Southwest Airlines' (LUV) CEO Gary Kelly on Q2 2014 Results - Earnings Call Transcript

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Southwest Airlines (NYSE:LUV) Q2 2014 Earnings Call July 24, 2014 12:30 PM ET

Executives

Marcy Brand -

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

Tammy Romo - Chief Financial Officer, Principal Accounting Officer and Senior Vice President of Finance

Ginger C. Hardage - Senior Vice President of Culture and Communications

Michael G. Van De Ven - Chief Operating Officer and Executive Vice President

Ron Ricks - Chief Legal & Regulatory Officer and Executive Vice President

Analysts

Michael Linenberg - Deutsche Bank AG, Research Division

Hunter K. Keay - Wolfe Research, LLC

John D. Godyn - Morgan Stanley, Research Division

Helane R. Becker - Cowen Securities LLC, Research Division

Helane R. Becker - Cowen and Company, LLC, Research Division

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Joseph W. DeNardi - Stifel, Nicolaus & Company, Incorporated, Research Division

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

Thomas Kim - Goldman Sachs Group Inc., Research Division

Operator

Good day, and welcome to the Southwest Airlines Second Quarter 2014 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 call over to Ms. Marcy Brand, Senior Director of Investor Relations. Please go ahead, ma'am.

Marcy Brand

Thank you, Tom, and good morning, everyone. Welcome to today's call to discuss our second quarter results. On the call today is Gary Kelly, our Chairman, President and CEO; Tammy Romo, Senior Vice President, Finance and CFO; Bob Jordan, Executive Vice President and Chief Commercial Officer, President of AirTran Airways; and Ron Ricks, Executive Vice President and Chief Legal and Regulatory Officer.

We will begin with opening remarks from Gary, followed by Tammy providing overview of our results and current outlook. We will move to the Q&A portion of the call following Tammy's remarks.

Please be advised, 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 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 Gary, now we'll turn it over to you for opening remarks.

Gary C. Kelly

Thank you very much, Marcy, and good morning, everyone, and thanks for joining us for our second quarter 2014 earnings. We're very pleased with the second quarter performance. I'd like to point out a list of things before Tammy takes us through the financial results.

First of all, I want to thank all of our employees for their hard work, for successfully transforming Southwest Airlines, for these stellar earnings results and then for the historic year of 2014 that they are managing.

Second, the quarterly results include significant planned benefits from our all-new Rapid Rewards program, the AirTran acquisition and our fleet modernization. We would not have these results without these initiatives.

Third, the network optimization over the last 5 years has paid off handsomely, supported, of course, by our strategic initiative, but we have significant market strength across our route network. It is very impressive. It's very encouraging. And while we have a very large percentage of the network under development, almost 20%, unlike a year ago, it's not a significant drag on our performance. And we've got reason to believe that this segment will mature rapidly.

Fourth, the cost control efforts, which is essentially our fleet modernization initiative, is working very well, producing fuel efficiency, as well as nonfuel efficiencies.

Fifth, we have a number of large nonroutine programs and projects that are being managed. Several become final this year, International, the repeal of the Wright Amendment and the completion of the AirTran integration. Let me just go through each of those very quickly.

First, we've finished and launched international right on schedule. That is a very key milestone for wrapping up the AirTran integration. There are probably thousands of people to thank for what has been a flawless effort to get international up and running for Southwest Airlines. And I am very grateful to them all, but in particular, our technology department and their leadership on this project.

The repeal of the Wright Amendment is now 88 days away. The schedule's out for sale. It is a superb schedule. The airport construction is close to completion. The airport is also working superb, and our marketing and advertising is in full swing and it is superb. We've got more surprises planned for the fall. It will be a joyous celebration after 35 years of restrictions at Dallas Love Field.

And then finally, we are right on track to move airplanes and people out of AirTran and into Southwest by year end, to convert the remaining airports and routes from AirTran to Southwest by year end and then retire the AirTran brand and the few remaining Boeing 717s that we'll have by year end. And of course, that's a lot of work that I just ticked through, and our people are doing a superb job of managing all of that.

Sixth, we are continuing to generate very strong cash flow, allowing us to reduce debt, reduce outstanding shares, return value to shareholders with LUV at a lifetime high. We've got a $1 billion-plus share repurchase authorization to continue returning value to our shareholders, along with our quarterly dividend. And that was just increased by 50% by our board in our main meeting.

And then finally, our third quarter earnings outlook is strong. That, of course, is at this point in time. We'll continue to closely monitor our results and our outlook, the economy and fuel prices as we now contemplate reasoned and measured available seat mile growth beginning in 2015.

And our immediate priority with growth is, of course, Dallas Love Field, number one; and then secondly, Washington Reagan. That is as we begin to operate and fly the slots that we acquired from American earlier this year for Washington Reagan.

And our focus will be reliable, excellent operations, outstanding customer service and consistent, strong profits, which means a return on invested capital of at least 15%. And as planned, we've got tremendous growth opportunities that have been enabled beyond 2014. And that really is a remarkable change since just 2010. And all of that is a wonderful thing.

But those opportunities will have to be prioritized, and they'll have to be pursued in a manner that allows us to achieve our annual goals. And again to repeat those, it is excellent, reliable operations; it is outstanding customer service and consistent profits at our target -- targeted ROIC of at least 15%.

So Tammy, with that overview, I'd like to turn it over to you. And congratulations, Ms. Romo, on a wonderful quarter

Tammy Romo

Well, thank you, Gary, and thanks to everyone for joining us today. As we reported, our second quarter 2014 net income, excluding special items, was $495 million or $0.70 per diluted share, which represents our fifth consecutive quarter of record profitability. These are very strong results, and we are seeing significant benefits from our strategic initiative.

