Southwest Airlines (LUV) Q1 2018 Results - Earnings Call Transcript

| About: Southwest Airlines (LUV)

Southwest Airlines Co. (NYSE:LUV) Q1 2018 Earnings Call April 26, 2018 12:30 PM ET

Executives

Ryan Martinez - Southwest Airlines Co.

Gary C. Kelly - Southwest Airlines Co.

Tammy Romo - Southwest Airlines Co.

Thomas M. Nealon - Southwest Airlines Co.

Michael G. Van de Ven - Southwest Airlines Co.

Linda B. Rutherford - Southwest Airlines Co.

Analysts

Hunter K. Keay - Wolfe Research LLC

Jamie N. Baker - JPMorgan Securities LLC

Jack Atkins - Stephens, Inc.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Savanthi N. Syth - Raymond James & Associates, Inc.

Michael J. Linenberg - Deutsche Bank Securities, Inc.

Duane Pfennigwerth - Evercore ISI

Darryl Genovesi - UBS Securities LLC

Joseph William DeNardi - Stifel, Nicolaus & Co., Inc.

Brandon R. Oglenski - Barclays Capital, Inc.

Conor Shine - The Dallas Morning News, Inc.

Alana Wise - Reuters

Mary Schlangenstein - Bloomberg LP

Leslie Josephs - CNBC

Dawn Gilbertson - The Arizona Republic, Inc.

David Koenig - The Associated Press

Operator

Welcome to the Southwest Airlines First Quarter 2018 Conference Call. My name is Tom and I will be moderating today's call. This call is being recorded, and the replay will be available on the Southwest.com in the Investor Relations section.

At this time, I'd like to turn the call over to Mr. Ryan Martinez, Managing Director of Investor Relations. Please go ahead, Ryan.

Ryan Martinez - Southwest Airlines Co.

Thank you, Tom, and I want to welcome everyone to our first quarter earnings call. Joining me today, we have Gary Kelly, Chairman of the Board and CEO, and Gary will kick us off with a few opening remarks. We have Tammy Romo, our Executive Vice President and CFO, who will provide an overview of our financial performance and outlook. Tom Nealon, our President, will cover revenue trends and outlooks; and Mike Van de Ven, our Chief Operating Officer, will provide an update regarding Flight 1380.

A few disclaimers before we get started. Today's call will include forward-looking statements based on the company's current intent, expectations and projections. A variety of factors could cause actual results to be materially different. We will also include references to non-GAAP results, which excludes special items. You can reference this morning's earnings release for further information regarding forward-looking statements and reconciliations of non-GAAP to GAAP results.

And I also want to note that the company adopted three new accounting standards effective January 1, 2018. Certain prior-year financial information has been recast to reflect the adoption of these new standards. And for more information, please reference our Form 8-K furnished to the SEC on March 20. You can find our earnings release and our SEC filings on the Investor Relations section of Southwest.com. And following our prepared remarks, we will open it up for questions.

So at this time, I'd like to turn the call over to Gary.

Gary C. Kelly - Southwest Airlines Co.

Thank you, Ryan, and good morning, everyone. And thanks for joining us for our first quarter earnings call. And I am pleased to have the opportunity to update our shareholders on a couple of important matters. I want to start by sharing that our priority remains supporting and caring for all of those that were affected by Flight 1380 last week and, of course, in particular, the family and loved ones of Jennifer Riordan. She was an extraordinary person and, of course, we all mourn her passing. It was a dark day, but the compassion and concern and support since the event have been truly extraordinary and it just touches your soul.

Our five-person flight crew, led by Captain Tammy Jo Shults, performed magnificently. Our Ground Operations Team in Philadelphia threw themselves into the task of supporting all of the customers on that flight, which took many hours. And on behalf of Southwest Airlines, I want to thank all of our competitors who came to our customers' aid that day. There were many, but I especially want to thank American Airlines. And finally, I want to thank the selfless customers who heroically pitched in to help while the flight was being diverted to Philadelphia.

In the aftermath, we had many teams that have sprung into action for support of our customers and our employees, for that matter, as well as the NTSB. We have an equal priority, and that is ensuring that there are no blades with metal fatigue. And our tech-ops team working with GE, CFM, Boeing and the FAA have truly led the industry through new inspection protocols, and for us, it dates back to 2016. So last week, we accelerated the inspections. They are going well. I've been very pleased with the preliminary findings, which reveal no cracks or fatigue.

We're working with GE, CFM and the FAA very closely to ensure we're in full compliance of CFM's service bulletins as well as the FAA's Emergency Airworthiness Directive that was issued last Friday, and we continue to work with and support, of course, the NTSB in their investigation of this event. We have multiple tasks underway, and I want to assure you that the Southwest team is up to the task.

And the next priority I want to cover is our business. Our first quarter results were very solid, despite it not being our best revenue performance, but it was still solid. Strong margins, excellent cost performance, strong return on capital, strong free cash flow, and shareholder returns makes for the second-best earnings per share for a first quarter in our history.

The booking softness that we mentioned in the press release since last week is predictable, and excluding that effect and taking into account the Easter timing shift away from this year's second quarter, the sequential trends look pretty normal to me. Regardless, our revenue plan this year has always been a second-half story, and we've implemented better revenue management techniques already in first quarter to manage against overly aggressive discounting. And we have several major enhancements to revenue management taking effect midyear relating to our new reservation system that you all are already aware of.

And of course, finally, we will be optimizing our flight schedule roughly every 60 days as the second half unfolds. And the bottom line of all this is demand has been strong. It remains strong. Tax reform should help that. Our outlook is positive, and the prospect of record non-GAAP earnings per share is very much alive.

A couple of other notable items in the release. We announced four Hawaii destinations: Honolulu, Kona, Maui, and Lihue, and our Hawaii work remains on track. And we announced firming up 40 more MAX 8 options from the 2026-2027 time period, moving them to ten per year starting in 2019. This is first and foremost an extension of our fleet modernization strategy. We have a very strong business case to replace older 737-700 aircraft, given the superior economics of the MAX 8. The tax reform benefit for Southwest makes this capital investment more feasible, and of course I want to thank Boeing for their support in making that happen.

With that, I'd like to turn the call over to Tammy Romo to elaborate further on our first quarter results.

Tammy Romo - Southwest Airlines Co.

Thank you, Gary, and thank you all for being on our call today. I also want to express my gratitude for our employees and how they pulled together to take care of our customers and each other during incidents like last week's accident. That's what families do in difficult times, and I am very proud to work alongside all of our compassionate and caring people.

This morning, we reported a strong first quarter performance with net income, excluding special items of $438 million, up 22% year-over-year, and our earnings per share was $0.75, up an exceptional 29% year-over-year and $0.01 above consensus. Our operating margins was a solid 11.8%, in line with first quarter last year. And our net margin was 8.9%, an improvement from first quarter 2017, 7.4%, as we begin to realize significant savings from the lower corporate tax rate.

Our pre-tax ROIC was 27.1%, or 20.8% on an after-tax basis for the 12 months ended March 31. Our first quarter revenue performance was right in line with our previous guidance. Our cost performance was better than expected, and that's primarily due to some spins shifting into second quarter with a solid cost outlook for the year.

While we are off our plan here in the first half of the year, the benefits from our new reservation system are ramping up in the second quarter with more significant benefits coming in the second half. We also expect the pressure from our sub-optimal schedule to recede in third quarter as we overcome our fleet deficit from our Classic retirement last fall.

Based on everything we know so far, we expect our second quarter year-over-year unit revenue performance to be a bottom for the year, and we will keep after our goal to have positive unit revenues in the quarters ahead. Our balance sheet remains very strong, and we had another quarter of very strong operating cash flow, allowing for $648 million of shareholder returns during the first quarter.

And as we continue to modernize our fleet, we still have manageable capital spending this year of $2 billion to $2.1 billion. With strong first quarter margins under our belts along with benefits coming online from our new reservation system, a great fuel hedge that provides meaningful protection in a rising fuel environment and benefits from tax reform, we are well-positioned to achieve our goal to expand our 2018 net margin year-over-year excluding special items.

And with that brief overview, I'll turn it over to Tom to walk you through our revenue trends and outlook.

Thomas M. Nealon - Southwest Airlines Co.

Okay. Thank you, Tammy, Good morning, everyone. So let me start off with our Q1 performance and I'll jump right into Q2. So as you know, we had record operating revenues of $4.9 billion in the first quarter, which was driven by record passenger revenues of $4.6 billion. We also had very strong performance in Other revenues, which were up 19% year-over-year.

