was modest, but the real difference is in '13 and '14. Right now, '13 is 1 to 1.1, and that had been in the 1.4 rate so it's definitely the next 2 years when you see most of it.

Operator

We'll take our next question from Ray Neidl with the Maxim Group.

Raymond Neidl - Maxim Group LLC, Research Division

Gary, I think you said on CNBC this morning that your ROIC goal is 15%. You've stated that previously. And I'm just wondering the components of that. It looks like it's coming from cost reductions, reconfiguration of your aircraft, resuming growth, which you're not doing for the next 3 or 4 quarters. So relatively speaking, is that a goal that's well beyond the year 2013, in other words, about 1.5 years out or more?

Gary C. Kelly

Well, we're -- the 12 months ended June of '12, we hit an 8% return on invested capital, I believe that's in the press release. This quarter, if you annualize the second quarter, it would be over 15%. And that's not my prediction for the next 4 quarters. But it just at least puts in perspective the kind of progress that we've made towards that goal. If we can sustain the current core earnings and then drive the values that we're targeting from the AirTran acquisition from the All-New Rapid Rewards rollout, the fleet initiatives, I think the way Laura categorizes those in her mind probably includes the 800s. Sometimes, I separate them in my own mind. But in any event that the -- what we have detailed for you in the press release shows very significant pretax earnings contributions coming from this collection of fleet initiatives, 800s, the Evolve, the swapping of the 717s in favor of 737s, and I already said Evolve. And by the way, we -- back to Duane's earlier question, we will likely retrofit 100 of our Classic aircraft with Evolve seating as well. But that won't meet the time line that Laura shared earlier. So all told, those more than take us from our current levels to the 15% returns. So we've got a very nice portfolio of opportunities that will bring very significant value. And with respect to your specific point about 2013, whether it's well beyond 2013, I don't think we're prepared to say at all that we won't hit our target next year.

Raymond Neidl - Maxim Group LLC, Research Division

Okay, good. That's good to hear. One other macro question, Gary. The industry is probably going to change here with the American bankruptcy, one way or the other. And is that going to have any effect at all or a major effect on Southwest if one, American comes at a bankruptcy to begin with, and if they did merge with U.S. Airways, they might become a larger, more aggressive competitor?

Gary C. Kelly

And just to tie-in again, Ray, on your 15% question, we've had a 15% target for 25 years. So that has -- I don't see that changing. So there's nothing new about that. On American, I think we agree with you that certainly, what we have to plan for is a much stronger, much more viable, much more cost effective competitor in the future. The old American is gone, and it will be replaced by something. So we agree with you. So we're gearing for stronger competition in the future. And that certainly provides the kind of discipline that we need to keep our costs low and our service levels high. Whether the reorganization of American results in some kind of opportunities for us, that's pure speculation right now on our part. But just like we were able to move very quickly to pick up a couple of slots at Washington Reagan, we know what we want to do with the airline over the next 5 to 10 years. And I think we've got the horsepower to move. And as some opportunities present themselves, I think we can decide and move quickly.

Operator

And we'll go next to Jamie Baker with JPMorgan.

Jamie N. Baker - JP Morgan Chase & Co, Research Division

From the time you announced the merger, my assumption was that the product AirTran was at the time would eventually become the product that Southwest is today. Basically, the Southwest way would prevail in terms of the passenger experience, single fleet type, IT, pricing and so forth. I'm curious now that you have a more thorough understanding of AirTran's operations and procedures, is there anything that they did better or different than Southwest that might actually continue? It could be as simple as red eye flying, for example, or maybe something much deeper than that? Any thoughts?

