Southwest Airlines Company (LUV) — Q4 2016 Earnings Call Transcript

Thank you, Tom, and good morning, everyone, and welcome to today's call to discuss our fourth quarter and annual 2016 performance. Please note, today's call will include forward-looking statements and because these statements are based on the company's current intent, expectations and projections, they are not guarantees of future performance, and a variety of factors could cause actual results to differ materially. As this call will include references to non-GAAP results excluding special items, please reference this morning's press release in the Investor Relations section at Southwest.com for further information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results. Joining me on the call today, we have Gary Kelly, Chairman of the Board and Chief Executive Officer; Tom Nealon, President; Mike Van de Ven, Chief Operating Officer; Tammy Romo, Executive Vice President and Chief Financial Officer; and Bob Jordan, Executive Vice President and Chief Commercial Officer. We will begin shortly with Gary providing an overview of our performance followed by Tammy providing a more detailed review of our fourth quarter results and our current outlook. Following Tammy's remarks, all of our call participants will be available to answer your questions. We ask that you please limit yourself to one question and one follow-up, so that we can accommodate as many questions as possible. At this time, I will now turn the call over to Gary.

Thank you, Marcy, and good morning, everybody, and thanks for joining us for our 2016 earnings call. First, I want to thank all of our Southwest employees for their very hard work and congratulate them on a superb year, and one where we set a number of records along with $586 million in profit sharing. So congratulations to all of our folks. Next, I want to welcome and acknowledge Tom Nealon, President of Southwest Airlines. Tom, welcome.

Thank you, Gary. Good morning, everybody. I am very excited to be with Southwest. I am very excited about the new role. I have a lot of passion and a lot of energy for Southwest and for the people and the culture of Southwest Airlines. As you all know, this is a very special place. We have tremendous momentum, we have a very clear purpose, and we have a very clear vision. I think we have a strategy that's going to help us achieve our vision over time, and I see my role as driving the execution and implementation of our strategy. I'm going to do it with Gary, with Mike, and with the entire team here at Southwest. So I'm very optimistic about our future, and we are moving forward.

Well, congratulations again, Tom, on your new role, and we're very excited to have Tom in this executive leadership role. Likewise, I want to welcome and acknowledge Mike Van de Ven, our Chief Operating Officer. Mike, welcome.

Thanks, Gary. I also am really energized about my expanded role, and I agree with Tom, we've got a lot of momentum. I really believe that our best days are ahead of us and I look forward to working with Tom and Gary and really the rest of our team to make that belief a reality. I do know a lot of you already, and I look forward to working with you a little bit more closely in the future. Thanks, Gary.

Well, congratulations to you as well, Mike. All three of us are very excited to be working more closely together. We're very pleased to report another record year, a record year of earnings, a record year of earnings per share. This is our 44th consecutive year of profits, which is unprecedented in the airline industry. I'm not sure how many others in corporate America can say that they've been profitable for that many years, so my guess is not many. But it certainly allowed us to take great care of our people, our customers, and our shareholders for over five decades, and as you can imagine, we're very proud of that. We're very pleased to end 2016 and begin this year on a strong note. Our average fourth quarter '16 fares were down year-over-year $5.51. Unit revenues were down 2.9%, but after two years of sequential declines, it feels like we're bottoming. We've outperformed the industry since 2014. We have a shot at flat unit revenues year-over-year here in the first quarter, although our current forecast is somewhat below that. That's our goal, and we will work hard to hit that first quarter goal. Regardless, we're seeing strength sequentially from fourth quarter to first quarter, and that, of course, is a welcome change. We've already announced that we've slowed our growth year-over-year in 2017. Consistent with that, even though we're growing international at a pretty significant rate, it's on a very small base, so the majority of our growth will be domestic. Another thing to note is that the percentage of developing markets has dropped below 4%, and obviously that's providing us some strength going forward as well. Really, that's the big news for this quarter: that business has strengthened. Otherwise, our report is pretty much an update; our 2017 plans have been set for quite some time, and the vast majority of the work surrounding our initiatives for this year is complete. We'll be finishing up and deploying our new reservation system, our new international terminal in Fort Lauderdale, and the new Boeing 737-8 aircraft. As planned, we will be grounding and retiring the remaining classic fleet in the third quarter of this year. We will launch international flights out of Fort Lauderdale in June and at that time open up one new destination, which is Grand Cayman. In terms of route news for this year, we will also consolidate our northeastern Ohio operations into Cleveland, and we will consolidate our southwest Ohio operations into Cincinnati. Cincinnati will be our second new city for this year. These airports are very close to Dayton and Akron Canton, which will give us the opportunity to continue serving our customers in those cities along with winning more customers. I'm very excited about our plans for 2017; I'm delighted that our trends have strengthened. Given the current economic outlook is pretty good, as well as the outlook for moderate energy prices, we're hoping for another great year in 2017. Our balance sheet is strong, our liquidity is very strong, our CapEx plans are very manageable, and our goal is to continue rewarding our shareholders. So, Tammy, with that very quick overview, I'll turn it over to you to take us through the quarter.

