Southwest Airlines' CEO Discusses Q2 2011 Results - Earnings Call Transcript

| About: Southwest Airlines (LUV)

Southwest Airlines (NYSE:LUV)

Q2 2011 Earnings Call

August 04, 2011 11:30 am ET


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

Ginger Hardage - Senior Vice President of Corporate Communications

Robert Jordan - Executive Vice President of Strategy & Planning and President of AirTran Airways

Marcy Brand -

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


William Greene - Morgan Stanley

Garrett Chase - Barclays Capital

Daniel McKenzie - Rodman & Renshaw, LLC

Duane Pfennigwerth - Evercore Partners Inc.

Jamie Baker - JP Morgan Chase & Co

Michael Linenberg - Merrill Lynch

Helane Becker - Dahlman Rose & Company, LLC


Welcome to Southwest Airlines' Second Quarter 2011 Conference Call. My name is Tom, and I will be moderating today's conference. Today's call is being recorded, and a replay will be available on in the Investor Relations section. At this time, I'd like to turn the call over to Ms. Marcy Brand, Director of Investor Relations. Please go ahead, ma'am.

Marcy Brand

Thank you, Tom. Good morning, everyone. On the call today, we have Gary Kelly, Chairman, President and Chief Executive Officer; Bob Jordan, Executive Vice President, Planning and Strategy and President of AirTran Airways; and Laura Wright, Senior Vice Present, Finance and Chief Financial Officer.

We will begin today's call with opening comments from Gary. Laura will then review our second quarter results and current outlook. And Bob will close with an update on our integration of AirTran before we open the call for questions.

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 actual results to differ materially.

This call will also include references to non-GAAP results, therefore, please see this morning's earnings release in the Investor Relations section of for further information regarding forward-looking statements and for reconciliations of non-GAAP results to GAAP results.

This morning's second quarter 2011 earnings release includes Southwest's results for the full quarter and AirTran results from May 2, the date of the acquisition, through June 30. Prior year results are Southwest only. In order to provide what we believe to be more meaningful year-over-year comparison on today's call, we will also be discussing specified results on a combined basis, which will include AirTran's results for all periods prior to the acquisition. In addition, outlook commentary will be provided on a combined basis as compared to combined prior period results.

And finally, the impact of purchase accounting has been applied as of the date of the acquisition, May 2, in all financial information discussed. We have provided supplemental current and prior year financial information on a combined basis in this morning's press release and in a supplemental packet posted this morning on the Investor Relations section of our website at

And now, I'll turn the call over to Gary for opening remarks.

Gary Kelly

And thank you very much, Marcy. And good morning, everyone, and thanks for joining us. First of all, I wanted to start by thanking Laura and her entire team, and especially Marcy in Investor Relations and Leah Koontz our Controller and our accounting department. They have done a superb job in a particularly challenging quarter, given the acquisition of AirTran. So thank you all very much.

I'm very confident whatever questions you have about the quarter from whatever angle, they can answer that. So as you all work your way through the second quarter numbers, I'll just tell you from personal experience, please be patient, and you can find your answers. But again, our kudos to the whole finance department. Great, great job.

Second of all, $0.15 a share was pretty much in line with our Southwest expectations. And that is recognizing there was no public guidance for the AirTran piece of the results. And that, of course, the AirTran results were just for 2 months out of the quarter. So regardless, though, of the expectations, the results were down from a year ago, down 48%. Obviously, we can't be satisfied with that. The primary culprit, obviously, is fuel.

Our second quarter revenue results were strong. We had records across the board. For a number of years, we've significantly outperformed the domestic industry. If you look at Southwest 2011 second quarter results, we're up 27% versus 4 years ago. So it's hard for me to complain about our revenue performance.

Compared to our industry peers, we're often in a different rhythm at Southwest Airlines it seems. The comps for Southwest are tough compared to last year. We had a bang-up performance in 2010. But in any event, revenues are strong. While they are strong, and I think that strength will continue based on July's results based on our current trends, based on bookings for August and September, the rate of growth has slowed, probably beginning in June where we report very modest unit revenue growth for the month of July. Once we publish our July traffic, I believe we'll see stronger year-over-year RASM growth in August, September. If you look at the full quarter, my best guess at this point is that we'll be up year-over-year, somewhere in the low single-digits range on a combined basis.

I do believe, though, we've seen some softening in business travel this summer and base that on demand for full-fare close in bookings, I don't know whether it will pick back up any time soon. Probably state the obvious, I am concerned about the U.S. economy, concerned about fuel prices. The current level of profits, obviously, demands that we take action, which right now is to manage our capacity more aggressively and very, very carefully.

AirTran announced earlier this week that it will close 4 cities next year. And Southwest announced the previous week that we'll no longer fly to certain city pairs beginning with our January flight schedule.

And as the AirTran integration and conversion begins in 2012, we'll have lots of opportunities to optimize the 2 route systems, especially the AirTran side of the route system, and drive substantial unit revenue gains with that conversion.

Of course, AirTran is 1 of 4 large initiatives that we have, strategic initiatives that we have at Southwest. Our all new Rapid Rewards program, which launched in March, is another one that's well underway and very much on track. Adding the 737-800 is a third initiative that's well underway and on track for first half delivery of 2012. And then finally, our reservation system replacement is a fourth significant initiative. That's a future project, and no timetable is set on that as of yet. But clearly, those are important initiatives and are certainly requiring our very keen attention.

So with that very quick overview along with -- again, my thanks for a great effort once again in this quarter. I'd like to turn it over to Laura Wright, our CFO.

Laura Wright

Thank you, Gary, and good morning, everyone. Our second quarter 2011 GAAP net income was $161 million or $0.21 per diluted share. Our GAAP second quarter results included 2 special items. First, we had a net $141 million of non-cash mark-to-market gains related to our fuel hedge portfolio, which were reported in other gains and losses. And second, we incurred $58 million of acquisition and integration costs before taxes, primarily for financial advisory fees and severance payments related to the AirTran acquisition.

