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Southwest Airlines Co (NYSE:LUV)

Q2 2008 Earnings Call

July 24, 2008 12:30 pm ET

Executives

Gary Kelly - Chairman, President and Chief Executive Officer

Laura Wright - Senior Vice President Finance and Chief Financial Officer

Analysts

Bill Greene - Morgan Stanley & Company, Inc

Mike Linenberg - Merrill Lynch

Dan McKenzie – Credit Suisse

Ray Neidl – Calyon Securities.

Duane Pfennigwerth - Raymond James

James Parker – Raymond James

Gary Chase - Lehman Brothers

Kevin Crissey – UBS

Operator

Welcome to the Southwest Airlines second quarter 2008 earnings conference call. Today’s call is being recorded. We have on the call today, Gary Kelly Southwest’s Chairman, President and Chief Executive Officer and Laura Wright the company’s Senior Vice President, Finance and Chief Financial Officer. Before we get started please, be advised that this 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 the actual results to differ materially. This call will also include references to non-GAAP results, therefore please see our earnings press release in the Investor Relations section of our website at southwest.com for further information regarding our forward-looking statement and for a reconciliation of our non-GAAP results towards GAAP results. At this time I’d like to turn the call over to Gary Kelly for opening remarks. Please go ahead, Sir.

Gary Kelly

Thank you Matt for that intro, and thanks everyone for joining us this morning for our second quarter earnings call. I will start it out by saying it was a very gratifying quarter in many, many respects, we are making tremendous progress in our efforts to transform Southwest and overcome a very challenging economy and worse, come to grips with gigantic jet fuel price increases—and our people deserve all the credit, they are doing a spectacular job in every way of navigating through this boiling cauldron of issues facing our industry. First of all, our customer experience in our brand continue to lead the industry in all of our research and surveys suggest that the changes that we are making are for the better.

Our operations continue to be excellent and among the leaders in the industry, I am especially pleased with our on-time performance. Very nice improvement in the baggage handling, and of course in our continued schedule reliability. Our flight schedule is under continual optimization efforts to trim flights that are successful in today’s fuel price environment, and our fleet growth has slowed dramatically this year in response to this difficult and volatile environment. But still, our schedule planning group has been able to capitalize on the huge success we’ve experienced in Denver and really focus our growth on that market. These route system changes have certainly contributed to a strong unit revenue performance this year so far a more refinements are baked into our future schedules over the next couple of quarters. We will be deciding very soon what our flight schedule plans will be for 2009, and as I have previously said, the range for our growth next year in terms of the fleet is anywhere from zero to 14 and we will make those decisions soon. And we have a number of factors at work here of course; we have a weak economy, growing operating cost, higher fares that dampening demand and all of that is being off set by huge fleet reductions in our markets by our competitors.

After Labor Day our competitors have scheduled fleet reductions of 15% so that’s 15%. But even with that, our outlook is very cautious. Our available fleet mile growth in the third quarter is only 2.4% that will drop to over 1% in the August, September time frame and our fourth quarter capacity growth year-over-year is just over 1%. And a way to think about it is that essentially from July forward, through the end of our schedule, our flying is essentially flat. And of course I have not taken into account holiday and other season’s variations. In the mean time crude oil prices have really played havoc with our 2008 revenue management plan. We’ve stared the year at $90 to $100 to $145 and now back down to $125 a barrel.

We’ve introduced new aggressive revenue management tools and techniques along with our new Business Select product. But with the sharp rise in oil this year, we’ve had no choice but to push through fare increases—four since April—we’ll have to continue, but gradually. We have a wonderful opportunity in this environment to differentiate Southwest Airlines in customers’ minds with our no-fees marketing campaign. So all combined, I was very, very proud of our company’s efforts, for revenues is very strong 11.1% in the quarter and that was right on our plan.

On the operating cost side, our people deserve a huge thanks. Excluding fuel, our operating costs were under budget for the quarter, and despite a very heavy calendar of engine overhauls and airport cost pressures our unit cost were up only 1.8% versus a year ago; again that’s ex fuel. And a particular note, our employee productivity improved by over 4% versus a year ago, as measured by head-count per air craft, and our fuel consumption for available seat miles decreased almost 2% and that alone was worth over $25 million in fuel cost savings in the quarter.

Now I would just again underscore that all these efficiency gains are occurring while the overall service of Southwest Airlines is improving. I want to thank all of our people again for a superb effort, I heard of course our hedging program was huge. It generated $511 million in cash fuel cost savings in the second quarter alone.