Thanks, Gary, and I'm excited too. Welcome, everyone. We are very pleased with the record profits we've reported this morning for 2016. Our earnings were a record $2.2 billion with operating income of $3.8 billion. Excluding special items, our 2016 net income was a record $2.4 billion with record operating income that produced a very healthy 19.4% margin. These results generated cash flows also at record levels, enabling us to deliver on our commitment to invest in our employees, our customers, and our shareholders. We had a return-on-invested capital of 30%, which is just an outstanding accomplishment for the year. Before I jump into fourth quarter results, I'd also like to congratulate our employees on our 44th consecutive year of profitability and their 42nd consecutive year of profit sharing, which was $586 million for 2016. As you can see from our report this morning, we ended the year with a solid fourth quarter performance. Our fourth quarter revenues were a record $5.1 billion, and unit revenues declined 2.9%, which was better than we expected at the beginning of the quarter. Travel demand and close-in yield pickup following the election carried through to the end of the year. Business travel leading to the December holiday was also better than we had expected early in the quarter. The strength in demand resulted in a record fourth quarter load factor performance of 84.4%, and thus far, the fare environment has held here in January. Based on these trends and current bookings, we are forecasting flat to down 1% RASM year-over-year as Gary took you through here in the first quarter. Considering our outperformance of the industry since 2014 and our 4% ASM growth in the first quarter, we are encouraged by the sequential improvement in our year-over-year RASM terms. We also expect strength in other revenues to continue into the first quarter of 2017. Turning to our cost performance; it was in line, right in line with our expectations. Unit costs excluding special items increased 2.9% year-over-year, largely driven by higher labor costs and union contracts ratified during 2016, as well as the accelerated depreciation associated with the retirement of our classic fleet. Our economic jet fuel price per gallon increased 2% year-over-year to $2.07 for the fourth quarter, which was driven by higher crude and heating oil prices. Based on market prices last Friday and our current first-quarter hedged positions, we expect our first quarter fuel price per gallon to decline from the fourth quarter to the $1.95 to $2 per gallon range. This estimate includes a hedging loss in the $0.25 to $0.30 range. And for the full year of 2017, we currently estimate a fuel price per gallon in the $2 to $2.05 range, including roughly $0.20 to $0.25 in fuel hedging losses for each quarter beyond the first. Just a few comments on our non-fuel costs excluding fuel, special items, and profit sharing for the fourth quarter; our unit cost increased 4.4% year-over-year, which was in line with our guidance. Roughly 3.5 points of this increase were attributable to our new union agreements, which included an immediate snap-up in wages for our flight attendants and pilots during the fourth quarter. An additional point was attributable to accelerated depreciation resulting from the retirement of our classic fleet. As for our 2017 cost outlook, we anticipate year-over-year cost inflation to peak here in the first quarter due to the timing of labor rate increases largely. With this in mind, our first-quarter CASM excluding fuel, special items, and profit sharing is estimated to increase in the 6% to 7% range year-over-year, with about four points of this increase related to labor contracts. By the fourth quarter of this year, we expect our