As a result of a modification to our profit sharing plan this quarter, in general, our one-time acquisition and integration costs that are identified as special items will be deferred from a profit sharing calculation through December 31 of 2013.

Beginning in 2014, we will start to amortize the accumulated deferred costs to the profit sharing calculation in a systematic manner.

The intention of this plan change was to better align the costs associated with the acquisition and integration to the periods that we should be realizing the expected synergy benefits. Excluding those special items, our second quarter 2011 non-GAAP earnings were $121 million, or $0.15 per diluted share, and a breakdown of that is $104 million profit from Southwest and $17 million from AirTran.

This was below Wall Street's expectation of $0.20 per diluted share, which included analysts' estimates of AirTran's second quarter results, which as Gary alluded to, we had not previously provided any guidance on.

The impact of our fair valuation of AirTran under purchase accounting as of May 2 resulted in an immaterial net reduction to our second quarter net income. Our current estimate of the ongoing impact of purchase accounting will be incorporated into the forward-looking revenue and cost guidance that we provide.

But before I walk you through our second quarter results and provide insight into our third quarter 2011 outlook, I want to reiterate what Marcy said. Any year-over-year trend guidance will be based on our current expectations of Southwest and AirTran's combined third quarter performance as compared to Southwest and AirTran's combined performance either in the second quarter of 2011 or the third quarter of 2010 as noted. Those prior period combined results are posted on

On the revenue side, we continue to have an outstanding revenue performance. We saw the number of all-time quarterly records, including passenger revenues of $3.9 billion, total operating revenues of $4.1 billion, a load factor of 82.3%, a 28.1% increase in traffic and in plane passengers. We also had record passenger unit revenues, record total unit revenues and record passenger revenue yields.

While our second quarter results included AirTran for the month of May and June, all of these records were also achieved based on Southwest's standalone revenue results. So again, a tremendous result from our revenue management team.

Our passenger revenues grew $860 million, or 28.5%, from last year's $3 billion, Southwest-only results. And about 54% of this result was attributable to AirTran's revenues in the second quarter, and the remaining $400 million of increased revenues was due to organic growth at Southwest.

On a combined basis, our passenger unit revenues grew 7.2% versus last year, and our total unit revenues grew 7.4%. In April, the combined PRASM was up 4% to 5%. May combined PRASM was up 11% to 12%, and our June combined PRASM was up in the 5% to 6% range.

Southwest's PRASM performance on a standalone basis was up between 6% and 7%, as indicated in our monthly traffic update. AirTran's PRASM on a standalone basis was up closer to 9% for the quarter, which when weighted for its size, dropped our combined PRASM to 7.2%.

While load factors remained at record levels, Southwest's mix of full-fare passengers for the second quarter was down 3 points to 19% from the first quarter of 2011, which was also off as normal historical sequential trends. AirTran's full-fare mix was 3%, down from 4% in the first quarter of 2011 and up from 2.5% in the second quarter of 2010.

That being said, our Business Select product had another strong performance with $25 million in quarterly revenues, and our Wright Amendment revenues continued to grow and were a healthy $63 million in the second quarter, which was a 15% increase from last year.

We've implemented 8 fare increases since mid-December, which is certainly aggressive. And in light of the economic uncertainty, we're continuing to monitor the demand environment closely. And as Gary noted, we can certainly see the impact of fare increases have had on our near end full-fare travel.

We started getting a little more aggressive with some of our summer promotions, and we have seen demand in the back half of July respond well. Again, indicating that customers are price-sensitive.

We will be reporting our combined July traffic soon. And at this time, we are expecting that our combined July passenger unit revenues will be up in the 1% range from the combined July PRASM of last year.

From July 23 through August 1, we've sold tickets with $36 million of incremental revenues based on the fare increase that we took after the expiration of the excise tax. However, we would expect a seasonal adjustment going forward if the ticket tax is not reinstated.

And again, to Gary's point, we do expect that our year-over-year comparisons will improve each month during the quarter. July is certainly the most difficult, with our July capacity up 6% versus last year on a combined basis and also compared to a July 2010 performance of up 18%.

In August, our combined ASMs will be up 5%. And in September, they will be up 3%. Again, our bookings in place for the rest of the summer look good, and we expect continuous high load factors.

And while our July comparisons are difficult and expected to be off normal sequential trends from June, we currently anticipate that August and September will return to more normal combined PRASM sequential trends.

Our second quarter freight revenues were $36 million, which was up 9.1%, slightly ahead of our guidance. AirTran has no cargo revenue in the second quarter, and we certainly look forward to growing that revenue stream in the near future, especially with the opportunities we see in Atlanta. We're currently expecting our third quarter 2011 freight revenues to be comparable to second quarter's $36 million.

We also had a strong second quarter other revenue performance of $224 million. Our very successful EarlyBird Check-in product contributed approximately $36 million in revenues. That was up $2 million from the first -- or last quarter and up from $23 million a year ago. And based on our first half EarlyBird results for 2011, we're definitely on pace to exceed our $100 million target for the year.

Our business partner revenues also continued to grow in response to our March launch of our all new Rapid Rewards program. We continue to see increases in our credit card applications and our membership, and the growth in our member O&Ds and our new members have both outpaced our system gross.

We continue to be encouraged by the overwhelmingly positive customer response to the new program, and we're still in the infant stage so we have a lot of opportunity in front of us over the next several years as the program ramps up.

Our pets, unaccompanied minors and excess bag charges at Southwest were $14 million in the second quarter. And on a combined basis, total other revenues were up $43 million to $258 million. $32 million of that $43 million increase was attributable to the Southwest products, and $11 million was attributable to AirTran.

We're currently expecting that our third quarter's 2011 combined other revenues will increase from third quarter 2010's combined $223 million, primarily due to increased business partner income and EarlyBird revenues.

Turning to costs, our second quarter operating expenses, excluding special items, increased 40%, or $1.1 billion year-over-year, largely due to a 72% increase in our economic fuel expense. Our second quarter economic fuel cost per gallon, including taxes, was $3.28, which was slightly better than our Southwest standalone guidance of $3.30 per gallon range.