Gary C. Kelly

And just so I don't confuse anyone, our plan for integrating AirTran is unchanged from what you initially described. In other words, we will follow through with moving all of the AirTran operations into Southwest Airlines with the product that you know and love today at Southwest Airlines. Absolutely, we've learned a lot from AirTran. I think they do operate differently, and they are an outstanding operator. I mean, they have very strong on-time performance, outstanding baggage handling, and they have a different method of scheduling than we do. And they manage their fuel loads different than we do. So there's a number of things that are still queued up for us, I would say, as opportunities to continue to explore. We don't like to make massive changes to our operating procedures. Safety is our top priority. We want to make sure that people are fully trained and before we undertake a very large change there, we're very measured and very reasoned about how we go about that. But those are a couple of items that I'm very excited about that I think over time, Bob Jordan and Mike Van de Ven have been looking at and some things I'm sure we will implement. The biggest value I think that they have brought to us besides just seeing how another company works is international. Because our ability to research international fares and profits is much -- as you know, is much more difficult than what we're able to do domestically. So this gives us not only just the operating expertise and experience. And we admit, at Southwest we're novices to this, so get that from AirTran. And in addition to that, we get very meaningful insight into those international markets. And of course, these are markets that are expansion opportunities for us. So all of that is really invaluable. But they're very fine people, and they're very excited to be joining Southwest Airlines. We've added a lot of former AirTran folks into our leadership team. And again, I can't say enough of good things about our AirTran family members. They're doing a great job.

Jamie N. Baker - JP Morgan Chase & Co, Research Division

Okay, very helpful. And a quick follow up for Laura. I'll recheck my notes related to last year's FAA shutdown. Do you disclose what the estimated third quarter benefit was? It's fairly easy to compute what your net benefit was for that -- at that time. But of course, not all the revenue fell all at 1. it was spread across 2 quarters.

Laura H. Wright

And I'll let Marcy correct me, but I believe the July benefit was $36 million last year. So again, I think going back to John's question earlier, that could be playing into some of the comps year-over-year in July as well. But...

Jamie N. Baker - JP Morgan Chase & Co, Research Division

And do you have an August and September figure, since revenue recognition would have affected those months as well?

Laura H. Wright

We disclosed those, so Marcy Brand will follow up later.

Operator

We'll take our next question from Savi Syth with Raymond James.

Savanthi Syth - Raymond James & Associates, Inc., Research Division

First question is does -- I understand the -- out of the $700 million, $200 million is coming from the 717 transition. Could you break out the $500 million between the 6-seat and the 800 transition?

Laura H. Wright

I don't know if we've broken it out, Savi, but what we have disclosed is with the Evolve, the 6 extra seats, that's conservatively a couple of hundred million a year. This from some pretty easy math on that. You've got the benefits of the 800s and the Classics being retired, that would really make up. All 3 of those together make up the $500 million.

Unknown Analyst

Okay. And then just a quick follow-up. Could you provide what EarlyBird and the Pets and Unaccompanied were in the second quarter, as well as what those 2 end businesses were like in the first quarter?

Laura H. Wright

You bet. So in the second quarter, our EarlyBird was $40 million, that was up from $36 million last year. I'll get your first quarter in a minute. Pets, UMs and excess bag charges were $19 million, that was slightly different, Southwest against standalone, that was equal to last year. And I don't know if I have 1Q in front of me. Again, I think that's something we can follow up with you. Marcy Brand will give you a call.

Operator

And we'll go next to Glenn Engel with Bank of America.

Glenn D. Engel - BofA Merrill Lynch, Research Division

A couple of questions. First on the 737 Classics, now, that you're pushing out the retirement of those, does that mean that maintenance is going to remain elevated for a few years?

Gary C. Kelly

Well, let me just -- while Laura is thinking about your maintenance question, just to clarify, we had an original useful life plan for our Classics. We accelerated the retirement of those. Then when we reached the -- in our planning, then when we reached the deal for the 717s, we pushed some of the accelerated retirement dates back a bit. But they're still earlier than what they would have been had we kept them the entire useful life. So I don't know that that's meaningful to your question. But...

Glenn D. Engel - BofA Merrill Lynch, Research Division

That tells me the depreciation impact that you talked about earlier in the year will be somewhat less than you previously said.

Gary C. Kelly

Yes, there's just a lot of things that are going on in our fleet estimates and retirement dates, and then are we going to have a 717 deal. So I think all that now is finally settled, and Laura has also updated salvage values and just a number of things related to all of the depreciation charges. But on the maintenance...