unit costs excluding special items and profit sharing to trend to roughly flat year-over-year. This brings full-year 2017 unit cost excluding fuel, special items, and profit sharing to an estimated increase of approximately 3% year-over-year, almost entirely driven by wage rate inflations. Beyond 2017, we anticipate wage rate increases closer to inflation-like levels in accordance with the ratified agreements. As always, we remain focused on controlling spending through our operational investments and ongoing fleet modernization. Turning to our balance sheet; it remains as strong as ever with $3.3 billion in cash and short-term investments at year-end. Our leverage, including off-balance-sheet aircraft leases, remains in the low to mid-30% range, and we continue to be the only U.S. airline with an investment-grade credit rating by all three credit agencies. During the fourth quarter, we repaid $352 million in debt and capital lease obligations and retired $110 million in convertible debt at maturity. As expected, the majority of bondholders converted their bonds to shares of stock, resulting in our remittance of approximately $68 million in cash and $6 million in shares. During the fourth quarter, we entered into a $215 million secured term loan and we issued $300 million in unsecured notes at our record 10-year low on coupon rates of 3%. In regards to our 2016 capital expenditures, we ended the year with $2 billion in CapEx as expected, with technology and facilities spend as the most significant drivers outside of the $1.3 billion in aircraft CapEx. Our estimated CapEx for 2017 is approximately $2.3 billion, with $1.3 billion of that for aircraft. With record earnings and sustained balance sheets, our operating and free cash flows reached record levels, enabling us to return nearly $2 billion to shareholders through buybacks and dividends. During the fourth quarter, we completed the $250 million accelerated share repurchase launched in the third quarter, and we launched a new one which we currently expect to complete in February. We have $950 million remaining under our $2 billion authorization, and since 2011, we have decreased our share count by more than 18% through over $5 billion of share buybacks and our Board of Directors declared our 161st consecutive dividend during the fourth quarter. We have a decade-long history of upholding our commitment to return value back to our shareholders, which is a designation that not many can claim in the U.S. airline industry. I'll give you a quick recap on fleet; we ended the year with 723 aircraft in our fleet as planned. Based on our current firm orders for delivery and 87 Classics, we will retire by the end of September. We intend to have just over 700 aircraft in our fleet this year and then grow our fleet to around 743 aircraft by the end of 2018. We believe this level of fleet growth will allow us to continue to optimize and prudently expand our already robust network. The 5.7% increase in capacity during 2016 was predominantly in our domestic markets, including our new city of Long Beach. We continue to manage 2017 capacity growth of approximately 3.5%, with domestic growth accounting for roughly 2.5 points of that growth. Domestic capacity growth has moderated from 2016 levels from the highs of 5% to 6% to levels more in line with GDP. I just wanted to point out that our load factors are growing in the low to mid-teens through the first half of 2017, but as this is said, just keep in mind that it's a small part of the base. In closing, I want to thank our employees again for a tremendous quarter, and I just can't thank them enough for their outstanding customer service. With that overview, I'll turn it over to you, Tom, and we're ready to take questions.