Our total hedging gains in the quarter were $0.03 per gallon, with a non-hedged fuel price of $3.31 a gallon. Fuel prices remained persistently high. In fact, the $3.28 per gallon that we paid in the second quarter represents about a 40% increase over last year and is rivaling market prices that we saw in the second and third quarters of '08.

Looking back just one year, if we would have paid second quarter 2010 economic fuel prices in the second quarter of this year, we would have seen a fuel expense reduction of about $420 million. We've been disappointed in the large increases that we've seen in our crack spreads since the beginning of the year. Our second quarter crack spreads averaged $25.50, that compares to $11 a year ago.

And as West Texas Intermediate crude has not risen in accordance with worldwide crude prices, we're seeing increased margins to price checks in market levels. With our crude oil hedging positions exclusively in WTI, we've been largely unhedged for this increase in spreads.

The current outlook for the margins relative to crude are forecasted to be up in the $36 range in the third quarter, which is over a 200% increase from last year.

On a combined basis, our second quarter 2011 fuel cost per gallon, including taxes, was $3.27, which was $0.05 better than our unhedged fuel cost per gallon. Based on the forward curve as of August 1, the third quarter 2011 WTI crude prices are expected to average around $96 a barrel. But again, the real story is in the cracks, which are pricing to the much higher Brent. The third quarter crack spreads based on the August 1 forward curve are expected to average around $34 a barrel, which is about a $9 increase from what we saw in the second quarter.

Based on our August 1 forward curve and our existing fuel hedge positions, we're estimating our third quarter fuel costs, including taxes, to be approximately $3.30 per gallon, which is about $0.03 less than our unhedged fuel price estimate for the third quarter.

For the third quarter of 2011, we're estimating hedging premium costs, which are recorded in other, will be in $36 million range. For the full year 2011, again, based on the August 1 curve, in crack spreads, we're estimating a combined economic fuel price, including taxes and hedging gains, of $3.20 per gallon.

And while we project a net hedging gain this year, the full year 2011 combined fuel price estimates equates to about a $1.5 billion capacity adjusted fuel headwind versus 2010. Non-capacity adjusted, the fuel headwind is about $1.8 billion.

I'll just spend a quick moment to address our fuel hedge portfolio going forward. As usual, we've included the detail of our hedge positions as well as sensitivity tables in our press release. But we have varying percentages of estimated fuel consumption hedged at varying WTI price levels for the remainder of this year and all the way up to 2015. At current market prices, the hedges that we put in place since late 2008 have market values that now exceed the locked-in losses. And the total value of our hedge portfolio, as of June 30, was approximately $370 million.

Our second quarter operating cost expenses, excluding fuel and special items, increased 9.3% year-over-year on a combined basis. The unit costs, excluding fuel and special items, increased to 3.1% to $7.41, compared to $7.19 second quarter of 2010. On Southwest's standalone basis, our non-fuel unit costs, excluding special items, increased 3.5%, which was in line with our guidance. And AirTran's non-fuel unit costs, excluding special items, increased about 1% year-over-year.

Again, the purchase accounting really had a net 0 impact to our second quarter costs, and I wanted to point out that to date, we have realized about $10 million in synergies before profit sharing related to the AirTran acquisition. And those are primarily in our other operating costs.

On an annualized run rate basis, we've already produced $50 million of cost synergies before profit sharing and taxes, and we have additional work underway for many more significant cost synergies.

Our combined salaries, wages and benefit unit costs increased 2.9%, primarily due to increased wage rates. And we also saw some pressure in healthcare costs this quarter.

Other non-fuel cost drivers on a combined year-over-year basis were increased advertising spend and increased revenue-related costs. And of course, at Southwest, we had an unfavorable comparison to the prior year, where we got the $18 million refund of security fees from the TSA.

Based on our current cost trends, we expect our third quarter 2011 combined non-fuel unit costs, excluding special items, to increase from the third quarter 2010's combined non-fuel unit costs of $0.07, primarily due to higher advertising and airport costs and less ASM capacity. And the current forecast is at about a 1% year-over-year change on a combined basis. For the full year 2011, combined non-fuel unit costs x special items, we're currently estimating them to be up in the 2% range from 2010's combined $7.45.

Our second quarter GAAP tax rate was approximately 41%. And it's a little higher rate because some of the integration costs are not deductible, causing a slightly higher tax rate. For the full year of 2011, we're currently projecting an effective GAAP tax rate again in this 41% range.

We ended the second quarter with a healthy cash balance of $4.4 billion of unrestricted cash and short-term investments. In addition, during the quarter, we replaced our previous $600 million credit facility with a new 5-year fully undrawn $800 million credit facility.

Our leverage, including our off-balance sheet leases, is now approximately 50% following the AirTran acquisition. However, we expect that it will fall somewhat by year end to the 45% to 50% range. During the quarter, we generated cash from operations of $237 million and year-to-date, cash flow from operations of $1.2 billion. That easily exceeds our second quarter CapEx of $215 million and year-to-date CapEx of $272 million. So as a result, we've had free cash flow year-to-date of $900 million.

For the full year 2011, we're expecting capital spending in the $900 million range. And we've got some manageable debt maturities for the remainder of the year, about $500 million. And we have debt obligations maturing in 2012 at about $560 million.

At this time, we don't foresee any financing needs given our current debt maturities, our current cash balance, capital spending plan and cash flow projections.

And finally, I'll give you a quick fleet update. We ended this second quarter with a combined 694 active aircraft in our fleet. Broken down, our combined all-Boeing fleet now consists of 167 737-300s, 25 737-500s, 414 737-700s and 88 Boeing 717s.

In terms of the full year of 2011, we'll have 20 total deliveries, 6 of which are remaining. And we plan to retire about half of that number of aircraft this year.