During the quarter we announced two new Rapid Rewards partners: Avis Rent-A-Car and Thrifty Car Rental. We also reached a memo of understanding with WestJet and announced that, we begin code-sharing rights to Canada with WestJet in late 2009, and we also have celebrated. We had a tribute to our Chicago Midway employees and all of our Illinois customers with the introduction of Illinois One, which was a Boeing 737 painted in the Illinois flag liberty. All told a very successful quarter, and especially given the very treacherous environment we’ve had no service disruptions to the communities we serve. No pay-cuts for our employees, no layoffs. We have a very strong cash position, a strong balance sheet, the lowest cost, the best fuel hedge, excellent operations, and the best customer value. And no one is better prepared for this environment than Southwest Airlines and I suspect that discipline is probably our greatest strength. So with that very quick overview, I’d like to turn it over to our CFO Miss Laura Wright.

Laura Wright

Thank you Gary and good morning everyone including our Webcast listeners. In addition, to Gary’s comments, I’d like to take a few minutes covering some additional aspects of our second quarter financial results.

Our GAAP second quarter net income was $321 million or $0.44 per diluted share compared to last years $278 million or $0.36 per diluted share, excluding special items which from early relates to added period FAS 133 item our second quarter 2008 net income was $121 million compared to 195,000,000 in second quarter 2007.

Our net income excluding special items of $121 million reflects our true economic cost of fuel which reflects the benefit of the $511 million cash settlements on field derivative contracts for the quarter. Our GAAP net income of $321 million includes non-realized gains on future fuel hedges which represents the most significant difference between our GAAP net income and our net income excluding special items.

Our net income for diluted share excluding special items was $0.16 in the second quarter, which was ahead of Wall Streets’ mean estimates of $0.12 per diluted share. Despite the weak economy and more difficult year-over-year comparisons, caused by East or shipment cost of this year, we reported record operating revenues of $2.9 billion and a year-over-year revenue for available seat mile for PRASM growth of 5.3%.

While we are making nice progress on the revenues side, the world has changed dramatically in a very short period of time, and we are moving as quickly as we can, to adjust to higher jet fuel prices.

In addition to fewer fare sales and promotions, we implemented four fare increases since the beginning of the second quarter, one of which will not be effective until the fourth quarter. A cumulative effect of our fare move and our enhanced revenue-management efforts drove most of the 6.5% yield growth in the second quarter. Our yield trends strengthened throughout the quarter of June up almost 13% verses a year ago.

As fares have moved higher and the economy has continued to weaken, we have seen some fall-off in demand as evidenced by the 3.9 points decline in our June load factor 78.2%. Still, the results for June were encouraging with year-over-year PRASM at approximately 8%.

Based on the revenue and booking trends so far, in July including a strong performance over the fourth of July travel period, we expect strong yields as lower loads to continue into the third quarter. Although July’s load factors will likely be down more than June, year-over-year decline, our July PRASM is also expected to increase in the 8% range compared to July of ’07. In addition to the excellent efforts of our revenue management team were also making strides in our revenue initiative.

We continue to see growth in our new Business Select product and the revenue increase from Business Select for the second quarter was approximately $20 million up from first quarters 15,000,000. Our continued schedule adjustment and industry capacity test also contributed to our record revenue performance. We’ve aggressively adjusted our public schedules over the last year to eliminate non-productive flying. And since last year, we’ve actually redeployed 67% of unproductive capacity in the developing markets such as Denver and San Francisco. This markets are responding exceptionally well for Southwest service. And Denver in fact is our fastest growing city ever and we are going to be at 115 daily departures to 32 markets by November. We have also added service to more mature markets such as Dallas Love Field to meet increased customer demands resulting from the Wright Amendment compromise, and although our second quarter 2008 revenues reflected the loss of 88 code-share revenue, we are making excellent progress to expand our network for code-share arrangements and we are very excited about our recent announcement to code-share with WestJet in Canada by the end of next year.

Our 2009 and 2010 revenue initiatives have such as our enhanced Rapid Rewards frequent flyer program and our efforts to evolve southwest.com are also progressing nicely. We had a strong other revenue performance. We were up 13.3% at $85 million and that was primarily due to higher charter revenues. We expect another year-over-year credit again in the third quarter but not at the same rate experienced in the second quarter.

Our freight revenue increased 12.1% to $37 million and that was primarily due to increased rates and we expect a comparable increase in our freight revenue for the third quarter of ’08. Our costs continue to be under enormous pressure as a result of foreign fuel prices. Our second quarter unit cost excluding special items increased 10.5% to $0.0998 largely due to the significant increase in fuel cost.

Our economic fuel cost increased 35.2% to $2.19 per gallon even with $511 million in favorable cash settlements from our derivative contracts. However, the steel cost performance was better than expected. Market prices for crude oil and the [inaudible 00:21:50] spread soared during the quarter however lower than expected jet fuel deferentials, and a better overall hedge performance more than offset the higher prices resulting in a better than expected economic jet fuel cost per gallon at $2.19.