Great, thanks guys, appreciate the time. Gary, in your opening remarks, I thought you said you're currently running – and correct me if I misheard you, but I think you said you're currently running below your guidance, and you hope to get there by the end of the quarter. Did I hear that?

Yes, if we were to give you a point forecast today, it would fall within that range of down one to flat. So right now flat is at the top of the range. We're very comfortable in saying today that the trends have improved and that sequentially, they've also improved just in the short period of time for third – from fourth quarter to first quarter, so obviously that's a very welcome change.

Okay. And I guess would you characterize your guidance for the quarter as more or less a good run rate to use, or are there items in there related to the holiday shift? You know, first of all, is there anything further that may have impacted January and March within your guidance that maybe we should be aware of?

Yes, I will let Tammy do that, but the answer to your question is it's not a straight line. Yes, there are a lot of choppiness in the quarter that we are trying to see our way through all the incomparabilities with periods. You have a holiday benefit, you have a holiday bogey, and I think there are some other things that are a little bit peculiar with the calendar change in January moving two days from the leap year also. You don't have the same number of strong days. Tuesday doesn't equal a Sunday, I'm sure you know. But what other color or clarity would you like to offer there?

Yes, I'll be happy to jump in there. We began January with positive year-over-year routes and trends due to the holiday return travel as Gary was noting there. When you actually line up the calendar days, there's fewer peak days, if you will, in January this year compared to last year. But yes, January here is starting off very solid comparing just walking to the quarter. February should have the cleanest or easiest comparisons of the quarter, with March being impacted by the Easter shift into April. So those are the things you probably want to focus on as you're trending for the quarter, but our outlook at this juncture is solid.

Great, thank you. If I could just ask Mike if you had any particular objectives that you would highlight with your expanded responsibility, that you think you might be more focused on, or the company might be more focused on than in the future than they have in the past? If you'd take a shot at that, I appreciate it.

I think about our priorities. I break it into two categories or two buckets if you will, and Gary hit on the first one, which is we have work to do. We need to get the classics retiring, get the Max in, and we have work to do to get the new reservation system in and that's all going great. Things like that, the work is in progress now is a category of priorities. My perspective is that the second category is very much focused on bringing our strategy and vision to life. There is a lot of work happening there. I think about our vision statement which you all know, it's very clearly a statement of our intent. We intend to do this. We know it's going to take time, and we're okay with that; the business is very strong. As I said earlier, we have a lot of momentum, I feel very good about that, and I think we have time to execute the strategy in a structured, thoughtful way. Let me give you a few examples of things. Very clearly, we could do a better job of enabling our front-line employees with the tools and information that they need to do their job. That's a big deal in terms of driving efficiency, improving their customer experience, and improving the quality of life for our employees. So we are very focused on that. Regarding our customer experience, we get tremendous praise and great feedback from our customers, but there are areas where we can improve. For example, we have a very strong mobile customer experience today, which is very important for customers. Ten years ago, five years ago, not so much. Today, it’s quite a big deal. I think ours is good, but there's a lot of enrichment we can do. One of the things that Mike and I – I've hit Mike on his shoulder here, one of the things that Mike and I are working on together is to continue to build out the operational capabilities. We're driving for reliability, driving obviously for efficiency. But we also need to build for scale; we need to make sure that the operating processes that we're implementing scale as we grow, and that's a big deal for us. So those are some of the things that I'm personally focusing on.

Yes, I think that you will just hear Tom and I be really riding on top of one another in terms of what we think that our priorities are. My first priority really is our people. We've done a lot, as Tom mentioned, and Gary has talked about over the last several years, expanding our company's capabilities, and a lot of those changes are driving needs to change some of our older processes. Focusing on us, having efficient and coordinated processes, having better tools for our people where they can have the information they need at their fingertips, having better decision support tools to help our customers and empowering them – that is probably the number one priority that I have. As for the next items, Tom mentioned, we have an operating infrastructure that we want to build the capabilities on. Our network is really complex, and we've got a lot of opportunities to improve our operation, reliability, and responsiveness in situations if we can make these kinds of investments. We've got a pretty critical focus area in our maintenance system, that cruise scheduling applications, or flight management systems, and decision support tools. Lastly, we need to focus on cost. We do a really good job with service, and as our company is growing, we have more challenges in the industry on the cost front. We need to be focused on what we can do as a team and execute better to be more competitive on the cost side of the business.

Great. Thanks guys. I appreciate your view.

Hi. I don't want to detract from the results of the quarter and the outlook, but I do want to come back for the domestic capacity guidance increase. Your earnings release in October said you're going to go 2.0%, and now you're saying 2.5%. This is my personal thing. I think we're willing to hear from you that this is not going to turn into a repeat of what happened in 2015 with small increase after small increase. I don't think anybody has an issue with Southwest going 2.5% domestically, but I think we need to hear early signs. To hear this is not going to go back to 3% and then 3.5% by the time the year ends, because if that dynamic repeats itself, I think it would be no surprise to anybody if this stock fails to work.

Tammy, you want to address that?

Yes. Just to summarize your question, Hunter, discussing why our domestic went from 2% to 2.5%. Really we just firmed up our capacity allocation and when it was all said and done, it was weighted heavier to domestic. That's really just the function of the additional seasonal international adjustments that we make and really just working through the logistics of our classic fleets. So it was really firming up our capacity for the year.