As we prepare for the transition of the AirTran fleet to the Southwest airline spec configuration next year, we will likely need some additional aircraft in our fleet to cover these additional maintenance lines. However, with over 100 owned 737 Classics in our fleet, we have great flexibility to adjust our retirement schedule to accomplish our ongoing fleet replacement needs while maintaining the integrity of our combined network.

Looking at capacity for the full year 2011, our combined ASM capacity is expected to be up in the 4% to 5% range compared to last year. Third quarter, we expect to be up 4% to 5%. And for the fourth quarter, our combined ASMs are expected to be up about 2%.

Last week, we published our first coordinated flight schedules for Southwest and AirTran through March 9 of 2012. And for 2012, we currently have 33 deliveries scheduled. 8 Boeing 700s and 20 800 firm orders. We got 2 options with Boeing, and we have other agreements in place to lease an additional 5 800s. We plan to retire a like number of aircraft to the deliveries next year. And as we look at our capacity plans for 2012, we currently expect that the combined capacity will be less than or equal to our combined 2011 capacity.

And given the fragile U.S. economic environment and persistently high fuel prices, we'll continue to be cautious as we plan for 2012.

And with that financial overview, I would like to turn the call over to Bob Jordan for an AirTran integration update.

Robert Jordan

Well, thank you, Laura, and thank you, everyone, for joining us today. We have made a lot of progress on the integration since we closed on May 2. And I'm eager to take you through some of that for a few minutes here.

But of course, any discussion of our accomplishments today would not be possible without the hard work and dedication of our employees, and that includes both Southwest and AirTran employees. I've split my time between Dallas and traveling to our AirTran locations this past several months.

I've had the pleasure of interacting with a lot of Southwest employees and meeting a lot of our new AirTran folks. And I can assure you, there's a lot of energy out there being dedicated to making the integration as smooth as possible while, of course, keeping the day-to-day operation as their absolute top priority.

And on a daily basis, I'm just amazed at the shared enthusiasm that people of both Southwest and AirTran have for bringing the 2 companies together and the optimism that they expressed about our shared future. And I can assure you, that optimism is greater, not less, than it was on May 2 when we closed.

Our people are doing an outstanding job, and I want to thank them for their warrior spirits in this exciting and often challenging time.

So now, moving on to our progress. Certainly, after close, we announced the new leadership structured of the combined companies. We quickly took measures to enhance our communication channels for all Southwest and AirTran employees to keep everyone updated on the progress we're making on our 2- to 3-year integration timeline.

We immediately began discussing transitional opportunities with AirTran employees not covered by collective bargaining agreements. And I am thrilled to report that more than 50% of our headquarters AirTran employees have already agreed to join the Southwest family. And many of those folks have already transitioned to Southwest as key support functions such as finance, marketing, revenue management and network planning, are already being managed out of Dallas by Southwest Airlines.

We also kicked off a One LUV tour in July that put Southwest employees in 8 key AirTran locations to introduce AirTran employees to our culture, communications, community outreach and benefits offered by Southwest. And I can tell you, from talking to folks, the effort was received with great enthusiasm, and that One LUV tour winds down next week.

We have also begun to integrate station facilities in cities that we both serve. To date, we've accomplished 9 station transitions in Palm Beach, Fort Lauderdale, Raleigh-Durham's, Kansas City, San Antonio, St. Louis, New Orleans, Las Vegas and Phoenix, and we have plans to transition 7 more by the end of September. And that includes Chicago Midway and Denver next week.

Southwest is also now handling ramp responsibilities for AirTran flights at West Palm Beach, Kansas City and San Antonio, the first of many of these efforts to come. We've also streamlined our back office functions where possible, and that includes procurement. That's created immediate efficiencies and cost savings with Southwest's significant buying power. We've had the opportunity to review and modify many of AirTran's existing contracts, primarily in the finance, treasury and maintenance areas, and we've already realized modest cost synergies in the second quarter.

On the labor front, the negotiating committees for our collective bargaining workgroups are in discussions and are making good progress on seniority list integration. We were very pleased that our 2 pilot groups took the lead on that front, with SWAPA, ALPA and the company's negotiating committees recently agreeing on a framework to integrate the seniority list there.

And I'm happy to report that late last week, the SWAPA board unanimously approved sending a tentative agreement to Southwest pilots for consideration, and the ALPA board will meet next week to consider approving the agreement as well. And if that occurs, the agreement then goes to both pilot groups for ratification.

Also, on the labor front, we've completed a very important preference bid for cross-trained AirTran customer service and ramp employees, so that AirTran employees currently serving in a cross-train station could bid for the position that they would prefer after integration with Southwest.

Now until the seniority list integration is complete, these employees will continue working as they do today. But this cross-trained preference bid positions us well for the integration of the workgroups to do that quickly when that time comes.

We are also on track to receive our single operating certificate from the FAA in the first quarter of 2012. At that time, we can then begin transitioning AirTran aircraft into the Southwest livery. Of course, we'll need to manage our active fleet accordingly to make sure that we have enough lift to cover our schedule as we transition the AirTran fleet. So as Laura mentioned, I think you'll see some ebb and flow there in our capacity.

Our crews will also undergo retraining at that time, and the changes will begin to become very visible to our customers.

And finally, we published our first coordinated flight schedule last week for the winter flying in 2012. And while that schedule release did not yet connect the networks, which we currently expect to do in the first half of 2012, this coordinated schedule is a great first step, and it begins to position us to connect the networks in the future. And it also positions us to provide a more optimized combined network.

The normal seasonal dip in demand in the winter coupled with very high fuel pricing warranted a slightly more dramatic reduction in published trips on a year-over-year basis. And as Laura noted, we are evaluating our 2012 capacity in light of high fuel prices. And currently, I do not expect year-over-year growth in ASM capacity for the combined network.

I absolutely believe we have significant opportunities to optimize our combined network while providing an even better schedule for our customers. And we are moving as quickly as feasible to achieve our targeted network synergies there.

So in summary, just absolutely great progress in a little over 90 days. And there's a lot more to come. While there's a lot more work ahead, we are exactly where we planned to be in the integration. And I would tell you, I think we are exactly where we should be at this point in the integration.