We have realized over $800 million in year-to-date cash settlement gains from our successful hedging program including the $511million from the second quarter. The premium cost of our hedging program was $40 million in the second quarter and we expect approximately $20 million in premium costs in the third quarter and these are recorded in other gains and losses. On a year-over-year basis, unit costs excluding fuel increased 1.8%, primarily due to higher maintenance expense, higher airport costs and fuel taxes which are recorded in other operating expenses.

Excluding fuel, we were pleased with our better than expected unit cost performance of $0.0672 up slightly from the first quarter of 2008 $0.067 versus our guidance of up 2%. We had better than expected cost performance in almost every category. On a year-over-year basis, unit costs excluding fuel increased 1.8% primarily due to higher maintenance expense, higher airport costs and fuel taxes which are recorded in other operating expenses.

Excluding fuel and special items if any, current trends suggest our first quarter cost will be in line with second quarter 2008 of $0.0672. On a year-over-year basis, we expect cost pressures in maintenance, airports and fuel taxes to continue into the third quarter. As expected, we had a significant increase in our second quarter maintenance unit cost $0.73. The 17.7% year-over-year increase was primarily driven by engine repair costs, which represent more than half of our maintenance expenses. All of our classic engines have been covered and are power-by-the-hour contract with General Electric, our dash 700 engine repairs have been on a time and material basis which is event driven.

As announced recently, we have extended our existing power-by-the-hour contract with GE, and now include our dash 700 engines. A new tenure on-point solution agreement with General Electric will transition our dash 700 engine repairs through a power-by-the-hour contract beginning this quarter. This contract will provide us long-term, cost effective, comprehensive leverage support and services enabling us to more accurately predict our engine maintenance costs. It should also significantly reduce the volatility that we have been experiencing in our maintenance unit cost due to the event-driven nature of engine repairs.

Based on current trends and factoring in the new engine contracts, we expect our third quarter 2008 maintenance unit cost for the airline with second quarter’s $0.73. Our salaries, wages and benefits declined 2% on a unit basis to $3.19 versus last year. Share base compensation expense was 5,000,000 in the second quarter of ’08 compared to 13,000,000 last year; our profit-sharing expense was 36.8 million for the quarter versus 55.1 million last year- and our second quarter 401(k) contributions was 38.9 million versus 36.8 million last year. Excluding the impact of profit sharing and 401(k), we expect our salaries, wages, and benefits for the third quarter to be in line with seconds quarter’s 2008 $0.0288. As a reminder last year’s salaries, wages and benefits included a $25 million charge related to the voluntary early-out program.

Our other operating expense unit cost increased 3.4% to $1.50 in the second quarter, compared to $1.45 last year. We are experiencing more volatility in other operating unit costs due to the higher physical price of fuel. A total fuel tax expense for second quarter 2008, which was included in other operating expense and not fuel expense, increased over 30% over last year to $51 million.

We expect our third quarter other operating unit costs—excluding any potential gains on aircraft sales which I will cover later—to be in line with second quarter of 2008. The second quarter 2008 affected tax rate on earnings excluding special items was roughly 40%, and we currently expect that our third quarter and full year 2008 tax rate will be in the 40% range on our earnings excluding special items.

Turning to the balance sheet, we feel very good about our liquidity and our access to capital. We remain the only U.S. Airline with an investment credit rating. Our leverage, including our off-balance sheet aircraft leases, is under 40% and as you know we entered the quarter with 5.8 billion in cash and short-term investments. In addition we had another 172,000,000 in auction rates securities recorded as other assets.

At quarter end, our cash and investments included $4.4 billion in cash collateral to profits related to our fuel heads, which has a corresponding liability recorded in accrued liabilities. We also have a 600,000,000 in secured line in credit that remains fully available and the value of our un-incumbent aircraft is between 9 and $10 billion. In addition we also had over $400,000,000 of cash on from the deposit with Boeing for future aircraft deliveries.

Our 2008 capital expenditures are still expected to be in the $1.1 billion range. We have, however, reduced our capital spending commitments for 2009 to approximately $1 billion. We continue to evaluate our future fleet plans, and to the expense we make any reductions will also be reducing our forward CapEx plans. At quarter end we had 733,000,000 shares outstanding.