And this is a combination of strength in our EarlyBird and Upgraded Boarding products, both of which were up double digits for the quarter, as well as the continued strength in growth of our Rapid Rewards program and business partner revenues, which are both performing very well. And we also had, as you know, a record load factor of 81.5% for the concluded first quarter. So having said all that, our revenues grew right in line with our ASM growth of 1.8%.

So, as we shared our 8-K last month, there were several factors that caused us to update our RASM guidance for the quarter, and I want to hit on those real quickly. The first factor was our March RASM trends, which were off for the first 20 days of March, and this was largely the results of the spring break calendar shift, which reduced travel demand more than we anticipated. This resulted in a little less than 1 point of negative impact to RASM.

Having said that though, we finished March very strong with very strong RASM performance, and strong load factors. In fact, during the last 11 days in March, we saw our yields grow in the mid-single-digit range year-over-year. And in particular, as Tammy said, the Easter calendar shift from April to March gave us a benefit of roughly $40 million.

The second factor we called out in our 8-K was our sub-optimal flight schedule and I think you all understand this. But as you know, we're in the middle of a fleet transition, which means that we had fewer planes to fly in the schedule, which then means that we're extending the day and doing more flying early in the morning and later into the night, and this generally results in lower yields. But just to be clear, these flights are still profitable and they contribute to the overall network profitability. But there was, in fact, a negative RASM impact for the quarter. And as Tammy said, you'll begin to see this recede in the third quarter as new aircraft come into service.

And the final factor was the competitive fair environments. And on this one, I want to speak specifically to California, which is, obviously, a very competitive market, and we've been competing very aggressively, and we will continue to do that. You all know that we have a very strong market position in California. And, in fact, we have a 63% intra-Cal market share and a 26% market share for all commercial air travel, which includes international in and out of California.

We've added a fair amount of capacity into California and even with our additional flights, we've been able to increase our load factors and we're getting new first time Southwest customers. It is, in fact, impacting our RASM. But we have low costs, low fares, high load factors and strong operating margins. We are generating strong profits and we're gaining new customers, and that's not a bad formula. We are very well prepared to compete, and we will succeed. The combined RASM impact of the sub-optimal schedule in the fare environment was roughly 1 point of RASM for the quarter.

So, that's Q1. Now let's talk about Q2. At the macro level, we are seeing strong demand, as Gary suggested, pretty much throughout the quarter and it tends to be across all regions. Now having said that, I think that we have several unique factors that are impacting our second quarter RASM and it gets us to a guide of down 1% to 3%. And the first, as you'd expect, is the impact of Flight 1380. We are forecasting lost revenue to be in the range of 1% to 2% in terms of RASM for the quarter.

And just for context, in the first week since the accident, we've seen somewhere between 0.5 point and a 1 point of RASM decline so far. That was skewed towards close-in bookings that will be very tough for us to recover. But we're also seeing an impact on travel for May and beyond. So, the full revenue impact isn't totally clear, but we do expect there would a continued impact for some period of time.

Now keep in mind, last Tuesday, we turned off all of our marketing immediately upon the accident. And that included all television, all emails, all paid search, all paid display, all paid social, everything. And that's pretty significant. Those marketing vehicles drive a lot of traffic to Southwest.com. And we only began to slowly bring our marketing back up this past weekend. But as we went back into the market, we did begin to see traffic to Southwest.com ramp back up, but it is not yet back to normal levels. And I think that with an event like this, this is pretty much what I'd expect to see. Traffic will rebound, but it's not there yet.

The second factor I want to hit on is the continued impact of the shoulder flying that I covered in Q1 update. And it's really the same thing. We will have this with us throughout the second quarter, but we will begin to see that diminish in the third quarter as we bring new planes into service. And the third factor is the ongoing competitive environment in California. As I said, we are generating strong profits and we are well prepared to compete and we will succeed financially and with our Southwest customers.

Now on the other side of the equation, we're also still on track to see $40 million to $50 million of benefit in the second quarter from our new res system, as we discussed in the past. And we continue to feel very confident that we'll capture $200 million annual benefit that we discussed with you in the past.

So while we are clearly off of our revenue plan for the first half of 2018, the second quarter is the bottom in terms of our year-over-year RASM trends. Things will begin to kick in and improve in the second half of the year. We'll begin to get our fleet back in balance with our new aircraft deliveries. We'll begin to re-optimize the schedule with the new aircrafts and we'll see the increasing benefit with the reservation system.

And as you expect from Southwest Airlines, we are very focused on solid earnings, solid margins and strong returns in the second quarter. So, we are very optimistic, and with that, Tammy, I'm going to turn it back to you.

Tammy Romo - Southwest Airlines Co.

Thank you, Tom. Turning to fuel, our first quarter 2018 economic fuel price per gallon of $2.09 included a $0.05 hedging gain from settled contracts and a $0.07 hedging premium cost. There was a lot of volatility during the first quarter, but actual market prices ended up being down only slightly from original expectations in January.

Looking ahead to second quarter, based on market prices and our hedging portfolio as of April 20, we expect our economic fuel price per gallon to be approximately $2.20, including an estimated $0.07 hedging gain and a $0.06 hedging premium cost. And for full year 2018, we currently expect our economic fuel price per gallon to be in the $2.15 to $2.20 range. And that includes an estimated $0.06 hedging gain and a $0.06 hedging premium cost.

Our 2018 fuel hedge position are producing modest gains at current Brent crude market prices with more material gains that kick in at $80 per barrel and above. Our hedge portfolio for 2018 and beyond provides us protection against catastrophic rises in energy prices without floor risk exposure, and it enables us to make prudent adjustments to our business in a rising fuel price environment in order to maintain our financial goals and reduce volatility in our earnings. We are continuing to realize fuel efficiency benefits from our ongoing fleet modernization. Our first quarter ASMs per gallon improved by 1.3% year-over-year; for 2018, we continue to expect a 2% to 3% improvement year-over-year in ASMs per gallon.

Moving to our non-fuel cost, our first quarter non-fuel operating expenses excluding special items increased 1.4% and decreased slightly on a unit basis year-over-year. Our unit costs came in slightly better than the low end of our latest guidance, primarily due to cost shifting to future quarters, such as advertising. Year-over-year increases in salary, wages and benefits, maintenance and airport costs were offset by lower depreciation and aircraft rentals and due to Classic retirement benefits.

For the second quarter, we expect our CASM, excluding fuel and profit-sharing, to increase in the 1% to 2% range year-over-year, and the primary drivers there include labor costs, including our agreement with AMFA and higher cost related to an extended operating day driven by our Classic retirement and our current fleet deficit; and as I mentioned earlier, cost shifting from first quarter and estimated costs related – and other more minor cost.

For full year 2018, we now expect our CASM, excluding fuel and profit-sharing to be comparable year-over-year, and again this includes our agreement with AMFA. I am pleased with our first quarter cost performance, and we remain focused as always on controlling our costs and finding ways to be more productive and efficient.

And now, before I cover our financial positions, capital deployment and growth outlook, I'd like to turn it over to Mike to provide an update on Flight 1380.

Michael G. Van de Ven - Southwest Airlines Co.

Okay. Well, thank you, Tammy. So, here's what we know from the NTSB so far. We had a failure of the number one engine, and there's an engine fan blade partially missing and that's blade 13 of 24. There was a remnant of the blade that was still attached to the fan hub; and when it was tested, it was found to be fatigued. And the NTSB has suggested that the fatigue fracture was the initiating event that caused fan blade 13 to break. Next, we know that the engine inlet cowling suffered significant damage and loss, and pieces of that cowling may be responsible for the damage to the fuselage, the wing and the stabilizer. And the loss of a single blade inside the engine just shouldn't have caused such dramatic impact.

So as Gary mentioned, we're completely cooperating with the NTSB, and they're doing a very thorough investigation. We have been in constant contact with all the parties involved throughout the investigation. Just some color on our fan blades. We've got roughly 35,500 fan blades that support our fleet. We had inspected about 17,000 of those prior to the accident last week and we were on a path to complete the inspections of the remaining 18,500 by year-end and that would've meant the recommended service bulletin timelines. Since the accident, we accelerated those remaining inspections with a goal to have them complete in 30 days, and we completed inspections on about 8,500 of them at this point. And as Gary mentioned, we have had no findings of subsurface cracks.