Our profits were up 77%, with EPS up 84%, which is a significant year-over-year improvement. And that was driven by strong revenues, lower fuel prices and our ongoing cost control efforts. Our second quarter GAAP net income was also a record $465 million.

Our operating income, excluding special items, also set a second quarter record and produced a stellar 16.3% operating margin. And of course, I'm delighted to say our pretax return on invested capital, excluding special items, for the 12 months ended June 30 was 17.1%, which, on an after-tax basis was 10.7%, well exceeding our weighted average cost of capital. This is a tremendous accomplishment that required much work and focus by all of our people, and I congratulate and thank all of our outstanding employees for the strong financial results released this morning.

Our second quarter revenue performance was very strong, and we broke many records. Operating revenues increased to a record $5 billion, driven by record passenger revenues of $4.8 billion, which increased 8.5% year-over-year on relatively flat ASM.

Strong demand for travel, both business and leisure, resulted in record traffic, passenger yields and load factors. And as Gary already said, our strategic initiatives also significantly contributed to our record second quarter revenues.

I also want to mention that our second quarter passenger revenues included $47 million related to a change to previously recorded estimates of tickets expected to spoil in the future. But with or without this additional revenue, passenger unit revenues were very, very strong. And as we reported, PRASM grew 9% year-over-year, and that was supported by unit revenue strength across all regions and lengths of haul.

This was an outstanding performance, especially considering roughly 2-point year-over-year unit revenue headwind from increased seat gauge and stage length, which, of course, had an even greater unit cost benefit. As Gary already mentioned, we had close to 20% of our second quarter ASMs under development, which is significantly higher than historical norms.

And our international and other developing markets, resulting in large part from the AirTran integration, are ramping up nicely and are performing in line with our expectations. Strong revenue trends have continued, [indiscernible] per quarter. And based on current bookings and revenue trends, we expect July's PRASM to be up year-over-year, roughly 3% over last July's strong performance. And bookings for August and September are also good.

So our revenue outlook for third quarter is quite good. But keep in mind, third quarter year-over-year comparisons will be more challenging due to the strong prior year trends.

Moving to freight and other revenues. Freight revenues grew 2.3% year-over-year as we continue to expand cargo service with the integration of our AirTran network. And we currently expect third quarter freight revenue to be comparable to second quarter. And although we had solid gains in our ancillary products, other revenues declined year-over-year as expected due to this decrease in fees, of course, as we wind down the AirTran line. And other ancillary revenues were also $58 million.

We currently expect other revenues in third quarter to also decline year-over-year, likely at a greater year-over-year rate than we experienced in second quarter. And that's simply due to the ongoing conversion of the AirTran network.

Turning to costs. We had a solid performance with operating costs comparable to second quarter last year. And on a unit basis, costs, excluding special items, increased only 1.2%. In addition to the cost reductions from our strategic initiatives, we also benefited from lower fuel costs.

Our second quarter economic fuel price per gallon was $3.02 per gallon, which reflected a $0.05 hedging gain. And our fleet modernization and other fuel conservation initiatives improved fuel burn by 1.4% year-over-year, which reduced our second quarter fuel costs by approximately $20 million.

Our third quarter fuel hedge consists of 10%. It's 10% hedged at varying crude oil prices and about 25% in Gulf Coast jet varying prices. Based on market prices as of July 21 and our current hedge position, our third quarter 2014 economic fuel price is forecast to be in the $2.95 to $3 range. And our hedging premiums are estimated to be about $15 million in the third quarter.

Excluding special items and fuel and oil expense, our unit costs were up 3.4%. A significant portion of this increase was driven by a record profit sharing of $127 million. And when you exclude profit sharing, our unit costs increased just 1.7% year-over-year. And this was slightly better than our 2% to 3% guidance on unit costs, primarily due to the shift of certain costs such as advertising and training to the second half of the year.

Based on current cost trends, we expect third quarter unit costs, excluding fuel, special items and profit sharing, to increase year-over-year, similar to what we saw in the second quarter, which was a 1.7% year-over-year increase.

Turning to our very healthy balance sheet and cash flow. We ended second quarter 2014 with $4 billion in cash and short-term investments, which included $105 million in collateral held from third parties. Our free cash flow during the second quarter was a strong $838 million. And year-to-date, we have generated approximately $1.6 billion.

As a result of our strong free cash flow generation, we've returned $652 million to our shareholders through the repurchase of $555 million in stock and the distribution of $97 million in dividends for the first half of this year. And since August 2011, our buyback authorization at that time and including our quarterly dividend payments, we returned a meaningful $1.9 billion to our shareholders.

In the second quarter, we repurchased $240 million in shares and distributed $42 million in dividend payments including our June payment, which represented our 151st consecutive quarterly dividend paid to shareholders in our history.

We have $780 million remaining under our $1 billion share repurchase authorization, which was announced in May, along with a 50% increase in our quarterly dividend. And since the acquisition of AirTran, we've also reduced our debt and capital lease obligations net by a significant $1.5 billion and intend to repay an additional $440 million, and scheduled that in capital lease payments for the second half of this year. Our leverage, including off-balance sheet aircraft leases, was 37% as of the end of June.

Our 2014 capital spending forecast remains at approximately $1.8 billion, with $1 billion to $1.1 billion of that related to firm aircraft spend.

And that brings me to the fleet, and I'll refer you to our press release for our second quarter activity. But here's a quick recap of our full year 2014 fleet plans. We have 33 firm orders for 737-800 from Boeing and plan to add at least 17 preowned 737-700. We've removed 41 of the AirTran 717s from service. The remaining 47 will be removed from service by the end of this year.

As of the end of the second quarter, we've transitioned 36 717s to Delta and currently plan to transition 16 more this year. In addition, thus far, we've transitioned 24 of the 52 AirTran -700s to Southwest, which will leave 28 -700 aircraft remaining that we plan to transition before the end of this year.