Turning to the fleet, we acquired 9 dash 700s from Boeings during the second quarter and we grew our ASM by 5.4% in the quarter. With respect to our 2008 fleet plans, we still plan to accept 29 new dash 700, of which we’ve already received 24 as of today. We now plan to retire 14 aircrafts this year by a net aircraft growth of 15, and of those 14 we have already returned 6 leased aircrafts this far, we currently plan to return three more during the third quarter and we have five aircraft that we are marketing for sale. Demand for the aircraft has been impacted by higher fuel prices and lack of credit resulting in decreases in values from a couple of quarters ago. However due to lack of availability from manufacturers there is still a decent demand for the next generation airplanes.

This fleet plan results in an estimated year-over-year 2008 ASM growth of no more than 4%. For the third quarter our ASM growth is estimated in the 2% range and in the fourth quarter in the 1% range. Over the past year. we’ve adjusted our growth plans a number of times as we continue to take the necessary steps to adjust to market jet fuel prices and to restore our profit margins. We do have a flexibility to adjust our flight schedule as necessary, to continue to eliminate unproductive flying or balancing any strategic opportunities that may present themselves during possible industry consolidations or downsizing in this high field environment. All signs point to a weak economy in 2009 and we are cautious about our growth plan. Although our 2009 billing delivery have not changed, we are evaluating our currently pre-plans and we may not grow our ASM capacity growth in 2009.

We have the flexibility with our fleet, with a number of leased aircrafts that can be returned. In addition, due to the fact that we have some many owned aircrafts, we have even greater fleet flexibility than most carriers. Our billing delivery schedule for the remainder of ’08 hasn’t changed and the reminder of the delivery scheduled for 2015 is also unchanged from last quarter as provided in earnings release for your reference.

And finally, our capacity by region for the second quarter was as follows. North East 14%, North West was 4%, South East 15%, South West 14%, Mid West 17%, and the West 36%. And Matt with that, Gary and I are ready to take questions.

Question-and-Answer Session

Operator

Thank you (Operator Instructions) We will go first to William Greene with Morgan Stanley.

Bill Greene - Morgan Stanley & Company, Inc

Yes, hi Gary and Laura. I am wondering if you can talk a little bit about your pricing strategy, because you noted that you want to be somewhere gradual in these price increases, and obviously the fuel hedge gives you some time there but if we exclude the fuel hedge, term possibility is quite challenged. So how much of the pricing decision is competitive in terms of what you are trying to do, relative to the competition, how much of it that you just don’t think you can actual push it through?

Gary Kelly

Good morning Bill. I think mostly we are certainly doing what we can do to improve our capabilities on appliance and tools and techniques and technology perspective. So I think we’ve got opportunities to perfect our methods if you will, but I think that there is risk in sub-optimizing revenues over the near term by pushing fares too fast, and you saw our June monthly load factor down 3.9 points. We were set and, as Laura reported, our GNU revenues were up over 8%, so Bill we felt really good about that, but the $64 million question is always had we somehow managed to keep load factors flat, would our unit revenue performance have been better than that. So we know, like everybody knows that we got to get our average fares up and we’ve got to get them up from where we are substantially. So, we are going to do that as we’ve said in a gradual way, so that we can continue to be confident about our ability to execute number one, but number two we are trying to make a buck here in the meantime also. But I don’t think anybody believes that we could in short order increase our average fares by $30 or $40 and have that be successful. I think that that would be unsuccessful. We have some evidence of course with our, in the industry with our competitors where they feel like they’ve pushed fares too fast they’ve seen bookings in demand reduced and then they’d had to have the follow-on reaction of reducing flights, fleet, laying off employees and so there is just no pleasant way on the downside there to make that happen. But I think we are pretty comfortable in the plan that we’ve laid out here and over the course of the next 18 months, we are going to do everything we can to get our average fares up substantially and then we will obviously be evaluating the remaining demand and make schedule adjustments accordingly. One of the big swinger items here is the fact that our competitors are in full retreat mode and we have got a 15% reduction occurring just after Labor Day, and we do not know yet what kind of benefit that will provide us either with fares or with passengers. So this is an intertip process and we are evaluating our performance. I don’t know that I would say every week, so literary but we are evaluating it constantly and we are just in a position where we are going to have to be prepared to make constant adjustments based on the results that we see. So I would say that mainly our—the short answer to your question is, we are trying to thread the needle of optimizing revenues at the same time that we are boosting our fares. We have got a lot of experience over 37 years of lowering fares, stimulating demand and meeting that and now we have the reverse scenario where we are forced to raise fares and I think we just want to be wise about how we go about that.

Bill Greene - Morgan Stanley & Company, Inc

Okay, so well if we look then at the other revenue trends, right and you have talked in the past about kind of trying to drive some of these non-fare initiative that the other revenue itself the growth rate slowed quite a bit and I realized you are using it as a somewhat of a competitive marketing campaign with the no fees and whatnot but I would still think that there is plenty of opportunity there and that the public probably to some extent expects you to try to offset some of these fuel costs with some fees like baggage fees and whatnot. It is not clear to me why we are not showing greater growth there?