Hunter, my answer is straightforward. We were not changing our fleet plan; we've already committed to growing the system 3.5%, and nothing has changed in our network plans for 2017 from October. I guess when we get down to the last half a point, things rounded differently, I don't really know. The only thing that we affirmed since October is we committed to open Grand Cayman, which we have announced, and that capacity was already a component of our flying out of Fort Lauderdale. In addition to that, we decided to consolidate in Cleveland and open and consolidate in Cincinnati, and that is pretty much a neutral change in capacity. So we're simply moving capacity from one allocation to the other. Beyond those very basic things, I cannot recall any change at all that we have in our approach to scheduling capacity for 2017 and I think importantly, when we look at the levers that we have to drive, given a fixed number of airplanes, which those ins and outs also have not changed to my recollection. The only other lever that we have left is to either increase or decrease the daily utilization, and that also is unchanged. Other than just reporting the component of domestic versus international, I was a little surprised this morning to the reaction to that, I will admit. But in any event, I think my answer is that nothing has changed.

That's good, Gary. I appreciate that and just getting a little bit deja vu with the 'rounding' because that was a word that you guys used a lot, again in 2015 as well. It was rounding as well as anybody. The sensitivity around this type, given your market share and your cost structure, you guys have the potential to be very, very disruptive. So I guess my follow-up question would be – and thank you for that color – are you prepared to use the word ‘cap’ in the context of domestic capacity growth to 2.5% with the realization, obviously, that the system is still going to be unchanged at 3.5%?

No, I'm not. But I think what I am saying is that there has been no change. There is no change that I am considering at this time. Something would have to happen for us to change, but no, I would never make a commitment like that because you just never know; something could happen. But there is no effort underway to bring in more airplanes – even if we wanted to bring in more airplanes. I doubt that would even be physically possible, knowing what we know about the market. We are already published through June – August, I beg your pardon; we have a June 4 schedule, it takes us through August. So the only thing left to tinker with would be the last four months of the year. Hopefully, I've answered your question. But I do want to be clear that we're talking about 3.5% growth and that in system ASMs and the split of that is 2.5% and 1%. If you look at the domestic growth, if you just look at the increase in domestic compared to the domestic system, that's different arithmetic. This is the mix of the 3.5%, it's 2.5% and 1%. But international is growing 30% somewhat if you're comparing it to the small international base. Then likewise, the domestic increase compared to the domestic base is something like 3%. I think the numbers to which you all are referencing back to is the split of the 3.5%. So 2.5% versus 1% point.

Okay. Yes, you answered the question. Thank you, Gary.

Thanks, Operator. Hi team, thanks for taking the time. I just have a couple of questions. One, on the international, is it possible for you to break out revenue or actual ASMs as opposed to just reporting them in one group?

Hi, Helane. How are you doing? It's possible, but yes, we haven't provided that level of detail. The international is about 3% of our network. We've been pleased with the development. Just to give you a little bit of color, we've been pleased with the development of those markets, and if you just look at the international market as an entity, we are seeing positive year-over-year unit revenue growth if you just look at the international markets. But again, it's a small, small percentage of the total system.

Is there a point where you get big enough where that has to be broken out? Even if just in your annual report?

Yes, absolutely. That's more than plausible.

At a point, yes. So we're just not yet there, Helane.

Okay. And then my other question is unrelated to that; it's on maintenance costs of clients in the fourth quarter. Did something happen there in the fourth quarter that cost it to be down too much, or is that the accelerated retirement of the classics? Should we expect that 11% decline for the rest of this year?

You've got it, Helane. We are seeing a favorable impact of the retirement of the classics, and you'll see that continue into 2017 as we go through the year here. So you've got it exactly right.

Hi. Good afternoon, everyone. Thanks for taking my questions.

You bet.

Gary, I guess the first one for you – and it's a regulatory front – could you just sort of speak to what you're hearing out of Washington with regard to any potential changes, stands or positions from a new administration relating either to your business or the industry overall? Obviously, we're all aware of potential tax policy changes which will benefit you guys. But just curious to get your thoughts on what we might see in terms of regulatory changes over the next few years, and if that's a positive for your business or not.