This is a direct result of the tireless efforts of our people, both Southwest and AirTran, and the efforts they have committed towards integration. And I am just very, very proud of them. The multi-year transition process will, no doubt, include challenges at some times. But I am confident in our ability to make this acquisition one of the most successful in the history of the airline industry, and ultimately, one that would create a more efficient, stronger and profitable company as a result.

And with that, I will turn the call back over to the operator to provide instructions on how to queue up for questions.

Question-and-Answer Session


[Operator Instructions] And we'll take our first question from Jamie Baker with JPMorgan.

Jamie Baker - JP Morgan Chase & Co

Gary, just wondering if you're disappointed that Boeing isn't building a truly new airplane for you and if you think that the 737 already does deliver enough improvement, vis-à-vis, whatever your operational needs might be?

Gary Kelly

Interesting question. I'm just going to give you a pragmatic answer instead of a wishful answer. I've been a proponent of the re-engining solution for years now. And I think my only disappointment is we didn't come to this re-engining decision sooner, where we could guess a re-engined solution sooner. So Jamie, I'm just skeptical of the timetable to bring forward an all-new aircraft. Clearly, that's where Boeing ended up at the same place, and they were concerned about the viability of that kind of a plan. Talking about 2018, 2019, 2020, whatever it is, that's a long way away. And a lot can happen in that period of time.

So short answer is I am pleased with the decision. I'm pleased with the decision to re-engine. We were aware that, that was Boeing's decision before that was made public, and which we appreciate. And we have -- as I think you know, we've been in discussions with Boeing about that and other things for quite some time. So we are anxious to sit down with Boeing and understand just what this reengineer plane is all about. And that has not happened yet. But I expect that, that will happen soon. And Boeing continues to be our primary focus, and if that all works out to our satisfaction, we'll continue to move forward with Boeing.

Jamie Baker - JP Morgan Chase & Co

So I assume this does take off the table any desire to consider other programs out there?

Gary Kelly

Well, it does in this sense. In other words, if Boeing can meet our needs, then I think there is a scenario where we feel like we're done and we can make a commitment and be eligible to launch this re-engined product with Boeing and perhaps, with other airlines. If they don't, well then I think we're obviously -- it's a free country, and we'll consider what other options we have. But our focus at this point is and has been, despite some of the more humorous media reports here recently, it continues to be with the Boeing Company.

Jamie Baker - JP Morgan Chase & Co

Okay. And second quick follow-up, apologies if I missed this before, but can you remind us the level of planned participation in the D.C. LaGuardia slot swap between Airways and Delta?

Gary Kelly

What plans we have to participate?

Jamie Baker - JP Morgan Chase & Co


Gary Kelly

Well, I think that we -- first of all, we'll see what the procedure will be with the auction. And we're very interested to increase our presence in the slot-controlled markets for the obvious reasons. It's just -- it's impossible, otherwise, to get any additional capacity. So yes, I think you can expect that we're very interested. And the odds are, more likely than not, that we'll make a bid. But at this point, I don't think we -- well, first of all, it's not a done deal. So until we actually see what it is and how it's going to work, I can't give you a real firm answer. But yes, at this point, we're definitely thinking that we want to make a bid for those slots.


And we'll take our next question from Bill Greene with Morgan Stanley.

William Greene - Morgan Stanley

Gary, you mentioned price sensitivity among the travelers. And I am just curious as to your thoughts about weighing the desire to sort of keep some of the tax holiday in the fare versus trying to stimulate some demand by giving it back. It seems like you've been mostly taking it, which I think makes sense, but where is sort of the mindset here as we go through the quarter? How do you think about that trade off?

Gary Kelly

Well, Bill, just start at the beginning of the year when, as our thought process has been -- I don't think we're surprised to see the economy in its current state. But we were hopeful that the recovery would be stronger by now. In that kind of a strengthening environment, we were hopeful that we could deal with the reality of higher fuel cost by passing those cost on with higher fares. We've had a number of fare increases, probably an unprecedented number of fare increases in the first quarter, at least 7 this year and probably more, Marcy, than that. Clearly, I think the report today, although Laura or I probably haven't said it, we think we've pushed fares about as much as we should right now to be productive. And now, we really need to more aggressively address capacity.

In the first quarter, I kind of felt pretty good about capacity. And obviously, with fuel prices in the economic outlook now, I think we're going to need to be more aggressive in addressing capacity. So in that regard, yes, we need every dollar we can get, and especially in light of the fact that second quarter was down 48%. That's just not anything that is going to satisfy anybody here. So we have adjusted our fares so that the taxes are kept to be blunt at Southwest. The same fares that our customers were paying before the authorization lapse. And even if we are able to collect the tax all quarter long, well, collect what was the tax with that de facto fare increase, it may still not cover all of the increase in fuel cost compared to a year ago. So absolutely, we're going to continue to stay the course. Now there are media reports, of course, of how the airlines are going to help customers who have previously paid a tax collected by the airline, remitted to the treasury. And we're leading that effort to find a way to refund to our customers the tax that was collected but that is now no longer owed, which is a different question than the one that you asked, of course.

William Greene - Morgan Stanley

Yes, okay. No, that's helpful. And when we look at all the line items, I mean, obviously, the passenger fare number is the big number, but I think it also helps you on cargo and ancillary and fuel. Is that fair?

Gary Kelly

With the reauthorization?

Laura Wright

On the -- yes, so the 7.5%?

William Greene - Morgan Stanley

Yes. Like in other words, frequent flyer mile sales. And I think there's a fuel benefit. And I believe that there's also -- I think those are -- oh, cargo as well.

Laura Wright

Yes, there's definitely excess checks on the cargo, which during the period, the taxes lapse is helpful. So you're absolutely right.

William Greene - Morgan Stanley

And just one quick question on modeling. When we look at the labor costs, how should we bleed in the increase from moving AirTran to Southwest, I guess, contract, is the way to say it? How do we think about kind of bleeding that in? Because it may very well come sooner than the revenue synergy?