Laura H. Wright

Yes, and so what I'm going to say to Gary's point, some airplanes still aren't accelerated somewhat. We have 40 Classics retiring this year, which is a significant number. So we do expect to see benefit. But all in all, when we look at the total operating costs of the 717 on a nominal basis compared to our 737s, when you look at ownership, maintenance, all the operating costs, they're about the same. So when you think of it that way, we're not expecting to see maintenance increase as a result of this deal. And we'll still get the benefit of the Classics that have been accelerated from where they were.

Glenn D. Engel - BofA Merrill Lynch, Research Division

So the current level of maintenance cost for ASM is something that's a good steady-state number?

Laura H. Wright

You're looking out for 2013 and beyond?

Glenn D. Engel - BofA Merrill Lynch, Research Division

Yes.

Laura H. Wright

Yes, we will give guidance on that for our 2013 plan. But certainly, with our fleet plan, we expect to see improvements over time with the acceleration of both the 717s and the Classics.

Glenn D. Engel - BofA Merrill Lynch, Research Division

So tax rate was relatively low in the June quarter, what will the tax rate be now for 2012?

Laura H. Wright

Yes, Glenn, it was 38% in the quarter, and we expect it to be in that 38% to 48% range for the full year.

Glenn D. Engel - BofA Merrill Lynch, Research Division

Why would it pop back up? Why wouldn't it stay down to 38%?

Laura H. Wright

It all depends on what your nondeductible items are, as well as just what your full-year PBT [ph] is. So that's why we are giving you a range. But certainly, a 38% range is reasonable.

Glenn D. Engel - BofA Merrill Lynch, Research Division

And finally, the headcount was up over 5% year-over-year in the June quarter, with capacity being down. Why? What's driving that and when will that reverse?

Gary C. Kelly

I think that's -- the same question, same answer that we've discussed perhaps as early as in the fourth quarter and the first quarter. We had -- first of all, we introduced a new frequent flyer program that simply required more support at our call centers. Now as that -- we actually have seen our calls offered this year compared to last year come down substantially. So I think some of the pressure that we had in our call centers is already behind us. The other thing that we are always trying to manage, Glenn, is just the right balance of staffing and overtime and other forms of premium pay. Last year, I felt like it was a little bit pushed too hard, and we had too much premium pay. So we have allowed for some of our staffing to increase in operating groups across the company, primarily in the call centers, by the way. But the overtime and the premium pay and all of those categories are down substantially, and the overall unit costs performance in salaries, wages and benefits was quite good in the quarter, as an example. So I don't expect our staffing to continue to increase. It has slowed to a crawl, if anything, for all the reasons that you pointed out. So now, all we're doing is simply trying to optimize the cost and the service levels, understanding that we're trying to keep our fleet roughly flat and more importantly, our trips and capacity roughly flat.

Laura H. Wright

And Glenn, I was going to add to that is on the AirTran side, Southwest is doing all of the ground service AirTran had outsourced previously in the stations that we both -- and we're doing that much more cost effectively, but it does mean we have more heads than we had on a combined basis.

Operator

And we'll take our next question from Hunter Keay with Wolfe Trahan.

Hunter K. Keay - Wolfe Trahan & Co.

So a question, Laura, just to follow up on the CASM x fuel commentary for the third quarter. You said mid to high single digits but that was, I guess, you said excluding profit-sharing. So assuming you have in higher profit on an absolute basis, which looks like it's going to be the case. Should we expect that CASM x fuel off the 7.39 number to be actually closer to straight up high single digits? Am I thinking about properly?

Laura H. Wright

I think that's probably reasonable. Let me just walk you through, Hunter, some of the items just so you can understand where the costs are coming from. But to your point, 2Q on a CASM x fuel, it was up 4.3, it was 2.7 with our profit-sharing, just to put that in perspective. And what we've got in the half of the year is I think Dan asked a question on Evolve. We've got 50 airplanes that were down in the first 6 months. I think it was maybe only 40. And we've got 100 per quarter in each of the third and fourth quarters. So that's going to be expensed, and that's going to put more pressure on our maintenance expense in the third and fourth. But high return on investment on that. On the airports, we've got some really nice credits that happen to hit in the second quarter. So all in all if you look at our airport costs for the year, they make sense. But first half is coming in lower. We are having some adjustments on our depreciation and ownership as a result of the myriad of things going on in the fleet side that are going to hit the back half of the year. And advertising is the other item where we significantly underspend on advertising and deferred a lot of that. So again, that's an investment that's going to hit in the back half of the year.