Our fleet plans still includes managing to a relatively flat fleet through the end of 2015 with a baseline of roughly 695 aircraft, which, again, was our combined fleet at the time of the AirTran acquisition. We expect our third quarter 2014 ASMs to increase year-over-year approximately 2% and full year 2014 ASMs to be up under 1% year-over-year.

And again for 2015, we expect our available seat miles to increase year-over-year, and that's driven by the 2% to 3% increase expected in seats from the updating of our fleet, along with the higher utilization of our fleet post-integration. 2015 ASMs are also expected to grow from a longer stage length on the new flights at Love Field, DCA, LaGuardia and new international flying from Houston.

As we manage the integration work and removal of the 717s and as previously guided, we plan to augment the firm orders and free [ph] on aircraft beyond what we have disclosed in our press release. So really, no new news there.

To close, we are delighted with our second quarter earnings performance, which exceeded our expectations. Our Southwest warriors have worked very hard to execute our strategic initiatives and restore our financial performance. And it's very gratifying to see how well it's all coming together here in 2014.

The benefits relating to the AirTran integration, our fleet modernization efforts, the -800s, and our new Rapid Rewards program are all meeting or exceeding expectations. And the full replacement of our reservation system is off to a great start.

July 1 was a day of great pride here at Southwest as we successfully launched international service to Aruba, Montego Bay in Jamaica with our new international reservation system. And the network opportunities that we have ahead are very exciting, and we will continue to focus on achieving and sustaining adequate returns on capital.

Our cash flow and balance sheet remain strong, and we will continue our diligent efforts to provide adequate returns to our valued shareholders. And although we still have a few months to go before we can claim victory for full year 2014, we are very well positioned to meet or exceed our 15% target, with the exceptional results produced during the first half of the year.

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

Question-and-Answer Session

Operator

[Operator Instructions] We'll now begin with our first question from Michael Linenberg with Deutsche Bank.

Michael Linenberg - Deutsche Bank AG, Research Division

Tammy, back to the -- on the aircraft. I think you said that you were going to be bringing on what, 17 used 737s. Are those -700s or -800s? Is that a mix?

Tammy Romo

It's -700s.

Michael Linenberg - Deutsche Bank AG, Research Division

And is that all this year or into next year?

Tammy Romo

Yes, the 17 that I gave is all this year.

Michael Linenberg - Deutsche Bank AG, Research Division

Okay, great. And then the -- when you talked about next year, I just -- to clarify, the seat count is up 2% to 3%, but then you threw in a point about longer stage length. So I guess, is it -- if we think about it on an ASM basis, it's going to be slightly higher than 2% to 3%? Is that how we should think of it?

Tammy Romo

Yes. Mike, we haven't provided our full year ASM outlook. However, we will be publishing our first quarter 2015 schedule in the coming weeks, and that will reflect about a 5% ASM growth year-over-year. And Mike, I know you'll remember this. We had 1.5 points of this growth is -- we're expecting that to be due to, as you recall, first quarter last year, we had -- we were impacted by the -- or actually, first quarter this year, we were impacted by the winter storms. And of course, as you would expect with the sunset of the Wright Amendment, we'll have -- likely have a longer flying out of Love Field and also DCA and likely LaGuardia. So I think that accounts for the difference between the -- kind of the 2% to 3% increase in seats versus the 5% ASM growth that we're expecting in our first -- in our schedule, which will take us through about March.

Gary C. Kelly

So again, Mike, that -- the 5% that Tammy's talking about is the estimate for the first quarter.

Michael Linenberg - Deutsche Bank AG, Research Division

Yes, very good. No, that's helpful. And then my second question and this is either for Tammy, you or even Gary. When you look at your sort of -- the booking window for customers, business and leisure, historically, you've been a lot shorter than the rest of the industry. I think the rest of the industry, I think it's 330 days, plus or minus a few. You've historically been, I don't know, 180, maybe you've topped it to that 200, 210. As you move into the newer systems, you move on to the Amadeus Altéa system and as you start flying international where people tend to book those, especially on the leisure front, some of those tickets are booked much further in advance. A trip to Jamaica or even down the road if you decide to fly to Hawaii, those are bigger decisions, and they tend to have longer lead times. Do we start to see your booking period extend? Is that in the offing? Would that be part of moving on to this new Amadeus system? Your thoughts on that.

Gary C. Kelly

I think there's 2 -- really 2 aspects to answering your question. One is just customer behavior. And you're right, even if we don't change our 180-day -- and your rule of thumb there is right, it's about 6 months out. Even if we don't change that, I suspect that we'll start seeing more bookings out farther on our booking curve. Secondly, with the new reservation system that we're working on, that won't be in place for 2015. And we haven't given a timeline for that yet, Tammy, I don't think.

Tammy Romo

We have not.

Gary C. Kelly

So really, we'll be -- we don't want to change our current reservation system capabilities, it's not worth it. So it will be a year or more before we'll have the capabilities to realistically extend the bookings. I think there's more to it than just adding the reservation system capability. That's a long time to put a schedule out. And as you know, the rest of the industry goes in and makes changes to it. And we typically have not done that. So that would be somewhat of a policy/procedure change that we would need to think through as well. So we agree with everything you said, that as we go longer and go more international, that there will probably be more demand for bookings further out. And that's something that we'll have the capabilities in the future to choose to do or not. But at this point, I don't think we've made a firm commitment one way or the other.

Operator

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

Hunter K. Keay - Wolfe Research, LLC

How much of your cost advantage do you attribute to having a single fleet type now that you've acquired and in the process of divesting 717s?