Gary Kelly

Well, the -- I would, again, just encourage you to work -- you may have already figured all this out, Bill, and maybe you're comfortable with that there are different ways to think about this. But as compared to Southwest standalone unit cost structure a year ago, adding AirTran isn't harmful at this stage. In some ways, it's helpful. But it doesn't move the Southwest 2010 unit cost needle very much, at least in my analysis. That's the second quarter, and that's the way to think about it going forward. So you'll have to wait from -- for guidance from us about how labor negotiations go as to the timing of implementing Southwest pay rates within the AirTran entity. And obviously, any AirTran employee who migrates over to Southwest, they're going to be at the Southwest pay rates. And you'll need to obviously understand how that's going to go too. So there really are 2 different pieces. It won't start until 2012, and until we get all of the labor contracts negotiated, we won't be able to provide you an answer there. You make a good point about the mismatch in the timing. I would just point out that we have other offsets within the AirTran cost structure to also help mitigate that. So in other words, we are not totally dependent upon revenue synergies to manage the change in cost within the AirTran unit.


We'll take your next question from Dan McKenzie with Rodman & Renshaw.

Daniel McKenzie - Rodman & Renshaw, LLC

Gary, I know you acknowledge that the quarter fell short of goals. But if I could punctuate it a little differently, when I look at Southwest as a stand-alone carrier, forgetting about AirTran, the 6.8% operating margin is Southwest's worst operating margin performance in roughly 2 decades if I am not mistaken. Worse than the second quarter of 2009 when the global economy was coming unglued and, I hate to say this, but worse than United and Continental. So looking ahead, I appreciate the capacity trends that have been announced, but what gives you the confidence the adjustments are adequate to help Southwest hit return objectives? And then I guess related to that, do the adjustments factor in a recession?

Gary Kelly

Well, I'll just take it in reverse. No, we're not -- the discussion that we're having is not planning for a recession. And so that would be plan B, if you will. Whether I'm confident that we'll be able to manage our way through higher -- really, we're talking about higher fuel prices. And that, I think, if you go back and match up the performance to the guidance that Laura and our team provided at the end of the first quarter, we're in line with that guidance, except for fuel costs. So fuel cost is an important piece that we're going to have to manage here. But I think you take the 3 to 4 strategic efforts that we have underway. You add that to, not really add it, but then you just focus on the opportunities that we believe that we have within the capacity optimization to drive unit revenues, and I think we're very confident. I think the big question is, if you set a recession risk aside, it continues to be at what fuel price? And we keep chasing the target up. And we're concerned about that. So I think that, that certainly suggest that we need to be very mindful of any fleet or capacity increases at this point in time.

Daniel McKenzie - Rodman & Renshaw, LLC

No, I appreciate that. And if I could just come back a little bit differently here, kind of on the same theme, and this is a question I know I've asked in the past, but taking fuel into consideration, taking the economic backdrop into consideration, is it necessary to manage the carrier perhaps even more conservatively? So I guess does Southwest instead need to really target a 20% return on invested capital and, of course, continue managing the Street to 15% as you've been doing, so that when fuel spikes or we hit demand softness, there is still a chance of hitting that 15% goal?

Gary Kelly

Well, our cost of capital, I think, is well below 15% first out. I think -- what I've asked our team to do is -- let's get to our cost of capital first, then we'll get to 15%, second. And then I think we can make some good judgments about how we want to invest in the business from that point forward. But it's been a long drought, Dan. There's no question about it. And I think Laura made the case very clearly, that the crack spreads have sort of added insult to injury here with fuel costs. So energy prices, well I think we were planning on a $90 crude oil mas o menos for 2011. And effectively, it's been closer to $120 here recently with the Brent prices. So it is obvious that we're not covering that kind of a fuel price yet, and we're determined to do that.

Now you look at the 4 initiatives that we have, including AirTran, and they're, in the aggregate, worth over $1 billion. I think the other thing that we're going to need to do in addition to those and managing the capacity here more aggressively, is we're just going to have to attack our cost inflation much more aggressively. The focus for the last 5 years, starting with me, has been on investing in and improving the customer experience to drive more revenues. And we're going to have to gradually turn our sights here much more aggressively to optimizing our cost structure. It's tough to do both simultaneously. Everybody at Southwest Airlines is working very, very hard with a lot of construction underway. And we're very, very mindful of that. But at the end of the day, we need to make our -- hit our return targets. And well, they're not targets, they're requirements. We've got to do it, and I'm confident that we will.


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

Duane Pfennigwerth - Evercore Partners Inc.

Just wondering if you can compare the flat capacity outlook for 2012 or, I guess, flat to down? How does that compare versus your prior plan?

Gary Kelly

I think we were looking more towards 2013. But I think we're going to be down. Bob, what do you think? 3 or 4 percentage points compared to what was available for 2012 capacity wise?

Robert Jordan

Yes. Yes, we were looking in the 4% range, and now it's flat to maybe even slightly down.

Gary Kelly


Duane Pfennigwerth - Evercore Partners Inc.

Okay. And then can you give us any sense for growth between the 2 entities, how that would split out?

Gary Kelly

I don't think we're thinking about it that way anymore. We probably can. But one headline is just to remember that once we get into a conversion process, we're going to have to take equipment out of AirTran to remodel it. So the AirTran capacity is -- and it's converting at the same time. So it's going to be coming -- But we're not going to be putting any more airplanes into AirTran. We'll be pulling airplanes out of AirTran beginning in the first quarter.

Robert Jordan

Right. Yes. So if you think about it, just -- we're going to probably run 3 to 4 conversion lines at the time, is kind of the current plan. And just that on its own takes probably 3% of AirTran available capacity out just for conversion lines.

Gary Kelly

So we have a hard -- in other words, Duane, when you ask the question that way, we're not -- it's hard for us to think that way, because AirTran will -- it's going to be shrinking. It will be shrinking, and we don't quite know yet exactly how aggressively. But it'll be numbers of airplanes per month once we get it up and running after SOC.