Hunter K. Keay - Wolfe Trahan & Co.

And as you think about the buybacks, you guys got very aggressive on this on your announcement, which I think a lot of the people appreciate. But how -- can you maybe give us some sense for the timing of those buybacks during the quarter? Sort of obviously, there's quiet periods or blackout periods that you can't buy the stock, and how should we think about how you think about timing future buybacks? Do you try to get opportunistic pullbacks, or is it more sort of systematic, methodical approach? Just anything in that area will be great.

Gary C. Kelly

I don't think we can give you any answers to those questions. I think first of all, we're managing the business and in particular, our operating cash flow. Secondly, we want to manage our operating cash flow in such a way that it drives free cash flow. So it will have -- we'll be thinking about having an available amount of money that we want to provide to our shareholders. But that, again, that just depends upon the performance and the availability of that money. I think the other way to think about the share repurchase and the reason that the board did authorize an increase back in May is because we were anticipating that we would before the next board meeting, which is next week, that we would be completing the first authorization. And we certainly wanted to acknowledge to you and the rest of the market that we're still willing to be a buyer, given the circumstances that I described. But there is no deadline. We'll certainly give no pricing guidance or timing guidance whatsoever.

Operator

And we have time for one more question. We'll take our last question from Jeff Kauffman with Sterne Agee.

Jeffrey A. Kauffman - Sterne Agee & Leach Inc., Research Division

Our questions have been answered.

Operator

At this time, I'd like to turn the call back over to Ms. Brand for any additional or closing remarks.

Marcy Brand

Thank you, Tom, and as always, if anyone has follow-up questions, Gary and I are available. Thank you all for joining us today.

Operator

Ladies and gentlemen, we will now begin our media portion of today's call. I'd like to first introduce Ms. Ginger Hardage, Senior Vice President of Culture and Communications.

Ginger Hardage

Right. Thanks so much. Now is the time we'd like to begin the media portion. So I now will queue up the questions for you all to be able to post those to Gary, Laura and Bob. So will you please give those instructions?

Operator

[Operator Instructions] We'll now begin with our first question from Matt Joyce with the Dallas Business Journal.

Matt Joyce

Matt here. I wanted to ask, Gary, what's your take on Spirit's expansion at DFW Airport and how it relates to the competitive feel for Southwest?

Gary C. Kelly

Gosh, Matt, I don't know that I have any particular reaction. Clearly, Spirit is one of just a very few airlines that are adding aircraft and expanding in this environment. And so we're mindful of that, and I don't know if you heard Laura's report earlier, but we're continuing to manage well, I think, out of Dallas Love Field and are looking forward to the day when all of our construction is complete over here and the Wright Amendment restrictions lapse. But Spirit is adding, they're adding airplanes and they're adding flights. And I think that's a fact. And they're a very, very fine airline, and we take that competition very seriously.

Operator

And we'll take our next question from Kelly Yamanouchi with the Atlanta Journal Constitution.

Kelly Yamanouchi

I just wanted to ask for a clarification. I think there was something I didn't understand about why is it that the net conversion, aircraft conversion costs are increasing by $50 million?

Gary C. Kelly

Well, very simple: because the cost of converting the aircraft is going to be higher than what we would have spent on it. And for us to make a deal with Delta, we agreed to pay those conversion costs. I would just -- just to further explain, we just amazingly found a home for all 88 of those aircraft. And so you might think of it as a volume discount that we were willing to offer to induce our sublease customer here to take those aircraft. But that's all it means is that the cost of converting the aircraft is going to be more with this deal than what we thought it would be. And as to how we make that work, well again, Laura explained that the value that we get from not flying the 717s and instead flying the 737s is substantial. So it -- what -- we'll pay for that conversion cost in the first 6 months.

Kelly Yamanouchi

And when you say the cost of the deal is more than you thought it would be, you mean the AirTran acquisition, right?