So, this is really – it's an all-hands on deck activity to work through the inspections, the investigation and to do a deep dive to understand what happened and why. And we're going to do everything we can to ensure it doesn't happen again. It has truly been a 24/7 around-the-clock effort, and I sincerely want to thank everyone involved for their thorough and their diligent and their committed work.

So with that, Tammy, I'll turn it back to you.

Tammy Romo - Southwest Airlines Co.

Thanks, Mike. I'll turn now to the balance sheet and cash flow, and take you through that quickly here. Our liquidity is strong, and we ended the quarter with cash and short-term investments of approximately $3.2 billion. Operating cash flow was approximately $1 billion in first quarter and free cash flow was $708 million, allowing us to return $648 million to our shareholders through share repurchases and dividends. Our leverage is approximately 30%, in line with our leverage target, which is in the low- to mid-30% range.

Based on our tweaks to our Boeing order book that we've already taken you through, our 2018 CapEx is expected to be in the $2 billion to $2.1 billion range. Included in this total, we expect 2018 aircraft CapEx of approximately $1.2 billion and non-aircraft CapEx in the $800 million to $900 million range.

We continue to effectively balance and manage our overall capital deployment, and we remain focused on preserving our strong balance sheet and healthy cash flows. We currently have $850 million remaining of our $2 billion share repurchase authorization, and we will continue to evaluate our investments in our company, our people and our shareholders, including the mix of share repurchases and dividends with an overarching goal to drive long-term value for our shareholders. We are benefiting from a lower corporate tax rate, and we continue to expect our 2018 effective tax rate to be in the 23% to 23.5% range.

Moving to a quick update on fleet, we had 11 deliveries during first quarter and we ended the quarter with 717 aircraft. As we've communicated, we're in a fleet deficit compared to midyear 2017 when we had around 735 aircraft before the retirement of the bulk of our -300 Classic fleet in third quarter 2017. And our fleet deficit will recede when we get into third quarter 2018.

We will have significant 737-700 retirements over the next 10 to 15 years, and this order book refresh that we've covered with you in the earnings release, and that Gary also covered with you, along with our remaining order books and options, allows us to manage through our retirement and growth needs in a measured way.

Aircraft CapEx remains very manageable at approximately $1.2 billion to $1.3 billion per year on average for the next five years, and we'll end this year with 752 aircraft, and our capacity outlook for the full year has not changed and we continue to expect an increase in the low 5% range year-over-year.

So in closing, our financial performance is off to a solid start for the year, and we're off to a good start to expand our net margin for 2018, excluding special items. And we are already realizing meaningful benefits of tax reform, and I am pleased that we can continue putting it to work by investing in our business, rewarding our hard working people, and giving back to our shareholders and keeping our costs and fares low for our customers.

So with that overview, we are ready to take questions.

Question-and-Answer Session

Operator

Thank you. And we'll take our first question from Hunter Keay with Wolfe Research.

Hunter K. Keay - Wolfe Research LLC

Hi. Thank you, guys. I appreciate the time. Tammy, just quick point of clarification, you're talking about net margin expansion now. Last quarter we spoke, you had said EBIT margin expansion. Is there a change in the plan? Or am I just misinterpreting the comment?

Tammy Romo - Southwest Airlines Co.

Hi, Hunter. No, you did not misinterpret the comment. And as we've acknowledged here for the first half of the year, we are off plan. So, obviously, in terms of margins, it will depend on how quickly we see our revenue trends recover here. And on the cost side is we feel pretty solid about that. And if you, in terms of fuel, we've got a great hedge in place, so that should be helpful on the fuel side. Certainly, when you take into the account of tax reform benefit from the lower tax rate, we feel good about our net margin goal. But we are not – I guess, I feel good about our progress towards that goal here in the first quarter.

Our net margin, we're just off to a great start here year-over-year, and we will just have to see how it plays out on the cost of revenue side. But I feel real good about the revenue benefits that we have coming on here in the second half. I think we've covered those with you pretty extensively with respect to the reservation system. And so, really no change in our goal. We're just going to keep compounding away on the unit revenue side. So I think that's really the question mark for us here as we think about our outlook for the second quarter. But again, we feel real good about all of the help that we have coming online here over the second half.

Hunter K. Keay - Wolfe Research LLC

Okay. Thanks. And then the incremental eight MAX 8s that are going to be coming in 2019 relative to the plan three months ago. Are those going to be offset by incremental -700 retirements?

Tammy Romo - Southwest Airlines Co.

Yeah, the order that we covered with you, yeah, those are for our fleet modernization efforts. So yes, that would be the intent.

Gary C. Kelly - Southwest Airlines Co.

Yeah, I would say, Hunter, that I'm just trying to recap my own little back-of-the-envelope math here, but there are some airplanes that are moving around absent this Boeing order from 2019 into 2018. So, I think we've covered that with you. And the number is ten, so there are ten additional firm deliveries in 2019, 2020, 2021, 2022. And casting this as part of our fleet modernization absolutely means that we are planning an equivalent number of -700 retirements for these additional 40 firm orders. Now, we've got flexibility in the fleet. We can choose not to do that. But that is what we are sharing with you today is that we have exercised 40, and however they fall, what we are telling you today is that we would offset those with retirements.

Hunter K. Keay - Wolfe Research LLC

Thank you.

Operator

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

Jamie N. Baker - JPMorgan Securities LLC

Hey. Good morning. Gary, I think it's a testament to Southwest's safety culture and your long-term track record that you haven't had to engage in book-away analysis in the past. But since this isn't the type of analysis that you had to do until this past week, would you be willing to share just some of the more specific modeling assumptions that you embraced in identifying the lingering weakness in May? Is there some industry precedent that you're following? All I'm trying to do is get at how you conducted the actual analysis since, thankfully, this is not an area of analytical familiarity for Southwest, and I mean that, obviously, as a compliment.

Thomas M. Nealon - Southwest Airlines Co.

Well, hey, Jamie. This is Tom. If you don't mind, I'm going to try and take that one, and I'll do the best I can for you (31:13).

Jamie N. Baker - JPMorgan Securities LLC

Sure, thanks guys.

Thomas M. Nealon - Southwest Airlines Co.

At this point, based on this morning, we are probably a little closer to 1 point versus 0.5 point. So, we're staying right on top of this thing. But it's not as though we haven't had other events that would draw traffic down, whether it was the technology outage or whether it was an event we had back in 2016. So, we do have some history with when we have a public event and people are aware, we see a dip in traffic and we generally see what it takes to bring it back up. So, that's kind of the basis for how we're thinking about this.

But as I said, that's kind of the baseline. That's our analytic baseline, if you will. I think the other way we are trying to respond to this is we really do want to get our marketing back online with our paid search. And keep in mind, we are not running any TV or any social right now. The reason we're not doing that is because our TV and our social has a lot of personality, and it has a lot of fun. And we just don't think it's appropriate yet to bring that back up online.

We're working really close with Linda Rutherford and her comps team, her social team, just listening for the sentiment, when does it feel appropriate for us to go back into the market, right? But just in terms of your direct question, we are going back and referencing prior events and what we saw happen with our traffic. And that's probably the best we have to go with at this point, but I do think 1% to 2% is probably reasonable based on what we are seeing thus far.

Jamie N. Baker - JPMorgan Securities LLC

Okay. That's excellent color.

Tammy Romo - Southwest Airlines Co.

Yeah, and I'll just add a couple other thoughts, just to be clear. We are continuing to see some weakness in our bookings, as Tom said. And as you expect and as we stated, we're currently running below our pre-accident run rate. And this is certainly understandable for all the reasons Tom's taken you through with respect to our marketing. And I'd just point out that that's very meaningful to our direct distribution model. So, as we return back to our normal marketing activities, we expect our trends to rebound. But admittedly, it is difficult to estimate the impact with precision. But we know we've already lost about a 1 point, as we pointed out in year-over-year RASM for the second quarter. So, based on that lost revenue, of course, it'd be tough to recover the loss in our close-in bookings, but we are hopeful that once marketing comes back online, we'll see those trends rebound.

Jamie N. Baker - JPMorgan Securities LLC

Understood, and as a quick follow up, in the press release when you discussed the slot transaction, you mentioned that "the new slots are going to complement our network." And I don't want to read too much into that, but you could've said grow our network. Does complement imply that you're only going to fly to existing Southwest cities with the new slots? Or is that just too cute of an interpretation?

Gary C. Kelly - Southwest Airlines Co.

Oh, I think all we were basically trying to say is we have a strong network in those two cities that we're able to complement from LaGuardia and for Reagan. And that the main point was that we'll simply use our existing fleet, our existing capacity, and those new routes will be a part of the growth that you're already familiar with, so.