Tammy Romo

Hunter, this is -- we know that we have a significant advantage just from a single fleet type. And I guess from the 717s, really the benefit of transitioning from 717s to -- back to a 737 fleet is pretty significant. Now of course, a lot of that is just driven by just the more fuel-efficient 737 fleet. So probably the best gauge I can give you, if your question is on really the 717s versus the 737, are really just the benefits that we provided in our fleet modernization efforts, which is the EBIT. We're expecting that to be in $500 million range here for this year. But clearly, we have the -- we have a clear advantage relative to the rest of the industry. And certainly, a single fleet type is a large -- is a contributor to that. And our advantage is, I think, Hunter, relative to the legacy carriers, our cost advantage is probably 30% to 35%. So I don't have a specific figure to give you here off the top of my head but certainly, it is a -- it's a notable contributor to our low-cost advantage.

Hunter K. Keay - Wolfe Research, LLC

Okay, Tammy. And as you think about the -- obviously, a longer stage length next year, and [indiscernible] to give ASM guidance on known seat count guidance and as we think about the increased popularity of the Rapid Rewards program, are you getting pressure from some of your better customers to improve the number of redemption markets and -- one of those being Hawaii? And I know you guys talked about expanding into Hawaii, your analysts, think it was a couple of years ago almost at this point. But how has that thought process evolved? And are the -800s coming ETOPS certified that will enable that to take place next year?

Gary C. Kelly

Well, I'm not sure until we follow on your question. So with the Southwest route network, we don't have any restrictions anywhere. And there are -- every seat, every flight, every -- obviously, every destination has access online. And then you've got the opportunity to buy seats offline with our Rapid Rewards program. I think our programs are fantastic. It's the -- by all measures, it is better than the other program. We've got record levels of membership and all the things that I know you know. So in terms of people being dissatisfied with how they can you use their rewards on the Southwest system, no, we don't get that at all. If we ever do choose to serve Hawaii, I'm sure they'll be delighted to have that. But in the meantime, they've got some wonderful Southwest destinations, which, Hunter, one way or the other, they're going to continue to get more attractive as we expand beyond the 48 states. Mike Van De Ven does have some of the -800s equipped with ETOPS. We have work to do to fly to Hawaii, which I doubt we'll be able to keep a secret. So you'll know when we've made that commitment when we decide that. And it will take us not years from start to finish, but it'll take us some time to actually activate that. Hawaii is 1 of 50 potential destinations that we now have created. And it'll just have to compete priority-wise with the other great opportunities that we have. So I've realize your question wasn't specifically about Hawaii. The only thing that I noticed, Tammy, looking at the utilization of the awards, which was interesting to me is that the growth we've seen in the award usage over the past 5-plus years is actually taking place more in short-haul markets. And in the old days, our program was oriented towards rewarding people for flying short, and then they would use the award to fly long. So interestingly enough, the growth in utilization is actually more in the short-haul markets. But I don't think we've got any complaints whatsoever at this point with our new program. It's working very well.

Operator

And we'll take our next question from John Godyn with Morgan Stanley.

John D. Godyn - Morgan Stanley, Research Division

Gary, I just wanted to follow-up on the last thing that you just said, 50 potential destinations out there that you've created. Can you just kind of walk us through the process here for how you're thinking about growth going forward? We've heard other low-cost carriers sort of talk about the rising price umbrella, creating a lot of new growth opportunities. I'm just curious sort of big picture how you arrive at that number and certainly sounds like you're now prospecting for new markets.

Gary C. Kelly

Well, we've been working on this, John, for years so there's no surprise with where we are. I think it is simply counting dots that have simply been created by adding the 737-800 and international capabilities, also propelled by the AirTran acquisition that makes these potential destinations available to us. They were not available to us in 2010 was the main point I was trying to illustrate. We won't go add 50 dots to the route map next year. The 50, as I'm describing it to you, they are all beyond the 48 states. So there's nothing new. It's Hawaii, Alaska, Canada, the Caribbean, Mexico, Central America and the northern part of South America. Those are all within the performance capabilities of the 737. And they all at least look sufficiently attractive when it comes to the traffic potential and filling up the 737. So it's a wonderful place to be, and whether we'll ultimately serve all 50 destinations is not guaranteed or committed to. It's just the fact that those are opportunities, there's a number of them and we'll have to prioritize according to, fundamentally, what's the next best opportunity for traffic and revenue and profits. It'll be a little complicated by the fact that in some cases, we'll need to add capabilities to the aircraft like ETOPS. So that has to be factored in. Or in the case of Mexico, in particular, you have to apply for route authorities, and then we'll have to do that on a strategic and the tactical basis as well. But it's a nice -- as I said in my remarks, it's a wonderful thing, and it's just nice to be able to have a number of opportunities to choose from.

John D. Godyn - Morgan Stanley, Research Division

Got it. That's helpful. I had understood it's 50 in general, but it sounds like you're specifically talking about international opportunities because of the changing capability.

Gary C. Kelly

Well, and it -- that's just the way our domestic route map has developed. After the AirTran acquisition, we added 17 more domestic destinations to the Southwest route map. And as you look at the route map, we cover the top 50 with one exception. So the -- we know and you know that our opportunities to add dots or destinations in the 48 states is rather limited. So absolutely, the opportunities to grow in terms of destinations is beyond the 48 states. Now let me quickly clarify that there are numerous opportunities to grow within the 48 states among the destinations that we currently serve, connecting dots, additional frequencies, Wright Amendment and -- or, well, rather Dallas Love Field and Washington Reagan being 2 prominent and easy examples there. But additional thoughts will be beyond the 48 states most likely.

John D. Godyn - Morgan Stanley, Research Division

That's very helpful. And that's a good segue to my second question, which is I understand sort of the difficulty in talking about ASM growth rates overall when you have so many different moving parts in international growth and so on and so forth. But domestically, over the next few years, what's the right framework for thinking about capacity growth or your willingness to add capacity growth?