Gary Kelly

Good question. I think that we have made a strategic choice at this point to continue to be more customer-friendly and recoup our costs through transparent fare increases as opposed to changing what has been our customer expectation for decades. And our brand rankings are showing, I think, the wisdom of that approach. What we have got to prove to you and ourselves is that also translates into a superior revenue performance—and I will let Laura speak to the variance in the other revenues, I think that is mainly timing but what I would describe as ancillary revenue opportunities are in front of us. So those are under construction in the forum of southwest.com and Rapid Rewards and will not come online, Bill, until later next year. The choice of charging for bags and change fees and other things is – that is available to us and if we find that that is what customers prefer, then we can change to that but right now we are in the enviable position of where we can differentiate Southwest Airlines dramatically from the pack and in a more tangible way than we have traditionally. So I think that we will win with more customers because we have better service, lower fares and a more customer friendly fare offering. Laura do you want to speak on the timing of the other revenues?

Laura Wright

The other revenues were really as we expected and there wasn’t any really was any discernible change in the trends and to Gary’s point, there was just some timing of events year-over-year but we were actually had increases in our total revenue which was actually better that we have had but the rest was as planned and in line to what we have been seeing.

Bill Greene - Morgan Stanley & Company, Inc

Okay. Thank you.

Operator

We will go next to Mike Linenberg with Merrill Lynch.

Mike Linenberg - Merrill Lynch

Yes, just two questions, Gary, the 15% reduction in seats, is that specific to LUV markets or are you talking about across the domestic industry, just a clarification?

Gary Kelly

Thanks Mike. That is specific to LUV markets and further to our specific airports. So there is a disproportionate reduction, in other words, taking place in the industry where there is a direct competitive overlap for Southwest Airlines and of course we welcome that.

Laura Wright

And Mike, that is the competitor’s seat in our market.

Mike Linenberg - Merrill Lynch

Okay, good. And then my second, and it is helpful, my second question, I realize that the WestJet, it’s a year away but any early view on what the annual revenue could be? I guess ATA was worth $40 million or maybe $50 million of annual revenue at its peak, is this of similar magnitude is this half the size, anything that can just give us a sense as we sort of build out the various buckets of what you are doing on the revenue side to hit the ’09 ‘10 target.

Gary Kelly

Well, you know what its kind of like our Business Select product, our Business Select product we think it has about $100 million annual revenue opportunity so I don’t know whether you want to call that a single or a double compared to our overall needs, but we need a whole series of those kinds of hits and I would put the WestJet opportunity in the ATA realm I don’t think its going to start out generating $30 million or $40 million or $50 million a year but I think that we are all hopeful that that’s the kind of potential that it has and obviously if we do better than that we’ll all rejoice but Canada is our first announcement we are still – and hopefully that’s exciting to our various constituents. We are working very hard on a Hawaiian solution as well as a Mexican and the Caribbean solution which with a little luck we’ll get all of those executed by the end of next and in the aggregate obviously we are pretty excited. I don’t know whether I would call all that an aggregate a grand slam home run, Laura, but I think its certainly very tangible progress and there is no doubt with our network that we are going to plug in and generate a lot of connecting passengers. So it’s a very tangible opportunity and one that I hope will rump up very rapidly.

Mike Linenberg - Merrill Lynch

Okay, very good thank you.

Operator

We go next to Dan McKenzie with Credit Suisse.

Dan McKenzie – Credit Suisse

Yes hi, good morning guys or good afternoon.

Company Speaker

Hi Dan.

Dan McKenzie – Credit Suisse

One quick housekeeping question here, where are you at in ramping up with Galileo and how that is contributing to average fares?

Gary Kelly

Well we are still in the construction process, I think that its full potential is still much greater than what we are experiencing today. We don’t have all of the capabilities in place to be able to turn on all of those travel agents full-up if you will so and there are things like exchanging rapid frequent flier numbers and ticket numbers and things that are important to a number of customers that we are still in the construction phase and likewise Worldspan is still in the construction. So those are all upside opportunities that are in front of us.

Dan McKenzie – Credit Suisse

Got it okay, and then Gary just following up on the code-share opportunity, I know you’ve looked at M&A over the past year and I know your focus of course is international but given the code-share with ATA and I wonder if you can talk about the pros and cons of say a code-share with another domestic low-cost carrier to gain access to markets that Southwest hasn’t yet cracked in particular maybe Atlanta or Reagan National or LaGuardia?