Laura Wright

Yes. Duane, I think the best way, going forward, really is to think about everything on a combined basis. That's just the way we'll be talking about it in planning.

Duane Pfennigwerth - Evercore Partners Inc.

Okay. And then when do you expect Southwest metal to show up in Atlanta?

Gary Kelly

Stay tuned.


We'll take our next question from Gary Chase with Barclays Capital.

Garrett Chase - Barclays Capital

Just a couple of quick ones. From what you're describing in the revenue environment, it would sound like you hit a little bit of a hiccup in July, at least relative to some others that we've heard from. And I understand, with all the adjustments and the combinations and so on, it's kind of hard to read. Wondered if that is accurate and what your perspective is on kind of getting things back on track? And when you said that you thought July -- or excuse me, August and September would be more normal sequentially, was that with a July that you said was off? Or more normal with like a June?

Gary Kelly

I think that's the new normal. So it's June. June was a little off trend, and then July was off trend yet again. So I think that you asked a very fair question. I don't know that we're certain that we know the answer to that yet. Look at our revenue performance over a longer period of time, and it's very strong. Some of it could simply be year-over-year comps. And of course, I know you know the numbers. But our 2010 performance was off the chart. So if you're looking at it that way, I don't think that, that will draw the best conclusion. On the other hand, if we're all looking at each other as compared to how we did in June, I think that's a pretty fair way to compare us. And I think we've got a little work to do ourselves before we draw any conclusions there.

We have obvious things to explore, how our new -- with respect to new markets and new capacity that's been deployed. How are they performing, and what our expectations in the near-term? We'll look at pricing actions that we've taken, sale activity and just basic revenue management, which is never basic, is the problem. It's easy to say and hard to do. But we'll be doing all of those things. In the meantime, though, we have some -- from a revenue management or a profit management performance, we have some "no regret" moves with capacity, which those are the ones that I referred to earlier, where we're going to -- AirTran is going to discontinue service to some cities, and then Southwest has discontinued some nonstop city pairs. And there will be more, I'm afraid. With energy prices continuing to be high, we'll probably have to continue to aggressively optimize the flight schedule. The great opportunity being, of course, where we take AirTran schedule and convert it into Southwest. I can assure you, it won't look the same. It's going to be different. And that'll -- if we've optimized Southwest over the last year, it'll be a super optimization effort that will take place there.

Garrett Chase - Barclays Capital

And I guess that kind of leads into or is a good segue into what I also wanted to ask. At least, as I understood, AirTran was very fuel sensitive. And I know right now you are operating AirTran largely as it was for the time being. I fully appreciate that's going to change dramatically in the near future. But I am wondering if maybe these adjustments and the capacity reductions that you are thinking are going to be disproportionately skewed towards that part of the network for the reasons that I was describing? Or you could draw...

Gary Kelly

Yes, I could say the same thing. I think that first of all, the AirTran route system underperforms the Southwest route system. And there's a mix of traffic, there's connections, there are small cities, there are subsidies, there's a whole bunch of things that are very different than the Southwest route system. And we will want to -- we have ideas and obviously, the very talented former AirTran management we have under contract and consulting agreements. And we'll want to work closely with them and get their views. But the point is, we see some significant opportunities to improve the unit revenue performance of that entity.

Garrett Chase - Barclays Capital

Okay. And then just one quick cleanup. Is SOC the earliest that you could see the labor cost change that somebody was asking about a little earlier, Bob? Could it possibly happen before that?

Robert Jordan

Well, I think it'll be a -- yes, I would separate them. SOC is the point at which we have the ability that under one single operating certificate to begin to move the aircraft, move the crews, and begin to really push forward on the integration of the operation. I would separate the work on seniority list integration and then whatever happens to the timing and wages from that. So I think the answer's no.

Garrett Chase - Barclays Capital

They're not related. Okay.

Robert Jordan

They're not relating.

Gary Kelly

Gary, the only thing that -- and I agree with everything Bob said. We'll be moving people from AirTran into Southwest. Laura and her department as an example has already done that in finance. So there are exceptions to that general rule that Bob mentioned. But by and large, in the operating groups, yes, the contract folks, they're going to come with the airplanes once they're paid in the Southwest livery, unless we negotiate something different which would logically be after SOC, their pay wouldn't change until they're a Southwest employee.


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

Helane Becker - Dahlman Rose & Company, LLC

So completely off-topic, can you talk about your experience so far in Newark, which I think is a new hub or a new city for you?

Gary Kelly

Yes, our experience there has been good. We're a little fish in a big pond there, and mostly driving our business from our -- the destination markets. We're looking to drive, most of our business right now, looking to Newark as a destination, maybe as a little bit clearer way to say that. And that's not at all surprising to us and certainly, what our expectation is. Load factors are solid. It didn't start off really hot it is a contrast of the presence that we have in South Carolina. It started off like gangbusters. So it's a little -- it takes a little bit more effort to get established and create awareness, but I feel like that's been done. Newark, it is a tough environment to operate in. There is no question about that. We went in with our eyes wide open, and we're operating a schedule that is pretty modest. And I think that, that makes sense. It is one of the most congested airports in the country.

Helane Becker - Dahlman Rose & Company, LLC

Okay. And then just with respect to the going forward, how we should kind of think about the announcements that you've made with respect to pulling out of a number of cities. I noticed that you are leaving a number of markets, for example, Philadelphia, Pittsburgh. I mean, is that -- I thought that was kind of a big market for you? And now it looks like you are leaving it. So could you just talk about what's going on maybe in Philadelphia within the context of everything else? Maybe your Philadelphia, Baltimore, too much capacity, too close together?

Gary Kelly

You bet. I'd just take it in reverse. No, I don't think there's any meaningful interplay between Philly and Baltimore that is worrisome to us. I think Philly, Pittsburgh -- I'll just admit to you, that's personally a disappointment for me. That's a classic short-haul market. It is extraordinarily weak. And it was not big for us, by the way. We started out with 8 daily departures there, and it never "took off." Remember, we opened Pittsburgh in '05, Philly in '04. We went to 6 daily departures, and we were down to just 4 dailies. And even -- we couldn't even make that work. So the demand across the country and many short-haul markets is very weak compared to what it was even in the 1990s. So it's actually not atypical. I'd love to be in the market but again, we just couldn't make it work. There's just not enough demand there.