Gary C. Kelly

No, I was saying the cost to convert an AirTran 717 into Southwest, we were going to spend $50 million. The cost to convert those over to Delta is going to cost $100 million. We're spending more money on the aircraft conversion, and there's also some modest accounting differences and subleasing the aircraft versus just using it ourselves. But the fact is, the Delta conversion cost is more than what the Southwest cost would have been.

Kelly Yamanouchi

Why is it not less if they're maintaining a front cabin?

Laura H. Wright

Kelly, it really comes down to their design for the spec of the airplane. So they're going to make more changes to the airplane than we would have.

Operator

We have time for one more question. We'll take our last question from Andrea Ahles with Fort Worth Star-Telegram.

Andrea Ahles

I was wondering if you could give a little more commentary on your fares. It looks like airfares were up 5% for you guys to about $150 is your average fare for this quarter. Could you talk a bit more about the fare environment, and where you think it's going to be going heading into the fall travel season?

Gary C. Kelly

Well, I think it's a little bit too early to tell you what the fare environment looks like, at least for the second quarter until we get all the earning results. But I think we have some idea what the rest of the airline's revenue results for the quarter, and they were all pretty good. I think the airline business right now has adjusted to the state of the economy and higher fuel costs. So I don't see that -- but again, based on Laura and Laura's and my earlier report, we're looking for a solid third quarter. We have some distortions with the Fourth of July holiday following on a Wednesday that she commented on and, I don't know if you heard that, Andrea. But otherwise, I think our business looks like it's continuing along. What I said earlier I would just repeat, which is I think it's prudent to be cautious in this environment just given the state of affairs in the world and our domestic economy. But aside from those normal cautionary comments, our business is continuing to be strong. We have very full airplanes and at least no immediate threat of higher energy costs like what we were saying in the first quarter, that seems to have steadied. I won't agree that these lower energy costs, which I heard some commentary earlier this morning on. They're not low. They're very high. But at least there's steady. And when we've adjusted our business to these levels of fuel costs.

Robert E. Jordan

And Andrea, if I can add one thing -- this is Bob. As Gary noted about just a little bit of caution, I think the second quarter for the first time in a long time was the first quarter where we had no domestic fare increases as an industry that stuck. So that gives you a little view into how the industry, I think, is thinking about the pricing power and all that. So that's a little bit unusual that we did not have any fare increases pushed through in the second quarter.

Andrea Ahles

Gary, you mentioned lower energy costs with the way you guys are being penalized for your fuel hedging contracts right now because oil has kind of stayed down and is not as high as had originally been anticipated. Will that change your approach to fuel hedging contracts in the future since you continue to see sort of a negative impact from those contracts?

Gary C. Kelly

Well, Andrea, sorry, I had the same reaction. Fuel costs aren't low, and we're not seeing any significant penalty for fuel hedging. Fuel hedging, by definition, is an insurance program. And best case is we spend some money on that coverage and never have to use it. So we had -- I think our folks have done a marvelous job of managing our fuel hedge position. There was a $0.03 penalty in the quarter, if you want to call it that...

Laura H. Wright

$0.04

Gary C. Kelly

$0.04. And that's -- we have positioned the fuel hedge this year to allow for declining prices and for the most part, our folks have participated with all of the reduction in fuel prices. With respect to our program going forward, we're about 30% hedged in the second half of this year, close to 60% hedged next year, about 50% in 2014. We've got positions in '15 and '16, all that is in our press release. So no, we'll continue to be very active in fuel hedging because if you don't have the protection in place, it's an enterprise risk. So it's really just that simple. So then the challenge for our folks is trying to spend an appropriate amount on the program that doesn't penalize the company. We spent less money on fuel hedging in 2012 than we have over the last couple of years. And again, I feel very good about our fuel hedging program. We have substantial protection in place when fuel prices go back up, as they certainly will.

Operator

And at this time, I'd like to turn the call back over to Ms. Hardage for any additional or closing remarks.

Ginger Hardage

Well, thank you again for participating today. If you think of any additional questions you might have from the media, don't hesitate to call (214)792-4847 and we'll get those additional answers for you. But thank you so much for calling in today.

Operator

And ladies and gentlemen, this does conclude today's call. Thank you for joining.

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