Jamie N. Baker - JPMorgan Securities LLC

Okay.

Gary C. Kelly - Southwest Airlines Co.

But both of those are still developing markets for Southwest, and we continue to tinker with frequencies and destinations, so I think yeah, I wouldn't necessarily read anything into the word complement.

Jamie N. Baker - JPMorgan Securities LLC

Okay. I appreciate it, Gary. Thank you very much.

Operator

We'll take our next question from Jack Atkins with Stephens.

Jack Atkins - Stephens, Inc.

Good afternoon. Thank you for the time. Gary, do you still expect to be RASM positive this year? And if not, are you prepared to maybe adjust some schedules in off-peak flying in the back, call it, back third – back four months of the year in an effort to better match capacity with market demand?

Gary C. Kelly - Southwest Airlines Co.

Well – and I know Tammy and Tom will have a view as to your question as well. I think that what is obvious is that we are off plan. Now, we've had an event, so I think in terms of my confidence level in telling you that I am X percent confident that we'll hit our goal, I think we all just have to admit that we're off our trend and we're going to have to regain our momentum here, which I'm very confident we will. I don't know exactly when, and I don't know exactly how much, and I don't know because of that what the end result will be.

Now I would say personally and again, don't read too much into this, but it's just too close to call. So said a different way, it is not obvious at all that we cannot make it. But likewise, it's not obvious that we can either. So, the goal will continue to be positive unit revenue performance, and don't count us out is all I would say. The only other thing I wanted to add onto that is the margins are important, and Hunter asked the question to Tammy earlier, and I was just going to add onto that. It's basically the same answer there that I think we're pretty confident of the goal of having net margin growth for the year, but it's just a little too close to call that for the same reasons on the RASM side. So, I think a lot will depend on what happens on that answer to fuel prices, number one, which are up since the year started. And then, secondly, obviously, what happens on revenue. Tom, so what do you...?

Thomas M. Nealon - Southwest Airlines Co.

Well, Jack. This is Tom. Hey. First of all, I concur with what Gary just said. I also think, though, that we always look at how flights are performing. And we'll probably take a more stringent look at how the shoulder flying is performing in terms of profitability. And if it's not profitable, we will find a way to pull that back and redeploy the capacity elsewhere. But the flying that we are doing on our shoulder right now is in fact profitable; it's accretive. It may be RASM dilutive, but it's still very helpful to us. So, I don't think that you'd see us turning profit away just to improve a metric, right? Understanding your objective though, so that's kind of my take on it.

Gary C. Kelly - Southwest Airlines Co.

Yeah, I think what Tom is implying is that, clearly, we would prefer to move those shoulder flights back into the peak part of the day, and that's what we'll be able to do more and more as airplanes come online. And I agree with Tom; I think that is the best technique we've got to address your question here in the second half of the year.

Jack Atkins - Stephens, Inc.

Okay, great. That's very helpful color. And then, for my follow-up, just a question on sort of new market development, could you remind us again sort of historically what's the timeframe to sort of get a new market once you start flying there to sort of system-level profitability or get it to where it's accretive from the time you enter it, I ask this in context to sort of kicking off the Hawaii flying, either late this year or early next year. Just how do you think that flying to Hawaii will ramp relative to sort of normal market development for you guys?

Thomas M. Nealon - Southwest Airlines Co.

Those are two different questions. Let me take the first one. The first one is how long does it typically take us for markets to turn profitable. And when we connect markets where we serve and the customers know us, it's typically a three-month turn from initiation to profitability, or so. I'm sorry. I misspoke. Three years. I'm sorry?

Tammy Romo - Southwest Airlines Co.

Three years.

Thomas M. Nealon - Southwest Airlines Co.

Yeah, yeah. Three years. So that's what we're seeing. In terms of Hawaii, I think that we're going to see a really nice ramp up very quickly, because the customers all know us in the West Coast. We have the largest customer base of airline on the West Coast. I think you're going to see it ramp up very, very quickly, and I think we're going to lead on pricing. I think that we're going to generate a lot of traffic very, very quickly.

Jack Atkins - Stephens, Inc.

Okay, great. Thank you, again.

Tammy Romo - Southwest Airlines Co.

Just to add onto what Tom said, agree with the three years. Normally, what we see for probably more of our international markets is three years, we'll see where Hawaii falls, but it really depends on the market. When you think about a market like Dallas Love Field, we saw that ramp up very quickly. That was probably about a year. And Hawaii, I think we're hoping that will ramp up very quickly here, given our significant presence in the West Coast.

Gary C. Kelly - Southwest Airlines Co.

Yeah, I agree. And then, Jack, you didn't ask this exactly, but our growth is very modest here in the first quarter year-over-year. And the percentage of markets that we call "development" is, I think, Tammy, 3%, or less. So, it's a very small component of the current system, number one. And so number two, that sort of sets us up well to undertake an expansion that we plan later on in the year, meaning that we don't have a lot of markets under development.

And the other little factoid I was going to offer up is that the growth in our newest segment, i.e., international, year-over-year, is very modest. I want to say that's also sort of low- to mid-single digits. So, the system is maturing. We've got some revenue-enhancing techniques that are queued up and especially for the second half, and I think we'll be in a very good position to undertake the Hawaii launch.

Jack Atkins - Stephens, Inc.

Okay, great. Gary, Tom, Tammy, thank you very much for your answers.

Gary C. Kelly - Southwest Airlines Co.

Sure.

Operator

We'll take our next question from Rajeev Lalwani with Morgan Stanley.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Good afternoon, guys.

Gary C. Kelly - Southwest Airlines Co.

Good afternoon.

Thomas M. Nealon - Southwest Airlines Co.

Good afternoon.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Tom, a question or two for you as it relates to the benefits around the reservation system, can you just talk about the progression through the rest of the year and maybe specifically provide what those features that you're going to turn on are so that we can get some comfort there? And then as it relates to the impact around scheduling, what's the hit to 2Q RASM and apologies if you provided that already? And then where do you see the benefit in 3Q and 4Q being or any kind of color that you can provide to help us triangulate how to get there.

Thomas M. Nealon - Southwest Airlines Co.

Yeah. Sure. Glad to do that. So the one res benefit, the primary one that we've been talking with you guys about is really this notion of O&D bid pricing capability or functionality. And I think you understand that, but what that does is it gives us the opportunity to maximize revenue by really optimizing the mix of non-stop and connecting passengers on the network. So, that's what we're trying to do there. And the old method, just by way of example, will focus more on optimizing the revenue at the flight level, so you'd optimize the flight but you're not optimizing at the itinerary level.

So, that's what we're trying to do and that's where the value comes from the primarily $200 million a year. And when we deployed this, oh, gosh, kind of late Q1 or mid Q1, and we are starting to see – so the team is kind of tuning it, they're getting it going and we're seeing really nice benefits. We feel really good about that and we have a lot of confidence in what we have already signed up for, for the first half and for the full year. So, we feel very good about that. And Rajeev, tell me again, I really couldn't hear your second question, it was where's the margin enhancement coming from in the second half? Is that what you're asking?

Rajeev Lalwani - Morgan Stanley & Co. LLC

Yeah, it's on the scheduling, the scheduling impact to 2Q RASM and then what will the benefits start to be in the back half of the year?

Tammy Romo - Southwest Airlines Co.

Yeah, it's – yeah, Jack, it's – Rajeev, it's 1 point of benefit that we're expecting for 2Q, in terms of our year-over-year RASM.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Okay. And in 3Q?

Tammy Romo - Southwest Airlines Co.

I'm sorry, penalty.

Rajeev Lalwani - Morgan Stanley & Co. LLC

And will that accelerate through the end of the year (44:36)?

Tammy Romo - Southwest Airlines Co.

That's well...

Gary C. Kelly - Southwest Airlines Co.

There's a 1 point penalty in the second quarter.

Tammy Romo - Southwest Airlines Co.

There's a 1 point penalty in the second quarter. I thought I'd said penalty, so apologize for that.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Okay. And then what is the benefit in 3Q and 4Q or in the back half of the year versus that 1 point penalty in 2Q?

Tammy Romo - Southwest Airlines Co.

In the second half of the year, and again, for the second half of the – for the reservation benefit, just want to make sure, on the shoulder flying part. So that's going to – yeah, we just expect that to recede. We will have overlapped our fleet by the time we get to, say, October and so we should see that continue to recede as we go through the year.