Well, I think we're hoping for some positives here. There are three areas that we're very enthused about: tax reform, regulatory reform, and then infrastructure investments, which I will admit, we're a little bit wary about how that might either help or hinder us. But clearly, our primary objective is to modernize the air traffic control system, which falls under infrastructure and could have a huge benefit for aviation and for the traveling public. But to answer your question, we probably know more than you do, but at this point it is fair to say that it is very early. I have not met with Elaine Chao yet, and we're very enthused about her nomination; we're very excited about working with her, but it's just very premature. I don't know that it's clear exactly what the administration's focus will be in aviation. I think there's a broad desire to roll back regulations, but I don't know that we know of anything that is specific. If I had to spend more time in Washington here in the first quarter, hopefully by April we may have a bit better read on that. But regarding broader corporate issues, we've looked at the tax reform proposals, and we're quite excited about that on the corporate front. But that's just on income tax. So then, we would also like to take up the heavy burden that we have with aviation taxes with the administration. That's a long answer to your question, and I think the bottom line is no, we don't know anything specific yet, but we sure like what we're hearing so far.

Well, that's very helpful insight, though, Gary. Thank you. And then for my follow-up question, just a housekeeping for Tammy. The $109 million hedge asset for 2018-2019 that you referenced in the press release, could you maybe break that down in terms of what's tied to 2018 specifically?

Yes. For 2018, it represents about $91 million of that of the $109 million that we reported in the press release.

Hey, good morning, or good afternoon, actually. Tammy, just a follow-up on an earlier question, I was wondering if you could elaborate a little bit more on what the holiday drags are, that we should – if you can quantify a little bit more the holiday's benefit to January and maybe the drags until March?

Sure, Savi. I'd be happy to give you a little more color there. As we've said earlier, the holiday impact was better than we expected due to the improvement in yields and stronger business travel. The holiday shift ended up impacting the fourth quarter rather than the first about $0.5 billion, while what we were about half a point, which was better than what we were originally estimating, which was that 1.5 point, and we estimate the January benefit as probably in the $20 million range. Just in terms of the quarter, again just to remind you, we've got the Easter impact to March, that will shift. So hopefully that provides you a little bit of color.

Any thoughts on the Easter one on that timing?

Yes, the Easter impact was about, probably in the same range, the $20 million range as well.

I think you characterized the last couple of years well. Going back over a longer period of time, at least starting in 2012, we had very, very modest if any capacity growth. So with the opening up of our field, we were preparing for more aggressive growth in 2015, as a follow-on to that, along with the opening of the Houston International Terminal, and then the third major route theme in that time period was the acquisition of slots from American primarily at Reagan. So we were comfortable with above – with more aggressive growth in that time period because we thought those were unique opportunities and we thought they would be very profitable, and all of that proved to be true. The 2016 experience was a follow-on to that buildup in 2015. Now we get into 2017, which is choppy as you mentioned because of the accelerated retirement and grounding of the classics. So that will make for some choppiness, but in relation to that, I think in 2018, it will probably be a little choppy as well. Trying to give capacity guidance beyond what we have published is very speculative; we want to grow at a rate that will produce positive unit revenues, that is our goal. Trying to tie that to a number or to GDP or anything else is somewhat nonsensical. But in any event, I think we're on the record as saying that we intend that our future growth would be no more than what we've had here in 2016, which is pretty ambitious growth. So I see it being low single digits, that's just kind of putting my thumb in the air, but right now we have plans that are very flexible, allowing us some rounding up or down. After this year, we won't have many retirements for several years, and we'll be able to dramatically reduce our capital spending after 2018 also. But hopefully that answers your question.

Just to speak to the MAX side, we're really, really good. From all discussions we've had with Boeing, that airplane is performing magnificently. It is on schedule, and we expect to be able to execute exactly as we planned.

In addition to the airplane, obviously Boeing and GE need to do their parts, but we then we have to be trained. So that's the other moving piece of this and we believe we have a full handle on that and have all the training capacity in place along with the hiring that Mike is going to need to support all that as well. So I think everything is lined up very, very well. And as I mentioned in my introductory remarks, we have three major things for this year. I don't know if putting a percentage to it is so literal, but my thought is that 90% of the work for the new reservation system for the launch of international out of Fort Lauderdale or for the MAX is done. We're down to that last 10% and the deployment phase, and I think we're all feeling very good about all three of those.