Gary Kelly

Well, we had a great amount of business to LaGuardia in particular, but also to Reagan so those are on our wish list but each one of these-code share relationshipsm in addition to the infrastructure work that’s under construction right now to implement a new revenue accounting system and broad based code-share functionality and then on top of that international capabilities we also have to do some work, which I would roughly size at about 90 days worth of work per airline partner. So we can only build so much so fast and our priority has been let’s get Canada and Hawaii online first and then I think dependent upon our potential partners, it will probably define the priority of what comes next. What we told you all is that we’ll be working on Mexico and the Caribbean but it could somehow it could emerge that we have somebody who could codeshare for us to New York or Washington. But right now, Dan, those are lower priorities for us.

Dan McKenzie – Credit Suisse

Understood, and then just one quick final question here. The non-fuel unit cost pressures are evident in a number of line items including other costs and just wondering what can be done if anything to offset these pressures in the near term and then in the longer term as well?

Gary Kelly

Well I think on the maintenance side, we had a nice engine holiday there for a couple of years, and Laura was right along with our operations posted a phenomenal job of putting this new General Electric maintenance contract into effect. So I think that we, what she described was very significant, we now have a lot more certainty as what our engine maintenance cost will be from period to period that will help us plan around that. So I think we’ve settled then to a cost that is going to be more predictable and I don’t see us going back to the $0.5 per available seat mile that we experienced in the 2005, 2006 time frame. So but at least, the cost pressure that we’ve been experiencing there increase after increase should abate. On the airport side, it’s a different story and it’s a mixed one. I think a lot of the inflation that we are experiencing in airport cost is simply because in and you’ve seen this before in previous recessions, where the industry shrieked the operating cost of the airport are essentially unchanged and shared by the remaining operating carriers, so kind of a good news, bad news. We are increasing shares at the airport because of less competition, but it showing up in higher airport cost. We have a few airports out there that I think are spending more than they should, quite frankly and so there are some real total airport cost increases that we are very vocal about and are positioned to especially in this environment but for the most part it’s the former and not the latter.

Dan McKenzie – Credit Suisse

Okay, good. I appreciate that, thanks.

Operator

We’ll go next to Ray Neidl with Calyon Securities.

Ray Neidl – Calyon Securities.

Yes, Gary. Regarding growth, I know these are uncertain times, but you gave a pretty wide range for 2009, between 0% and 14%, I am just wondering…

Gary Kelly

No Ray, not 14%, 14 airplanes.

Ray Neidl – Calyon Securities.

14 airplanes, I’m sorry. Going back to the ’08. Okay. It’s still pretty wide range though, and I’m just wondering, what would be your thinking on going flat, 0%. What circumstances would need to come into effect for you to decide not to grow the airline, especially as your competitors are sharply cutting back. In the past you’ve taken advantage of airline if I cut back to pick up market share, what would daunt your decision making there?

Gary Kelly

Well, I don’t think the spread is that great, 14 airplanes next year is probably 2% to 3% potentially at the most. So you are talking about a spread of a couple of percentage points that we are considering and I would agree that it’s unlikely that we would put net 14 into service based on what we know right now. So I don’t know what else we can add, Ray. Those are the items that are in the mix, we’ll need to make a decision on our January schedule right now, we are published out through January the 8th, we’ll need to make a decision on the schedule that gets published January 9th through mid March soon and then we’ll, so we won’t have the advantage yet when we have to make that decision of what benefits we might see from industry cut backs post Labor Day. So I think that that is the only reason at this point that I would hold out that we might want to grow some next year, unless we see some, I believe we are going to see some fairly significant benefits from that. I don’t have a good strong argument to grow the fleet next year.

Ray Neidl – Calyon Securities.

Okay.

Gary Kelly

I think we’ve said for some time that we are seriously considering not growing the fleet. And if you would, the image I am trying to create here is not so literally zero airplanes; it is zero capacity growth in terms of trips and fleet miles and that kind of thing. And the other thing to know is that we are essentially not growing. Since the end of June for the balance of 2008, we are trimming some markets, we are adding some flights in other markets, but we are already in a mode where we are not growing Southwest Airlines so it’s not too hard to believe that we will continue that on into 2009. I agree with Laura’s comment earlier that the more the time goes by, the more concern we get about our overall economy in 2009 and certainly that is weighing very heavily on our views about growing capacity next year but right now we are not real bullish about adding flights at all, versus where we are operating today.

Ray Neidl – Calyon Securities.

Okay, good. I am glad to hear you being conservative around this aspect with the fuel where it is. The second thing is congratulations on the agreement with WestJet. In my opinion you are getting a fine partner there, somebody that mirrors your own model up in a growing market up in Canada. Now, from what I understand, the Canadians are talking about maybe removing ownership restrictions on their airlines. Do you see down the road that maybe Southwest making an investment, or even buying WestJet if they do loosen the rules a bit?