Gary C. Kelly

I think it's to be determined. I think that we have a real high class problem, which is we have far more places that we would like to serve than we'll have airplanes and we'll make those judgments tactically based on, again, the inputs that I've described to you. But we'll -- one would assume that if we have mature markets that have growth opportunities that, that would probably compete for a top priority spot. But again, there's no reason for us to make that commitment at this point. And we'll just have to manage this in a very measured way year-to-year and with the annual objectives in mind of running a great operation, offering outstanding customer service and hitting our return on invested capital target. And those are going to be the guidepost in determining how we grow and how fast we grow.

John D. Godyn - Morgan Stanley, Research Division

And do you think about that ROIC target for growth differently for international versus domestic, given just different risks?

Gary C. Kelly

Well, I think, yes. I mean, in other words, every opportunity is going to have to meet the 15% threshold, and if the risks are higher, well then, they'll have to be factored in.

Operator

And we'll take our next question from Helane Becker with Cowen and Company.

Helane R. Becker - Cowen Securities LLC, Research Division

Just on the 717 transition, so what will salaries and training costs look like after this year? And maybe percent change or what percent is from this year's related to the training and so on to move those pilots from the 717s to the 737s?

Tammy Romo

Helane, yes, after -- I think it's really after this year. I think we may have some training costs that dribble into next year, but it shouldn't be all that significant. And in terms of just the step-up in the wage rate as we bring our AirTran employees, convert them over to Southwest employees, really all that's remaining there are the, of course, the crews. And -- but that's all been factored into the guidance that we've given you. So really all the employees are already Southwest employees, with the exception of the pilots and flight attendants that we need over on the AirTran side until we bring that flying over to Southwest.

Gary C. Kelly

Helane, I probably won't add anything to what Tammy has already said, but just for a little color, and this is a huge shout out to all of our folks in our training departments, flight operations, and then all of the rest of our operating groups, they're doing a phenomenal job. We have record training events occurring in 2014. So in other words, in the first half costs that you already have seen, we have an unusually large amount of training underway. And that will continue through the balance of this year. And I agree with Tammy, by the time you get into 2015, we'll be back more to normal, although I think, Mike [ph], there's probably some front end, maybe 2 months of 2015, where we'll have heavy training events. But the other point to make here is that you have a lot of aircraft and a lot of employees "out of service" in 2014 and we're still producing strong results. Well, those airplanes effectively come back into service next year as they get through the conversion. And then our employees, as they get through all the big gulp training that's taking place in 2014, they'll be more productive next year as well. You'll have more -- you'll have a higher percentage of employees at the Southwest pay scale next year, so that will create some inflation. And I'll just refer to Tammy on that.

Tammy Romo

Yes. Helane, only other point I just wanted to make on the training, if you're working on your model there, just as a reminder, those training costs are included in the integration costs. And as we said in the earnings release, we're expecting that total cost to be about $550 million. Training is just one component of that, of course. So that's where the training costs, at least, are showing up.

Helane R. Becker - Cowen and Company, LLC, Research Division

Okay. So the 8% kind of numbers we're looking at in salaries is kind of a true number and doesn't have any of those events in it?

Tammy Romo

That is correct. It does include -- as we're converting the AirTran employees over to Southwest, it includes that step up, but it does not include the training costs. Those are included in the integration costs.

Helane R. Becker - Cowen and Company, LLC, Research Division

Okay. And then just my follow-up question on an unrelated item. I think you said you opened the schedule and are now starting to take bookings for the Wright Amendment sign, yes, with 88 days to go. Early days here I know, but is there -- can you give us some color on how that's booking and what you're seeing in terms of, I don't know, picking up passengers that may be going on -- that may have been avoiding you, not going on a one-stop basis over some of your other cities?

Gary C. Kelly

They look really -- they look very normal, they look very solid. And that's just within the context that the outlook looks real strong. So it all looks good. I think Tammy mentioned in her comments just the second quarter performance of the "Wright Amendment markets," and we saw a very strong increase already, and I suppose a lot of it's just the awareness that's been created about the restrictions coming down and the publishing of the new schedule. But yes, I think we had a 21% increase in the Wright Amendment revenue oriented around Dallas, obviously, in the second quarter. So -- but yes, those markets all look good. There's 15 new nonstop destinations that we'll launch in -- October 13th to early November and we can't wait.

Operator

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

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Just continuing on Helane's question there, but specific to fleet. As you think about lower utilization, transitioning aircraft to Delta and from AirTran to Southwest, can you quantify what the headwind to CASM is this year as it relates to fleet transition and lower utilization?

Tammy Romo

Duane, I'm just thinking here with you. We would be impacted some on the utilization. I don't know that I can pinpoint a specific number for you as we move forward. But we should see, as we get all of the flying over to Southwest, obviously, an improvement in the utilization, which is also driving some of the ASM improvement or the ASM increase that I mentioned for the first quarter. I'm just trying to think through and reconcile with you what that number might be, but...

Duane Pfennigwerth - Evercore Partners Inc., Research Division

It just feels like it's a -- it's probably a material component of your CASM growth...

Tammy Romo

Yes, I think to your point...

Duane Pfennigwerth - Evercore Partners Inc., Research Division

May not recur, right?

Tammy Romo

Yes. And to your point, we definitely have opportunities, as we look ahead to 2015, to be more efficient with our fleet. And as you can imagine, with the conversion of all the markets in 2014, just from a staffing perspective as well, we're not -- we're clearly not as efficient as we could be going forward as well once we have just more stability in our network. So we haven't given unit cost guidance for next year, but as you can see this year, we're certainly benefiting from the increased gauge, and I would expect in 2015 that we would also get some benefit from just the overall improvement in utilization. But we're still working through our plan and our schedule and all the details for next year. And it will give you a better guidance on that as we get a little bit later in the year and have a little more certainty on our schedule for 2015.