Rajeev Lalwani - Morgan Stanley & Co. LLC

And if I can ask Mike a quick question. In terms of – associated with the accident, have all your maintenance procedures been reviewed, et cetera, and you're all in good shape there, if that's appropriate to ask?

Michael G. Van de Ven - Southwest Airlines Co.

You're asking if are all of our maintenance procedures in line with the service bulletin?

Rajeev Lalwani - Morgan Stanley & Co. LLC

Exactly.

Michael G. Van de Ven - Southwest Airlines Co.

Yes. So we went back and we've been participating with GE and CFM since our first incident back in August of 2016. And so we have been lockstep with them on the service bulletins and the requirements through that. And at this point in time, it doesn't look like we have a compliance concern.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Very helpful. Sorry for the confusion, guys.

Gary C. Kelly - Southwest Airlines Co.

I would just add that the procedures that we're using are the same ones that were developed with CFM back in 2016, meaning that we do the ultrasonic inspection by removing the blade. And then our service provider, which is GE, when they do the overhaul, they do a more extensive eddy current inspection at that point.

So the procedures themselves are unchanged. What is different now with the most recent service bulletin and air readiness directive is the frequency of doing those inspections. And as I reported earlier and Mike confirmed with his report, with the inspections that we have stepped up since last week, we've had no findings at this point, which is obviously what we would expect and obviously a positive.

Rajeev Lalwani - Morgan Stanley & Co. LLC

Thank you.

Operator

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

Savanthi N. Syth - Raymond James & Associates, Inc.

Hey. Good afternoon. If I might follow up on the California strategy here, it seemed to me – and correct me if I'm wrong – that part of this strategy of defending your position has been to kind of pull forward the opportunities maybe that you were kind of planning for California and kind of strengthening your offering to the passengers there.

So from an impact to unit revenue, should I think of that as more of a kind of a near-term thing? And is it fair to assume that as those markets develop that they should start to normalize? Or is this kind of a multiyear kind of fast-tracking growth?

Gary C. Kelly - Southwest Airlines Co.

Well, I think it's the former. I think what you've got here is very typical. Whenever there is an expansion underway in a market, whether it's by us or by our competitors, there's going be some impact on unit revenue. And then it matures over time. And what you should expect is, all else being equal to be fair, that you would see improved unit revenue performance. And things are dynamic. So we'll tune, our competitors will tune, but absolutely this is – the way we're looking at it, these are opportunities that – there's an opportunity cost, if you will. So we know that we have opportunities to enhance our route system in the West for our customers, and at some point in time, we would attend to that.

So perhaps your interpretation that perhaps we're accelerating a bit, I don't quarrel with that. But I would also point out that while Tom was highlighting California, it's really as an example. The Southwest performance is not just California. We've got competitive situations all over the country. And considering how competitive it is, and I think Tom said this, it's performing very well. But we're not going to add this much capacity and have competitors adding this much capacity and not see some kind of a unit revenue impact. I think the only time in my memory that that has ever happened was the Love Field expansion. And I think everybody knows how unique that was. But it was almost instantly – well, it was instantly profitable and with nary an impact on unit revenues. That was remarkable. But that is clearly the exception.

Savanthi N. Syth - Raymond James & Associates, Inc.

That's helpful. And if I may, just a clarification on the 2018 capacity growth. How much of that is – can get skewed around on the timing of kind of the launch of Hawaii? Was Hawaii always kind of expected to be at the very end of the year and therefore not a meaningful driver of the kind of 2018 capacity? Or depending on when Hawaii actually gets launched, could that capacity move around in the second half?

Gary C. Kelly - Southwest Airlines Co.

No, I think that's right. I think that our best opportunity that we've been planning towards would be pretty deep into the year. So I think that you nailed it. Your thought is spot on.

Savanthi N. Syth - Raymond James & Associates, Inc.

So that it wouldn't have an impact.

Thomas M. Nealon - Southwest Airlines Co.

Well, it's not going to be a massive impact. It just depends on when we get our – first of all, you have to understand, we're still going through our certification process with the FAA and ETOPS. We've been saying – we just announced to those cities today, but we've been saying we sure want to be able to sell this year. And now we're saying, we sure want to be able to fly this year. It just really depends upon the ETOPS certification. I think what you'll see is part of the ETOPS certification is you can't start with a full schedule. You have to kind of grow your way into it and demonstrate proficiency with the FAA and that kind of thing. So I think the back half of the year, late in the year, I would love for us to be flying Hawaii. But I don't think it's going to have a significant impact on our capacity.

Gary C. Kelly - Southwest Airlines Co.

So in other words, right now we've reserved airplanes for these flights. We haven't told you exactly what we're planning because we can't commit to an exact date yet. And then I think if we don't fly Hawaii later on this year, then the question becomes what do we do with those airplanes, and I think that answer will be dependent upon when we know that and what our options are at the time.

So I think Tom was trying to give you the most honest answer possible. It could have some impact on our capacity, but in theory it wouldn't. If we're not flying in Hawaii with those airplanes, we'll fly somewhere else where we have an opportunity. It just depends on when we know that and how productive we think that move off of Hawaii would be. But right now, we're obviously hoping that those airplanes are going to Hawaii.

Savanthi N. Syth - Raymond James & Associates, Inc.

Got it. That's great color. Thank you, guys.

Operator

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

Michael J. Linenberg - Deutsche Bank Securities, Inc.

Hey. I guess just two questions here. Gary, it looks like JetBlue is going to scale back Long Beach by about a third. And so, obviously, free up slots. I know you're now in that market. Is that a market that you feel like it's sufficiently served? Or would you be interested in growing your Long Beach presence?

Gary C. Kelly - Southwest Airlines Co.

Sure. Tom and I agree that we have been hobbled by not being able to have more access to Long Beach. We have a very modest operation there, so that's welcome news.

Michael J. Linenberg - Deutsche Bank Securities, Inc.

Okay. Okay. And then just my second question, and this is Gary or Tom. Just the engines through this inspection process, as I recall, I believe and I could be wrong in this that you did have maybe power-by-the-hour agreements. And I'm just wondering does, if you do, does that cover some of the costs, mitigate some of the cost impact of these extensive blade checks?

Gary C. Kelly - Southwest Airlines Co.

Mike, you want to speak to that?

Michael G. Van de Ven - Southwest Airlines Co.

Yeah, sure. Yeah, we have our – engines are on two different types of agreements. We have some of them that are on this kind of power-by-the-hour, as you say, and then the others are on time and material. This particular airplane with our 700s are on time and material – excuse me, on power-by-the-hour. And so, yeah, that does help us mitigate the cost of those because the risk transfer is back to the GE, our service provider there.

Michael J. Linenberg - Deutsche Bank Securities, Inc.

Mike, do you have an early sense on what that potential cost could be in the quarter for Southwest, even the fact that you do have some protection there? I mean, are we talking, is it millions of dollars? Is it hundreds of thousands of dollars? Or is it just too early?

Tammy Romo - Southwest Airlines Co.

It is a little early, but I would expect it to be in the millions of dollars, just to give you an idea directionally. And in terms of what would actually hit our CASM-ex line, there's some capital costs involved with that. But, again, we've given you our best guess as to what the cost implications would be within the guidance that we've provided.

Michael G. Van de Ven - Southwest Airlines Co.

And those would be mostly outside of actually the engine repair costs. That would be over time those kinds of things. The labor costs associated with doing the inspections, some other delay remodeling (55:52) costs, those kinds of things.

Michael J. Linenberg - Deutsche Bank Securities, Inc.

Okay. Okay. Great. Thank you. Thanks, everyone.

Operator

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

Duane Pfennigwerth - Evercore ISI

Thank you. Gary, on capital allocation, you've got capital to allocate in lots of different ways. I'm just wondering how you think about M&A versus other alternatives. You have some experience there. Are there cyclical considerations or other considerations? How do you think about that in the current environment?

Gary C. Kelly - Southwest Airlines Co.

Well, Duane, I think it's very fair to say that our primary focus is investing in Southwest Airlines. This year in particular we've got a lot of our major strategic initiatives behind us. There's always work to do. But, in particular, here in 2018 and my hope is 2019 and 2020, we're really focused on the quality and the cost-effectiveness of our operation, the hospitality of our customer service, those very basic things. We want to continue to grow the airline. We've got wonderful opportunities to grow. And the tax reform, obviously, is a nice little boost to our sources of financing.