Gary Kelly

Ray, I would just, thank you for your compliment there. I would just say that we haven’t released any details of our MOU with WestJet and so if you would, my comments will speak directly to the MOU that we have with them. We are working on a formal codeshare agreement that requires regulatory approval et cetera so I hope we will be done over the next six to eight weeks. But our view of investments in other airlines is really unchanged at this point and we do not have any plans to do anything along those lines.

Ray Neidl – Calyon Securities.

Okay, great. Thank you.

Operator

We will go next to Duane Pfennigwerth with Raymond James

Duane Pfennigwerth - Raymond James

Thanks. Good afternoon Gary and Laura.

Laura Wright

Hi Duane.

Gary Kelly

Hi.

Duane Pfennigwerth - Raymond James

With regard to the 15% reduction in CTC and in the forth quarter, how does that compare with what you saw in the second quarter?

Laura Wright

Duane, it is down 6% in our direct markets in the second quarter and in the third quarter.

Gary Kelly

The only thing I might add to that thought or your question Duane is that this is compounding. So Laura I think the competitors were down in our markets in the fourth quarter of 2007 by a like amount, the 5, 6, 7% range. Though we’re continuing to see reduced competition and it’s pretty broad in terms of the markets where we are seeing reductions and in some cases we have seen competitors announce exits from markets, city pair markets completely.

Duane Pfennigwerth - Raymond James

That is helpful. And then just regarding your fuel guidance for the third quarter or 250, what does that assume amount the 20% that you are un-hedged?

Laura Wright

For the—we used yesterday’s market prices to really come up with our fuel guidance so that is really yesterday’s market prices for crude and crucks and then we will also consider if the actual hedge positions that we have Duane so.

Duane Pfennigwerth - Raymond James

Okay, thanks and I think Jim has a question as well.

James Parker – Raymond James

This is Jim Parker. Just quickly Gary to pursue this airport cost issue a bit further, in that a 15% of the freights come out against Southwest that means maybe 15% of flights, are the airports just going to make up that by charging you more and just going further? There is a lot of competition in Europe from smaller airports to get airlines to bring passengers in, when is the U.S. going to move in that direction if ever and if anyone should have the leverage, volume leverage to begin to move that it should be Southwest?

Gary Kelly

Jim, you are right on the mark my friend but that is the way it works. The airports financing is basically on a pass, they spend other people’s money and they spend the airlines money and it is a complete pass through so I completely completely agree with you that it is a very serious issue for the airline industry to get airport costs under control and of course primarily I am speaking to future spending that translates into future rates and charges but that is the way it works and in some cases we are seeing individual airport costs per passenger up in the 35%, 45%, 50% range. It is not a modest amount so very, very dramatic cost increases and the answer to Duane’s question earlier is that we are counting on revenue offsets there by picking up market share.

James Parker – Raymond James

Okay. Thanks.

Operator

We will go next to Gary Chase with Lehman Brothers.

Gary Chase - Lehman Brothers

Good morning everybody?

Gary Kelly

Morning Gary.

Laura Wright

Hi Gary.

Gary Chase - Lehman Brothers

Just ten seconds here. Laura, you said the fuel guidance was predicated on yesterday’s forward curve. Is that also true of the disclosures you made in the press release about the collateral deposits that add threads in it you gave a distinction between where it is at present and at quarters end.

Laura Wright

That’s correct; the press release reflects the collateral deposits as of yesterday, market value as of yesterday.

Gary Chase - Lehman Brothers

Could you elaborate a little bit more on what’s going on with cost in the third quarter, and I understand the maintenance issue but I guess what we are looking at it is as typically unit cost decline from the second to third quarter, is there something else? Because you know the maintenance story I understand it but it was there in the second quarter as well so what’s changed this time, you don’t typically see that.

Laura Wright

Well, what we have in the second quarter is really the three items that we’re seeing the most pressure on are maintenance which we had in the second quarter airport as well as the physical fuel taxes which assumed in other expenses for us. I guess what you have on top of that, Gary, is we’ve got a capacity growth in the second third quarter of about 2.4% versus over 5% in the second quarter.

Gary Chase - Lehman Brothers

Was there something in like the other expense line or something that helped in the second quarter?

Laura Wright

No it really isn’t so—

Gary Kelly

That maybe one that we have to take offline we’ll get to.

Gary Chase - Lehman Brothers

Yes, okay we’ll be happy to follow up. And then just this one last

Gary Kelly

I don’t think of any reason, I think basically you are just saying sort of constant unit costs obviously overall from second to third. I’d have to think about your annual, seasonal question a little bit more, sorry about that.