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Okay. And then one for Gary. I mean, when you hit this target, which we've been pointing to for years and you finally realize it this year, what do you do? Do you raise it? I mean, what happens when you hit a sort of long-standing aspirational target?

Gary C. Kelly

Well, I think Duane, we do what I said we're going to do, which is we're going to take up every year and have a goal to run an excellent, reliable operation, provide outstanding customer service and have a business and a plan that continues to have consistent profitability, achieving at least a 15% pretax return on invested capital. We've got opportunities to grow the network both domestically and internationally, as we've described. And we'll want to manage that growth very, very carefully so that we sustain all 3 of those performance levels. But we want our return on invested capital to continue to be at least 15%, with 15% as the floor.

Operator

And we'll take our next question from Joe DeNardi with Stifel.

Joseph W. DeNardi - Stifel, Nicolaus & Company, Incorporated, Research Division

Tammy, maybe going back to the Rapid Rewards program kind of in the context of how successful you view that being for you guys, can you just talk a little bit about the growth in the frequent flier liability there? And it's growing at a rate a little bit faster than your peers. I mean, is the plan to manage that a little bit more aggressively in the future? Or are you okay with the growth you're seeing?

Tammy Romo

Well, we -- we're constantly evaluating the -- our Rapid Rewards program. And just as a reminder, we did recently increase the coefficient for using a Rapid Rewards flight. And so that's at least keeping the usage in line with what we -- with what our more recent trends have been. But as Gary stated earlier, we've been extremely happy with the Rapid Rewards program. And the -- let's see, the benefits -- the second quarter impact related to our Rapid Rewards program is probably roughly $95 million on a year-over-year basis, $95 million. So we're seeing probably a 40% to 50% increase in our revenue year-over-year. So we're delighted with how that's performing. But to your point, we've obviously got to keep an eye on the liability where we're monitoring the usage. But the overall economics, we're very happy with.

Operator

And we'll take our next question from Jamie Baker with JPMorgan.

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

Quick clarification. The cost guidance doesn't contain any accruals, correct, Tammy?

Tammy Romo

That is correct.

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

Okay. And more broadly speaking, and I'm not asking you to negotiate in public here. I'm just curious if there's been any change in the tone of negotiations in light of your very impressive recent results.

Gary C. Kelly

Negotiations continue. We've got negotiations with a number of workgroups. And the pace and understandably, the texture of those negotiations is different by workgroup. So it obviously puts the company in a position where it can afford to do certain things. But the main thing that we need to do is to preserve Southwest Airlines' low fare brand and low-cost position competitively. And it doesn't change the need to do that. Our competition is stronger today than it has been in a long time. And so we'll -- that hasn't changed, Jamie, and therefore, it's a great rallying cry for all of our people to work together to beat all of our competitors, so that's -- that work continues.

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

Sure. Okay, I appreciate that. And secondly, I know you don't guide on fuel efficiency, but with the amplification 717s going out, 73 is coming in, longer stage lengths, I personally could use an assist. I mean for 2015, would you expect ASMs per gallon to exceed 74? Or is something in the 73 range more likely?

Gary C. Kelly

We've got -- and I'll let Tammy think about that while I just make one quick comment here. And we -- and Jamie, I think we can do that. Now we have tried to -- or at least our Investor Relations effort here has tried to give you some guidance with the fleet modernization benefits, which I think, Tammy, are largely fuel efficiency.

Tammy Romo

That's correct.

Gary C. Kelly

So you do have that. But you're right. It hasn't equated precisely to the consumption number. So -- but yes, we're already realizing significant benefits from the fleet modernization/fuel efficiency. Of course, the fleet modernization with an upgauging benefit, as an example, has -- as you well know, has benefits beyond just fuel burn. But anyway, let me -- do you have a...

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

Yes. And I would definitely agree with that conclusion. I mean, you've punched nicely north of 72 as of the fourth quarter of last year.

Tammy Romo

I think directionally, you're in the ballpark, Jamie. I had sort of a 73 in mind. But I think we'll continue to see improvement as we go for all the obvious reasons as we continue to replace the 717s and the classic aircraft with more fuel-efficient airplanes. But we haven't given a number yet for the next year, but I wouldn't be surprised to see it exceed 74.

Operator

And we'll take our last question from Thomas Kim, Goldman Sachs.

Thomas Kim - Goldman Sachs Group Inc., Research Division

I know your credit rating is very important to you, and obviously having a strong balance sheet makes a lot of sense. I'm just wondering whether you think your balance sheet is bordering too conservative at this stage with cash and short-term investments hovering north of about 200% of consensus revenue estimates for the year.

Tammy Romo

Well, obviously, maintaining a healthy balance sheet obviously has always been a top priority for Southwest. And we really do have a lot -- which really -- it's really a balancing act and we have a lot of guideposts. Of course, one of our goals for this year that we stated is to -- we have an investment grade balance sheet. We would like to notch that up, and so that's obviously one consideration. But as Gary said earlier, we have a lot of high-class problems. Our questions on our hands is -- so really, our overall goal is to enhance shareholder value. I think we'll need to balance our capital expenditures against our desire to continue to enhance capital through our shareholder deployment. So I think -- and I think the other guidepost I would just point you to is just our cash balance, it is $4 billion. Our target is probably closer to $2.5 billion. But keep in mind too, there's some seasonality in that cash balance. And we do have -- as I mentioned earlier, we've got over $400 million in debt due later this year. So of course, with the peak second quarter, we're kind of -- we've got higher cash balances and seasonally, that's typically the case. So that's just another factor. So we're looking ahead at what our needs are and with the overall goal in mind to enhance shareholder value through either deploying capital back to our shareholders. And also as Gary mentioned, we want to continue to grow the airline.