So there's no imperative that we need to be hunting for an acquisition. I think that that's different than where we were in the late 2000s; 2009, 2010. And clearly this is our priority is just to grow organically. Having said that, we've always got to have our eyes open and be thinking about how we can improve shareholder value, and if there is a good opportunity in our view, it's something that we'll take a look at. We're always thinking about that, but admittedly that is not a focus and clearly not a focus right now.

Duane Pfennigwerth - Evercore ISI

Very good. Thank you.

Operator

We'll take our next question from Darryl Genovesi with UBS.

Darryl Genovesi - UBS Securities LLC

Hi, everybody. Thanks for the time. Of the $200 million from the new revenue management and reservation system that you said is going to come through this year, have you said how much of that is embedded in your second quarter guidance?

Thomas M. Nealon - Southwest Airlines Co.

Yeah, Tom, we did. We said between $40 million and $50 million.

Tammy Romo - Southwest Airlines Co.

$40 million and $50 million.

Thomas M. Nealon - Southwest Airlines Co.

...was attributed to the second quarter.

Darryl Genovesi - UBS Securities LLC

Thank you.

Thomas M. Nealon - Southwest Airlines Co.

And our target is to get to $200 million for the run rate in the year.

Darryl Genovesi - UBS Securities LLC

Thank you. And then if I could just follow up on Rajeev's question. If I think about your fleet this year on a seat basis, it looks like you're going to average about 115,000 seats in the fleet, which is 2.5% to 3% higher than last year. If I consider that within the context of your low 5% ASM growth guidance, it implies something like 200 basis points of incremental utilization this year versus last. And that number looks to me to be pretty steady in quarters one through three and then stepping up in the fourth quarter based on the acceleration of your capacity growth that's implied by your guidance in the fourth quarter.

And I guess when I try to think about the RASM headwind that you've called out from suboptimal time of day flying, I guess I think that that's something that should be more or less correlated with the year-over-year increase in your utilization rate. So can you just sort of reconcile the dynamic with the utilization versus what you're saying on the RASM hit from off-peak flying sort of fading as we make our way through the year?

Gary C. Kelly - Southwest Airlines Co.

Well, I'll go first here. The answer is no. I'm not necessarily following all the puts and takes that you're describing. And my recollection, without having studied that this morning is that our utilization for this year is "very normal." And we pushed the fleet pretty hard in the fourth quarter last year. So my recollection is that the absolute utilization of block hours and all those kind of basic things that we used to look at is very normal in the second half of the year and especially the fourth quarter. So why don't you let our IR folks take that one offline and we can be sure that we're following your question. The gauge is increasing because of the classic – all these things I know you know, but that's increasing. The stage length right now as I recall is down a bit.

Tammy Romo - Southwest Airlines Co.

It's down.

Gary C. Kelly - Southwest Airlines Co.

So the trips are doing what the trips are doing. And so anyway, I just don't have of all that in front of me, and I think it would be easiest to take that offline if that is okay.

Darryl Genovesi - UBS Securities LLC

Okay. Thanks very much.

Gary C. Kelly - Southwest Airlines Co.

Yes, sir.

Operator

We'll go next to Joseph DeNardi with Stifel.

Joseph William DeNardi - Stifel, Nicolaus & Co., Inc.

Yeah, thanks. Gary, it feels like the last couple of quarters have been pretty un-Southwest-like. The revenue side hasn't met expectations that there's a little bit of CASM creep this year. Can you just talk about – obviously, some of this is outside of your control, but a lot of it is in your control, I think. Can you just talk about why you think this has happened and what gives you confidence that you can get back on track in the near future?

Gary C. Kelly - Southwest Airlines Co.

Oh, I think it's a fair question. I don't know that I would agree that it is so un-Southwest-like. I think sometimes we do get spoiled by how good our performance is. It's just been – I think in retrospect, it's been a challenge to go through this fleet transition. And it's also been a challenge in the same year to roll out a brand new reservation system. So I think it's more timing than it is absolute execution.

I think the third thing that I would put in there, and these are things again that we're focused on. So the third thing that I would say that we're focused on is just the competitive fair environment. And we've already made some enhancements to our revenue management techniques in the first quarter I think to better manage in that kind of environment. So those are the three.

I think the route system itself is very strong. We're continuing to optimize it as time goes by, understanding that right now the length of the airplane day is too long. I just mean which cities are we in, flying to, which other destinations. That process has been really sound and especially over the last several years. So all of that looks really good to me. The international expansion looks really solid, and those markets are showing very dramatic improvement as they are "developing and reaching maturity." So I think we just have some fairly significant things that we're managing through. It's not an apology. I'd kind of go back to my opening comments. When we know that it wasn't our best revenue performance, we still had a really good quarter and are very well positioned to finish this year very strong.

Joseph William DeNardi - Stifel, Nicolaus & Co., Inc.

Okay.

Gary C. Kelly - Southwest Airlines Co.

But I understand your point. We get it here, and any time we have a plan and we miss it, we aren't happy with ourselves. So I can assure you that we're not saying that this is satisfactory. In that sense, we're never satisfied. But on the whole, I think it's still a very solid performance.

Joseph William DeNardi - Stifel, Nicolaus & Co., Inc.

Okay. That's helpful. And some of my other questions got asked, so I'll go with this one. The disclosures that you guys provide around the Chase agreement continue to be kind of the worst in the industry. So I'm just wondering if you could address that. And then, secondly, can you appreciate that the market and the investment community may like to know more about a business where you essentially take a cut of every dollar spent on the Southwest Chase credit card?

Tammy Romo - Southwest Airlines Co.

Sure. I'll be happy to provide a little more information for you since you asked today. So just to kind of help you understand economics a little bit better, if you look at our passenger revenues and other revenues related to Rapid Rewards, approximately $490 million of our passenger revenues were attributable to Rapid Rewards redemptions. And most of our revenue, other revenue, which I believe we've pointed out before, relates to our partner revenue associated with Rapid Rewards. So overall, we're continuing to see a nice growth in our Rapid Rewards program, and for the first quarter that grew in excess of our capacity growth.

So that should give you little more insight on the revenues, and we'll be providing more robust disclosures for you once we get our 10-Q filed. And then just to help you on the balance sheet a little bit. $1.8 billion of our roughly $4 billion – I think it's $4.4 billion air-traffic liability, the current portion of that on the balance sheet relates to Rapid Rewards. So when you add that amount to the $1 billion of noncurrent ATL related to Rapid Rewards that you see on the balance sheet, you'll get a total air traffic liability balance related to Rapid Rewards of $2.8 billion. So roughly half of our total ATL when you add – when you look at both the current and noncurrent portions relates to Rapid Rewards. So I hope that helps you in your analysis.

Joseph William DeNardi - Stifel, Nicolaus & Co., Inc.

Gary, can you understand why the market would maybe want to know more about that business? I'm just interested in your perspective on it. Thank you.

Gary C. Kelly - Southwest Airlines Co.

Well, I'd be happy to share my perspective. And again, I'm certainly deferring to Tammy to guide us as to what our requirements are, and we'll meet whatever requirements we have for disclosure. And I don't mean this in a harsh way at all, but you ranking us last doesn't move me at all. I think what we have to balance is, first of all, our function here is called investor relations. And I'll bet, you give them high marks. I think they bend over backwards to meet our investors' needs. And that's kind of very much the spirit of Southwest Airlines.

At the same time, we're slugging it out with competitors every single day, and there are things I do not want them to know. I don't want them to know how we manage our revenues and that would include the Chase component, consider all of these things – well, many of these things to be proprietary. So that's the only reason. We're not trying to hide anything from our investors, per se. But I think you understand that investors also aren't loyal to Southwest. They own our competitors. So we have the duty of protecting Southwest, and we guard that very jealously. But that is the only reason that we wouldn't provide more information because we don't want our competitors to know, and so we'll continue to make judgments about what will meet your needs and also meet the companies' needs.

Joseph William DeNardi - Stifel, Nicolaus & Co., Inc.

Yeah, thank you, Gary. And I wasn't trying to insult Investor Relations by any means. I just think more color on that side of the business could help sentiment and the multiple on the stock. I think that's pretty clear. Thank you.

Gary C. Kelly - Southwest Airlines Co.

Oh, no, I don't think anybody feels insulted. You ask a fair question and I hopefully at least gave you a reason why we just don't open up the whole general ledger.

Operator

And we have time for one more question. We'll take our final question today from Brandon Oglenski with Barclays.

Brandon R. Oglenski - Barclays Capital, Inc.