Gary Chase - Lehman Brothers

And then just one broader question I mean what you talked to this a little bit but, the ad campaigns that you’ve been running and what you described as an opportunity to take advantage of the fact that all those others are charging fees which are quite clever but, has anything changed in your philosophy about how you are going to drive this required revenue contribution? Or has this sort of been in the plan all along that you never intended to go there.

Gary Kelly

Gary we never intended to go in other words to fees, well I think I would admit that we have not been and I don’t think you would expect us to. We haven’t laid out exactly what our future announcements might be but I think it was the charging for the first bag is what we really seized upon. We’ve never had any thoughts that we would charge to check a bag and of course we carry more customers than anybody in the world so I think it’s pretty easy to represent we probably have a customer remote on our hands, now five years from now who knows what the expectation is going to be so right now I think it just gives a really sweet advantage and we are trying to take advantage of it. I will tell you and undoubtedly that our reservations employees tell me the first question they get when a customer is calling right now is do you charge to check a bag? And so I believe deeply that we are gaining passengers because of our approach and I’d be the first to admit that if we are in a mode where we have got to make adjustments to higher operating cost and if we determine overtime we are doing extensive research if we determine that customers are wiling and actually prefer fees because they get the hour cut choice, we’ll do it, but that’s not what our research and our results are telling us right now. And it’s not what we want to do, it’s just not consistent with our philosophy.

Gary Chase - Lehman Brothers

But when you outline that opportunity you never thought it was going to be fees is I guess what I’m saying.

Gary Kelly

I never thought that we would be contemplating charging for checked bags, now I will admit to you there are other fees that we are—we have contemplated, some we’ve dismissed and some we’ll probably continue to think about and a lot of it depends on how successful we are in the aggregate with all of our other revenues plans. The nice thing about Southwest is that we have an anonymous portfolio of opportunities to pursue, its not like we are down to the last opportunity and we would rather do all of those first with a superior customer experience and win that way. But we’ve got all these things in reserve if we need them and we ’ve just been, you know, as we’ve said many times over the last year and a half we are in a transformation phase and it is very exciting. So we just have a lot of more opportunities to generate a lot more revenue and I believe in what we are doing.

Gary Chase - Lehman Brothers

Thanks a lot guys.

Operator

We have time for one more question. We will take our final question from Kevin Crissey with UBS.

Kevin Crissey – UBS

Hey, hi guys.

Gary Kelly

Hi, Kevin.

Laura Wright

Hi, Kevin.

Kevin Crissey – UBS

Two quick ones. Laura, maybe you could address your August and September RASM (ph 01:00:39) comps a little bit, you talked July, 8 percent-ish, how tough was last year in August and September?

Laura Wright

How tough was last year?

Kevin Crissey – UBS

Well, if you got 8% last year in July this year, does your comparison get worse or easier in August, September?

Laura Wright

I think clearly September I think is an issue that we are all waiting to see what happens with demand and once we get past post-summer but if we look forward I think there is a lot of things going our way. We’ve got benefit of the fare initiative that we pushed through during the forth quarter. We should continue to see those ramp up during the quarter. We’ve also got better comparisons on a year-over-year basis not only with our competitor’s capacity but with our own capacity. We’ve got last year-over-year growth as we move through the quarter as well and on the other hand as we’ve mentioned a few times on the call, we are cautious about the economy and what our consumer’s reaction is going to be to high fares and what that is going to do to the demand equation. So I think it is too early to really give any guidance but we think there is a lot of good things going our way.

Kevin Crissey – UBS

And then the last question I guess for the call may be is what do you see in terms of the regulatory environment or just the environment in Washington regarding consolidation and greenhouse emissions and small communities that are losing service and basically what is happening on the hill that might be of interest for the airline and how do you fit in to that?

Gary Kelly

Well there is a lot and so right now I do not sense that there is anything eminent from a regulatory perspective but there is a lot under discussion on all of those points and I would say that our trade association, the Air Transport Association is working very hard to manage all of those various issues but they are active and they all require attention. There is not anything that is all that meaningful underway “re-regulation” and the first question that you and others should ask is, have you defined “re-regulation” because I think people have different ideas in mind. But on climate change, Passenger Bill of Rights, FAA re-authorization. Again there is a long list of issues under consideration in Congress that are being minded about but it doesn’t appear if there is anything eminent on that part.

Kevin Crissey – UBS

Thank you.

Operator

At this time, I would like to turn the call back over for any additional or closing comments.

Laura Wright

Thank you, guys for joining us this morning. The IR team will be available to take any calls that you have and hope everybody has a great day.

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Source: Southwest Airlines Co, Q2 2008 Earnings Call Transcript
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