Gary C. Kelly

Just trying to be real quick with you here. I think if I just take your questions literally, is it too conservative? I would say no, it's not too conservative. Is it too aggressive? No. So is it the exact right spot? I don't know that I'm ready to answer that quite yet. So we continue to -- as you know, the rating agencies don't just look at leverage. In fact, interestingly enough, they don't look at leverage much at all. And that's the way we normally casually talk about it. So there's other things that they look at and we'll want to continue to work with them in an effort to try to improve the credit rating. I think that, that would be better than being so close to junk. On the other hand, if trends continue for several years like they have been for the last couple, that the balance sheet's going to continue to show less and less leverage. And yes, it is possible when it gets to a point where we think that it's "too conservative," but I don't feel that we're there right now. And like Tammy, said I think that's a high-class problem and something ultimately can be managed. The only other thing that I think needs to be mentioned here is that we've lived through a brutal decade where every balance sheet in the industry was stressed and most went bankrupt. So you just can't extrapolate 2014 into infinity. And we do want to make sure that we err on this side financially of being conservative and being very well prepared for the unpredictable. And the unpredictable's happened a lot to us in 43 years. But again, it's not say that we're worried. We're not. We're feeling very confident, very good and very pleased with this quarter and very pleased with our outlook.

Thomas Kim - Goldman Sachs Group Inc., Research Division

I definitely appreciate all of that. If I could just ask a separate question, Gary, on your international expansion. Can you help us understand your thought process behind building depth versus breadth in your network? And then sort of a separate question related to the international side. Obviously, we appreciate that your fleet will have much longer range. But I'm curious as to how your unit cost advantage or competitiveness changes when you start competing against your network peers that are going to be flying larger gauge fleet.

Gary C. Kelly

Excellent questions and questions that again sort of put in that high-class problem category. Well, we're going to have to choose, and I suppose that the choices will, from time -- from one decision point to the next will probably have different priorities, things will just change. We want to do both. We certainly want to increase the diversity and the breadth of our route system. But we have opportunities that we haven't seen in quite some time to also improve the depth in a lot of our markets. And those are the exact conversations and debates that our commercial experts are having right now. I'd rather not tip our hand as to exactly what we might do. But again, just to put it in perspective for everyone, international right now is 1% of Southwest route system. So it is a very, very small component, and it's going to be small for a long time. So I think that may very well help direct us in the future as to how we think about additional flights from one schedule to the next. But 50 dots on the route map obviously is a great opportunity to increase the breadth. And again, all this has to fit in with hitting our return requirements. I think by definition, increasing the depth, one would think would be less risk as opposed to increasing the size of the route network. So all that will have to be factored in as well. So we've got a great opportunity to grow, grow the earnings and continue as we grow the capital base, along with the growth in earnings to hit our 15% minimum target. And it's very exciting and we've got opportunities to do both. So that's, again, a very high-quality problem.

Thomas Kim - Goldman Sachs Group Inc., Research Division

I appreciate it's late in the call. I mean, do you care to comment on -- just a last question about unit cost competitiveness over the longer haul? Or is it just...

Gary C. Kelly

I'm sorry. Yes, I didn't skip it on purpose. I'd forgotten to answer the question. Well, I think, yes, as you go longer, it gives us less ability to bring our strength, which is efficiency and turning airplanes. It makes a little bit harder to bring that competitively to the market. So that will have to be factored in. I don't know that we are well prepared for "ultra long-haul flying". But we feel we have a very solid cost advantage with the 737 and in the route network that we're envisioning to, again, North America and the northern part of South America. So I think that, that holds true at least with the analysis that we've done. And that's been the case over a number of years. We want to continue being the low-cost producer and work hard to achieve that position and then maintain it, and certainly, we want to be known as the low-fare brand and that we're going to work hard to sustain that as well.

Operator

And 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 thanks again to everyone for joining our call today. As always, I'll be available this afternoon if you have any additional questions. Thanks again.

Operator

.

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

Ginger C. Hardage

Great. Thank you, Tom. And we would like to welcome all the members of the news media who might have questions for Tammy and Gary. So I think Tom's going to give instructions and we'll get that started.

Operator

[Operator Instructions] We'll now begin with our first question from Mike Sasso with Bloomberg News.

Michael Sasso

I noticed that you announced earlier that you're going to purchase 17 preowned 737s. I noted as I was on the call earlier with United folks and they announced a kind of a new strategy for them to buy used, and certainly Delta is kind of well-known for pursuing that strategy. I wonder if you could just talk about used planes and -- as a strategy and kind of what's going on with that?

Gary C. Kelly

Well, sure. We -- for us, it's not new either. I think we used the preowned market historically for more tactical growth opportunities. And we were very active in the 1990s, in particular, going out into the used market, finding good airplanes and have the capability of quickly converting them to the Southwest livery, and putting them into revenue service. That is a -- when the market is available, that is a very good strategy. And in particular, it works well for us right now. So what is unique for Southwest is that we're an all-737 carrier. We are the launch customer for the 737 MAX, which is coming online in 2017. And it -- all the indications are it will be a vastly superior aircraft from an economic perspective. So if our Chief Operating Officer had is druthers, he'd rather be getting those airplanes new right now as opposed to the current generation. So a wonderful way to bridge the gap is to go into the used market rather than buying the current generation new from Boeing, understanding that we'll be using them for a shorter period of time, but that just means that we'll get the 737 MAX that much faster again compared to buying an airplane here in 2014 and keeping it for 30 years. That all works great, that's a great strategy, but the airplanes have to be available. And it just so happens that there are a lot of 737-700s on the used markets at attractive prices that are available. If they are not, then I'm sure we wouldn't continue to pursue that strategy. So everything has to come together. We love the 737-700, which is the NG product. That's what Mike is picking up and economics are fantastic, so I think that works very well. So it's not necessarily a new strategy for us. The circumstances are different this time that caused us to pursue that. But it definitely helps us manage our capital spending at a time where we would like to not only replace retiring equipment, but also begin to pick up new units to grow. So all way around, I think it's a great strategy and something that's working very well for us.