Hey. Good afternoon, everyone. Thanks for getting me in at the end. So, Gary, I'll just ask one, and I think you even alluded to it. If you can't get the Hawaii flying off the ground, you'll find somewhere else to put the aircraft in the back half of the year. But the reality is fuel prices have come up quite a bit since we've had that plus 7% capacity growth outlook out there. And this is an issue for your competitors as well, but costs go up and revenue is not tracking, so everyone's being asked as an investor do believe it's different this time. We're going to offset fuel. But no one's taking that proactive step yet to really reflect that reality. So are we just looking at fuel prices that are too volatile and not thinking long term? Or how should investors expect fuel volatility to maybe come out of this? Or is that just something we have to live with?

Gary C. Kelly - Southwest Airlines Co.

Well, let me give it a try and you redirect if I'm not hitting your point. But first of all, these are phenomenal financial results. After being in the business for four decades, I'll take this year over the vast majority of the years that I've been working in the industry. So these are really, really good results. We are very well positioned from a couple of perspectives with our fuel hedging as well as the really prosperous margins that we have, the cost outlook we have in other areas and the revenue outlook that we have. I think we're very well positioned to manage our way through a real fuel price shock. What we have now is not an issue. If we get to $100-plus a barrel, then I think we have something else to talk about.

But I'll just repeat, which I hope will sum it up, what our goals are. Our goals are to have every year positive unit revenue performance. And in addition to that, perhaps more importantly, we want margin expansion. So when fuel prices go down, the industry doesn't seem to get much credit for margin expanding. And likewise, I think we all need to recognize that margins will be impacted somewhat when fuel prices go up. So if fuel escalates more rapidly, clearly that would put more pressure on us to also have our revenues cover that. That won't happen in a quarter.

And one of the tools that we would have to look to would be the schedule. But I think Tom made the point on an – I would just say as an analogy, we're still better off flying these shoulder flights because they are profitable and at the margin, they add profits as compared to simply not flying it. So fuel prices would have to be looked at in the same way. If we were not able to raise fares, would that immediately lead to a decision to stop flying some of our airplanes? Well, not if they're still profitable.

So I think a lot of this just depends. But again, the bottom line is we're very motivated. We're very motivated to generate shareholder returns, which means we'll need to continue to drive unit revenue growth, but the prize is to continue to generate very, very strong margins and aspire to margin growth. We've got net income margins, which we have a shot at this year to grow significantly. I'm happy. I think it's a very good environment, and at least we're well-positioned to have to manage our way through a somewhat higher fuel cost environment.

Brandon R. Oglenski - Barclays Capital, Inc.

Appreciate it, Gary.

Operator

And that concludes the analyst portion of the call today. Thank you for joining. Ladies and gentlemen, we'll now begin with our media portion of today's call.

I'd like to first introduce Ms. Linda Rutherford, Senior Vice President, Chief Communications Officer.

Linda B. Rutherford - Southwest Airlines Co.

Tom, thank you very much. We can go ahead and get started with the media portion of our call today, if you'll give them some instructions to queue up for questions.

Operator

Yes, ma'am. . And, ladies and gentlemen, we will now begin with our first question, our question comes from Conor Shine with The Dallas Morning News.

Conor Shine - The Dallas Morning News, Inc.

Good afternoon, guys. So my question is just regarding – and I understand this NTSB is still involved in looking at the accident from 2016 with the engine failure. I'm wondering if there's any color or comment you guys can provide about what the conversations were like with CFM International in the months following that, and what level of risk was expressed around those fan blades.

Gary C. Kelly - Southwest Airlines Co.

Well, Mike, maybe I can start and you can correct it. But, well, I think that there was, first of all, surprise that a fan blade would fail, and then also surprised that the inlet cowl would – it would fail in such a way that it would destroy the inlet cowl. So that immediately led to the realization that we needed to increase the inspections. So GE actually does the engine maintenance, not CFM, Mike, I believe. So GE increased their – they changed their inspection technique. They do our overhaul work, Conor, which has to happen before 20,000 cycles.

And they changed their inspection technique to the eddy current. And then, Southwest, working with CFM, also implemented the ultrasonic examination. And we were doing that initially on the – just in layperson's terms, we were identifying the older blades in our fleet and examining those first, and then, ultimately, by the end of 2017 decided that we would inspect every single blade in our fleet every time that we touched it for our maintenance step in between the overhaul, and that is every 3,000 cycles.

And by the way, that is what you now see the service bulletin by CFM and then the Airworthiness Directive by the FAA has evolved essentially to that. So, well, I beg your pardon. I think it's just the service bulletin by CFM. So I think the short answer is I thought their response was appropriate. It was aggressive and we'll continue to work with the manufacturer to improve the blades so that, in essence, the inspections aren't necessary. But again, you look at what Mike reported earlier and what I did, with all the blades that we've examined, you just don't find any cracks in these blades. I think we found one previous to 2017, and that blade, of course, was discarded. But just very, very few failures, but we'll continue to work with both Boeing and GE to improve those engines. In the meantime, we'll make sure there are no blades on engines that have fatigue in them.

Michael G. Van de Ven - Southwest Airlines Co.

Yeah, Conor, you also, just in that first event back in 2016, the engine, the worldwide fleet of those engines probably had north of 300 million flight hours on it, and that is the first time in the history of that engine that they had that kind of an event. And so I thought that GE and CFM, I thought they were very aggressive on trying to understand what happened there and whether or not it was just an anomaly or that it was some type of age or other type of issue. And so I agree with what Gary said. So they focused on inspection techniques, they were needing improvements to inspection techniques, there was an introduction of the ultrasonic inspection, there was a drive to look at older engines, then into certain part numbers, and then into this most recent service bulletin that I think is very comprehensive.

Conor Shine - The Dallas Morning News, Inc.

Thank you.

Gary C. Kelly - Southwest Airlines Co.

And we'd be happy to take you through that in more detail because there have been – there is confusion, there have been now three service bulletins by CFM and, Mike, I think that they probably supersede the previous one, in effect, but that's confusing. The FAA was working on a proposed rulemaking asking for comment during 2017 while we were already doing these inspections. So that has never been issued in that form. Instead, the FAA came out with an Emergency Airworthiness Directive last Friday, which we will do all the incremental inspections required by that very easily before their deadline. I think we'll want to work with them to agree that we are in compliance with all the other engines that we have inspected, things like that. But the stepped-up inspections are necessary. I think we're doing them at a very quick interval, and it's just to make darn sure that we don't have any blades on engines that have a crack in them.

Conor Shine - The Dallas Morning News, Inc.

Thank you.

Operator

We'll take our next question from Alana Wise with Reuters.

Alana Wise - Reuters

Hi. Thanks so much, everyone, for taking my question. So this is something that I think has been a little bit unclear throughout the course of this whole thing, but prior to the blowout on Tuesday, had the engine involved been inspected as part of the 2016 look into this class of engines?

Gary C. Kelly - Southwest Airlines Co.

No, that was made clear. That engine was not inspected. And the reason is because it did not meet the criteria that the manufacturer had established for inspection. It was due for the inspection this year. So it was on, again, it was on the schedule to be inspected, but just had not been inspected by April. So what, of course we have done since last Tuesday is we said we are going to inspect every engine in the fleet, meaning every blade in the fleet, either since 2016 or over the next month. And then we will have a baseline, and we will be inspecting those every 3,000 cycles from that point forward. So hopefully all those moving parts made sense to you.

Alana Wise - Reuters

Fantastic. Thanks so much.

Gary C. Kelly - Southwest Airlines Co.

Except for your question, the engine had been through all of its required inspections and overhauls, et cetera, so it was fully up to date in terms of its maintenance. It just had not been inspected for this current matter yet. So again, it would've been later this year.

Alana Wise - Reuters

Thank you.

Operator

We'll take our next question from Mary Schlangenstein with Bloomberg News.

Mary Schlangenstein - Bloomberg LP

Hi. Thanks. Gary, I wanted to ask, because you said there'd been one previous cracked blade found before 2017. Can you say when that was? And then my second question is maybe for Mike. You said you haven't found any fatigue or cracks, but have you found anything else in the blade inspections that you guys thought was unusual or noteworthy or anything at all?

Michael G. Van de Ven - Southwest Airlines Co.

Well, Mary, I'll start, so yeah, we all do the blade inspections, and I wouldn't say we found anything noteworthy. You see normal coating, maybe the normal mix you would find on fan blades with foreign object debris, things like that. So as we found those in these inspections, we have replaced those blades.