Helane Becker - Dahlman Rose & Company, LLC

Okay. I was actually wondering about that. Since the past 10 years have gone by and the way things have changed in the industry with security blah, blah, blah, I kind of wondered if short-haul traffic was actually suffering significantly more than long-haul. So it seems like you're confirming that.

Gary Kelly

That is a fact. And even if you look at a longer time horizon than a decade, even 20 years, you know well the cycles and the effect, especially on business travel. But typically, post recession, those markets rebound. And many short-haul markets did not rebound after the 2001 recession, which is obviously compounded by 9/11. A lot of theories on why, and I don't need to speculate here on why that might be. But we have tried to mitigate that risk by diversifying our route structure. And of course, you've seen us fly longer and longer over the last 10 years. And we've also facilitated more connecting opportunities, which has worked out handsomely for us as well. But those are some of the business reasons that we've done that. You look -- Interestingly enough, when you look at -- nobody really asked the question, but since I'm talking, I'll go ahead and share this with you all. When you look at the current performance in the second quarter, our short-haul market's revenue performance is very strong, intra-Cal, intra-Texas, so I wouldn't extrapolate our Pittsburgh, Philly report too much because we still have a dominant share of our flights, are in short-haul markets and obviously, they produced a very significant profit for us.

Helane Becker - Dahlman Rose & Company, LLC

Okay. And then just on your advertising, I noticed that you have gone to this frequent flyer redemption program, the Red Tape ads. That's what I see a lot of, and I don't see the Bags Fly Free ads. Is that a seasonal ad campaign? Or are you thinking about checked bags differently? And that is my last question.

Gary Kelly

Yes, Bags Fly Free will definitely continue. So there is no intent to begin to message differently on Bags Fly Free, just to make that clear. We're very committed to Bags Fly Free because it works. And it generates a lot of profits for us with that approach. We have an all-new program in terms of the Rapid Rewards and so had agreed that we were going to put a lot of advertising muscle behind that. And as Laura reported earlier, we think it's just working magnificently. The membership increases are off the chart as are other revenues, the fair premium we get from our frequent flyers and on and on and on. I'm kind of shuddered to think what the revenues might be without some of that boost, quite frankly. So that's all that is. And we've run those ads for quite some time now, and you can -- I'll give you a little wink, and you'll be able to look forward to some new stuff coming pretty soon so.


[Operator Instructions] We'll take our final question from Michael Linenberg with Deutsche Bank.

Michael Linenberg - Merrill Lynch

Just 2 quick ones here. Laura, you've provided the ticket tax piece, I think, for the first couple weeks, and I missed the number. Did that include -- was that just the passenger piece? Or did that include all of the various taxes that did lapse with the absence of the FAA reauthorization?

Laura Wright

Yes. So Mike, it was really on the passenger side. But you should really think of that as the majority of it. The other items that you're talking about are not as material. But it was really for the 10-day period, from July 23 through the 1st, the impact of the fare increase we took for both Southwest and AirTran was about $36 million in ticket sales during that 10-day period.

Michael Linenberg - Merrill Lynch

Okay, good. And then just my second question, Gary, you made the point earlier that you sort of felt like that maybe fares have been pushed as far as you thought they were given the backdrop. And kind of in the context of that, we did have -- about a month ago, there was a broad fare increase, and it looked like everybody was on board, including yourselves and AirTran, although you quickly backtracked. And I think it was within a day, and there was a view that one day, arguably, is not enough to assess whether something sticks or not. And I'm just curious if you can at least give some color on that? I mean, was that indicative of maybe what you think you're seeing? That maybe you're seeing pushback quickly? Anything you could say on that would be great.

Gary Kelly

Mike, I'm not sure I can say a lot. With respect to the -- just sort of the drama of that one, I don't recall anything like you're describing. I'm not saying it didn't happen that way. But in other words, what I am comfortable in sharing is we didn't put a fare increase out and then change our minds. So I don't mind telling you that. We did not do that. What we did, and I'm not sure -- of course, fares change so much. But with respect to -- I don't know that I'm comfortable talking about our philosophy or what we might do next, other than what we've already said, which is we do sense that there are problems with the economy. Common sense would tell us that, that might have some impact on business travel. We know that we have the majority of our traffic flying for personal reasons and more consumer-oriented, when we all know that they're price-sensitive. And it just feels like -- we know we've been -- and finally, we know that we've been aggressive this year in moving fares up.

Now, having said all of that, that clearly, that creates an image that we're not really bullish about the demand right now. And that's why we have acknowledged that we'll be aggressively addressing capacity. Having said all of that, that doesn't necessarily mean that we have perfectly managed our fares. And it doesn't mean that we could not have had higher fares in certain ways or certain days or with various fare sales or what not. And we'll be reviewing all of that as we always do. But no, I think it -- my way of saying this, and I think that we're very consistent with the industry, personally, and very consistent with what we're seeing and hearing from other businesses, is that we've been able to grow our revenues aggressively post recession, but that the rate of growth is slowing. And that slowing, we began to see signs of that in the second quarter. And it seems to me that, that slowing rate of growth is continuing here into the third quarter. It's not saying that we have a weak revenue environment. It's not saying that it is soft. It's not saying that it's getting worse. It's just that the rate of improvement is slowing.


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

Laura Wright

We just like to thank everybody for listening in this morning. Marcy and her team will be available as usual for any follow-up questions. Thank you all.


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

Ginger Hardage

Great, thank you so much, and we welcome our media folks. I know many of you have been on the call the entire time. Now is a great opportunity to queue up, and we'll get ready to answer your questions right away. So Tom, do you mind refreshing everyone on those procedures?


Yes, ma'am.

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