Michael Sasso

And so a quick follow-up. You said there are a lot of 737-700s on the market. Why is that right now?

Gary C. Kelly

Mike, you want to speak to that?

Michael G. Van De Ven

Yes, Mike, it's just a function of them rolling off lessors' order leasing books. So they typically lease the airplane out anywhere from 8, 10, 12, up to 20 years. And they roll into the marketplace, and we just have a bow [ph] wave of them rolling in the market place over the next couple of years.

Gary C. Kelly

And we're the largest 737-700 operator in the world, and it's an airplane that we really like. And it could be that other airlines are pursuing other aircraft types. It's often hard to know, but we like that airplane and for whatever reasons, there's a lot of them. And that was Mike Van De Ven, our COO by the way, that was answering that question.

Tammy Romo

And just one thing to add. The lessors love to lease the Southwest Airlines because we do have a very strong balance sheet.

Gary C. Kelly

Yes, you heard the question earlier about our credit rating, and Tammy makes an outstanding point. Yes, which we are a preferred customer for anybody who wants to get paid.

Tammy Romo

That is correct.

Operator

And we'll take our next question from Doug Cameron with The Wall Street Journal.

Doug Cameron

This is one for Gary or maybe Ron. Going back to the international expansion, guys, I see you've been sort of active in some DOT dockets with regard to potential Mexico flights, which kind of makes me think, I wonder if any of the international expansion in that region is kind of dependent on any regulatory changes, be it either bilateral or whether there's kind of plentiful opportunities for you with the status quo as far as current air service agreements are concerned.

Gary C. Kelly

Ron Ricks, our EVP and Chief Regulatory and Legal Officer, will step up to the microphone here.

Ron Ricks

I think the only new development there that might merit some attention is that the United States and Mexico are discussing a new bilateral. And what we're hearing is that for the first time in quite some time -- by the way, I don't think the treaty between the 2 countries has been renegotiated since the early 1960s. But for the first time since then, Mexico is interested in liberalizing that treaty, liberalizing this context, meaning more opportunities for more flights by U.S. carriers. That is a goal that we support, and it's something we're urging the United States government to pursue in the negotiations in hopes that we can achieve a new bilateral sooner rather than later, which means expanded opportunities for us.

Doug Cameron

[Indiscernible] there are only 2 or 3 designations. Now, Ron, you're confident you could get one of those if and when you decide to fly from Hobby or any other points?

Ron Ricks

There are a number -- if I understand your question, there are a number of routes that we're interested in pursuing over the short-term and there are opportunities. But the point of the new bilateral negotiations is to expand that list more and -- so that we can have more opportunity. But I think regardless of whether there's a new treaty or not, to Gary's earlier commentary, there are plenty of opportunities for us, again a high-class problem. There are lots of places we can go, so we don't think we'll be route-restricted, if that's a concern. But on the other hand, Mexico is a very attractive place for us to fly our existing route structure in the demographics of the United States today. And if there are more opportunities in Mexico, then I'm sure Mr. Andrew Watterson and his team and our network planning group would be happy to pursue them.

Gary C. Kelly

And Doug, the other thing -- so Ron is acknowledging -- we're acknowledging that there may be some city pair routes that we can't get the route authority to fly. We know that. But the thing that is different about Southwest Airlines is we have dozens of cities that we have point-to-point networks that originate from. So we have routes into Mexico right now from Orange County, California; Austin, Texas; San Antonio, Texas as an example. So we -- Houston may not be open to us to certain Mexican cities, but I'll bet we can find other spots on the Southwest system that are. But in any event, we have 50 potential beyond 48 state destinations. And if we can't go one place, we'll have ample opportunities to go somewhere else. And as a practical matter, we simply cannot satisfy all the growth opportunities at the same time anyway. So it will help prioritize if we're restricted. But clearly, we're in support. And Ron made this clear, we're in support of liberalizing the bilateral agreement between the United States and Mexico and that will bring more competition. That will lower fares, it will be better for consumers. So it's not just about us selfishly. It's really what's good for consumers.

Operator

Our question comes from David Koenig with the Associated Press.

David Koenig

I will make it easy, an easy one here. Gary, I know that -- I see that the release does talk about a 3% present [ph] gain expected in July over last July. Anything else you can say about demand in the third quarter and bookings? And part of that is how soon do you expect it's going to be into everybody starts dumping a bunch of extra capacity into the system?

Gary C. Kelly

Well, I think that capacity -- just go backwards with your question. I think the supply side of this is generally a longer cycle. So, I mean, if you just look at us, if we wanted to add more flights next month, we just -- we couldn't do it. That's a fairly long lead time that's required to require equipment, hire and train employees, et cetera. So right now, the demand is very strong and it is balanced very nicely with the supply of seats. We're going to manage our growth very carefully so that we don't upset that balance for Southwest Airlines. And what the rest of the industry does, of course, I can't speak to. I think David, the bigger risk, personally, is the economy and fuel prices. With all the turmoil there is in the Middle East, things could change quite rapidly, and I'm much more concerned about that. The demand side things, if you will, are continuing to be stable and strong as opposed to a radical change in the supply side anytime soon.

Operator

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

Ginger C. Hardage

Well, great. Thank you so much for your interest today. We know there's a lot of news going on in the industry but thank you for tuning into us. If you have any additional questions, our communications team, that number is (214) 792-4847. Thank you so much.

Operator

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

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