Mary Schlangenstein - Bloomberg LP

Okay.

Michael G. Van de Ven - Southwest Airlines Co.

And then back on your question on – the comment that Gary had, it had a crack in it, that was part of some work that we were doing with GE, and it was back in May of 2017.

Mary Schlangenstein - Bloomberg LP

Okay. So it was after the 26th incident?

Michael G. Van de Ven - Southwest Airlines Co.

Right, it was part of the inspection processes that we were going through and found that blade.

Mary Schlangenstein - Bloomberg LP

Okay.

Gary C. Kelly - Southwest Airlines Co.

And I think we have about 36,500 blades. And so out of all those blades, we found one. And so obviously, now we know that there will be blades with cracks in them. So there's nothing so extraordinary about that, but it is at least hopefully comforting to know that there was only one that was found with the inspections that were done. So now the point being, we'll just have to keep up with all the blades in the fleet with very frequent inspections with an abundance of caution to make sure that that doesn't slip through.

Mary Schlangenstein - Bloomberg LP

Okay. And if I can double check on the number, you said 36,500. I thought Mike earlier said 35,500. But maybe I just misheard. The total number of ...

Michael G. Van de Ven - Southwest Airlines Co.

It's 35,500.

Mary Schlangenstein - Bloomberg LP

35,000. Okay.

Gary C. Kelly - Southwest Airlines Co.

As usual, Mike is right.

Mary Schlangenstein - Bloomberg LP

Thank you very much.

Gary C. Kelly - Southwest Airlines Co.

You're welcome.

Operator

We'll go next to Leslie Josephs with CNBC.

Leslie Josephs - CNBC

Hi. Thanks for taking my question. You, Mike, had said earlier that a fan blade itself isn't capable of causing so much damage. Are there any tests you're doing, or CFM is recommending to test the cowling or how stable it is or something like that? And my second question, are you speaking or working on any training with the flight attendants? I know there was a lot of commentary about people using oxygen masks wrong, just about how to ensure the passengers are following along with the safety briefings? Thanks.

Michael G. Van de Ven - Southwest Airlines Co.

Just a couple of things. First of all, in terms of engines and engine design, the engines are frequently tested with respect to a fan blade failure and having those contained inside the engine and in the engine cowling. The cowling that we're talking about now is an inlet cowl, so it's a before – it conducts airflow into the engine, and so it's before the containment part of that. And that's what we're talking about is whether or not there are opportunities in the inlet cowl to improve its durability so that it can minimize the kind of energy that comes out with this fan blade release.

In terms of the flight attendants, actually one of the great things about social media is that you do get a good view of what is going on inside the cabin. And we absolutely will look and try to learn from things that we can do better, make our customers more safe, make sure that the training and the communication out into the cabin is adequate. And as a matter of fact, the NTSB has set up a group to kind of study the in-cabin services, so I know that they'll do a thorough investigation of that and may come out with some good recommendations.

Leslie Josephs - CNBC

Since that incident, since the 1380, they've done that?

Michael G. Van de Ven - Southwest Airlines Co.

Who's that? The NTSB?

Leslie Josephs - CNBC

Yeah.

Michael G. Van de Ven - Southwest Airlines Co.

Yeah, that's part of the 1380, that's part of the investigation, they're looking at the onboard in-cabin activities.

Leslie Josephs - CNBC

Okay. But you're not working on anything specifically just yet?

Michael G. Van de Ven - Southwest Airlines Co.

We're supporting them in that effort.

Leslie Josephs - CNBC

Okay. Thank you.

Operator

We'll take our next question from Dawn Gilbertson with The Arizona Republic.

Dawn Gilbertson - The Arizona Republic, Inc.

Good morning. I have two questions. One, can you give us, either Tammy or Gary or somebody, a dollar figure associated with the bookings hit from flight 1350?

Gary C. Kelly - Southwest Airlines Co.

Well, I think what Tammy and Tom were talking about earlier was 1 to 2 points or percent of second quarter revenues, so do you have that off the top of your head?

Thomas M. Nealon - Southwest Airlines Co.

An absolute number? It's in the $35 million to $40 million range.

Tammy Romo - Southwest Airlines Co.

Yeah, (1:27:43).

Dawn Gilbertson - The Arizona Republic, Inc.

Perfect, thank you.

Tammy Romo - Southwest Airlines Co.

It's just a rough ballpark. It's $50 million to – if you just do the math, and it's a wide range, so we were kind of going in the middle, it's going to be at least a $50 million impact and, if you just do the math, it's $50 million to $100 million.

Dawn Gilbertson - The Arizona Republic, Inc.

Okay. And one more question unrelated to that, for Tom on the ETOPS certification in Hawaii. I'm no ETOPS expert, but when you were just mentioning, you were talking about, through this process you might be able to start small with Hawaii as you're going through the process. Can you give us any more color on that? I just wasn't aware that was an option as you go through. I thought that you had to get your certification and then the service began.

Thomas M. Nealon - Southwest Airlines Co.

Oh no, once we get the certification, we will begin service. So I think the question is when will we get the certification. We're hoping to get it sometime later this year. But in terms of our scheduling, Gary announced the four cities via the four airports we intend to serve. Our network planning team certainly has laid out, here's what we would see the schedule being. It's not time for us to announce that, but when we do start service, it will be smaller, and it will begin to ramp up over time, I would think.

Dawn Gilbertson - The Arizona Republic, Inc.

Okay. I must've misunderstood what you said then.

Thomas M. Nealon - Southwest Airlines Co.

Yeah, but in other words, Dawn, it's always been our intention to start modestly, like with probably one city pair and focus that way, and then we would like ultimately to those four airports that we announced today. Obviously, that's our committed plan to serve all four. What we've not announced is what routes and when we'll start, and which one we'll start with. But we've always intended and the FAA has always understood that we'll start modestly.

Dawn Gilbertson - The Arizona Republic, Inc.

And when you say modestly, with that one city pair. Is that your goal for this year, if you are able to pull it off this year?

Thomas M. Nealon - Southwest Airlines Co.

I mean, on the first day, I think it would be probably one city pair. And part of that, I think in fairness to us, is to be determined in working with the FAA. But that's kind of the idea that you ought to be thinking about. Now I don't see us serving just one city pair for very long, and I'd rather not say how short just yet. But yeah, I think we're definitely planning to start very modestly.

Dawn Gilbertson - The Arizona Republic, Inc.

Thank you very much.

Operator

We'll go next to David Koenig with The Associated Press.

David Koenig - The Associated Press

Hi. Thanks. I know it's getting late. I have two questions, but the first is kind of to clarify what Mike said earlier and then Gary followed up on. So if I heard Mike correctly, you've inspected, it sounds like, 25,500 or so of your 35,500 blades. So that would mean you've got, what about 10,000 left to inspect and you're going to do those in the 30-day window. Are those all newer second-generation blades?

Michael G. Van de Ven - Southwest Airlines Co.

Well, we've been focused mostly on our 700 fleet, David. So yeah, so the lion's share of what's remaining really is the 800 fleet, and those should be – we just started taking the 800s five or six years ago, so generally speaking, yeah, those would be the newer-generation blades.

Gary C. Kelly - Southwest Airlines Co.

But I think, David, we started with going back to 2016, the oldest blades, then we worked out within Southwest and with CFM, the oldest engines. And so the focus has been on engines since then, knowing that blades move around between engines. So by accelerating all the inspections to within the next 30 days from last week, we will have covered every single engine regardless of the age of the blade.

David Koenig - The Associated Press

Right. Okay. Great. Well, that leads into the other question I had, which was whether you ever considered grounding any planes, like maybe those with engine cycles, with the most engine cycles either new or since their last shop visit? Was that ever under thought?

Gary C. Kelly - Southwest Airlines Co.

Based on all the...

Thomas M. Nealon - Southwest Airlines Co.

After, yeah.

Gary C. Kelly - Southwest Airlines Co.

...evidence that we have, based on discussions with CFM, Boeing, the FAA, the NTSB, that wasn't a consideration because of the accelerated inspection cycle and just the history and the data that we have on these fan blades.

David Koenig - The Associated Press

Okay. All right. Thank you.

Operator

And, ladies and gentlemen, at this time I'd like to turn the call back over to Ms. Rutherford for any closing remarks.

Linda B. Rutherford - Southwest Airlines Co.

Thank you all very much. If you have any follow-up questions, please do reach to our Communications team. You can get them at 214-792-4847 or via our media website at www.swamedia.com. Thanks very much.

Operator

Thank you for joining.

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