Great. Thanks guys. I appreciate your view.

Good afternoon, all. Thanks for taking my question. And Gary, I know this might sound a little arrogant, but keep in mind we don't run money, we don't run companies, so it is what it is but 50 points capacity; I think it's not that big of a deal. But maybe if we can look at the bigger picture. Do you feel the network is over in your level of return to margins and should we be thinking outside the fleet transition this year? Does growth ramp back up into '18 and '19 really grow into a lower-term profile and expand even? How do you view this business long term, given where your returns are today?

That's a fair question. I would just offer a couple of points. I think it depends on three major levers: the economy, fuel prices, and competition. One thing that I don't think you all have focused on enough is the competitive environment within the Southwest route network. Yes, we're growing and producing really stellar returns, but this is in the face of very significant other airline capacity. When I look at the fourth quarter as an example, the markets that we serve grew; that's what we reported. The big competitors against their base of service in our markets grew much more than that. It was well over 6%. So there is a lot of capacity, which is not too shocking given that Southwest is now the largest airline in the country. By definition, we serve the larger traffic pools. If our competitors are going to grow, they're going to grow likely in our markets. If you think about the growth of the rest of the carriers, I bet you 95% of that growth was in our markets. I'm just mentioning that to give you a sense of how resilient Southwest is to competition. We have a great product, we have a great route network, we have low costs, we don't charge back fees; there are just a number of things that put us in a very competitive position. That is the main factor for you to think about in answering that question. If you go back to what Tom and Mike are profiling, we're doing really well today, but we have ambitious plans to make Southwest even better in the future with a customer experience, with our operation, but also to drive more efficiency. Completing that strategy should put us in a position where we can grow. How fast we grow, I think, will want to make that judgment on an annual basis, and maybe a schedule by schedule basis. But the overall return, under the assumption that we can continue to produce positive unit revenues, will be dependent upon where fuel prices land, which has been a main driver since 2014 and one of the reasons we have these record returns on capital. My opinion is that we're going to continue to see pretty moderate energy prices over the next three to five years, and we'll have hedging in place to protect against catastrophic increases so that we can commit to some kind of a growth plan. We all know how cyclical the business can be. Everything we see says that the economy is going to continue to expand for a number of years, but we want to be careful in making commitments just in case that proves to be wrong.

Well I appreciate the answer. As you look at your consistent results, your investment-grade balance sheet, and your relative stock valuations, I mean what is the market missing in Southwest's stock? What can you do as a management team to really try to drive home that value for shareholders?

We need to execute. I'm very happy with the value that we've been returning to shareholders; I think our shareholders are as well. I think the stock price performance has been very good over the past five years. So we're very pleased with that, and we just want to continue. The opportunities for us are to continue to fine-tune our customer experience and our revenue production. We need to be aggressive in managing the cost, as Mike mentioned. If I don't know that people are missing anything. But it's not just Southwest; every company intends to get better. I think what we have to do is demonstrate to our investors that we will in fact continue to get better and better and better, and through that continue to be an industry leader and drive superior returns. We have a history of demonstrating that as we have better tools and strengths in place today than we have ever had in our history. Implementing a new reservation system this year is going to be a game changer. It won't change the game in May, but over the course of time, over the next several years, we will have significant new technologies and tools that will be deployed that will make us even stronger. It's all about being best in class and winning customers against our competition. Our competition is better today than it ever has been; we're going to continue to get better as well.

I appreciate it, thank you.

Hey guys, thanks a lot for taking the question. Could you maybe Gary, kind of dope about a little bit and talk about the step up in aircraft CapEx for 2017 and just give us a sense for kind of where that money is going to go, how that is going to impact the business in the next couple years? And then longer-term, what you think about the things you want to get done in the next five years from an investment perspective, and how that can affect kind of the run rate spending.

Yes sir, I'd be happy to. First of all, under the assumption that we continue on with the strategy that Tom, Mike, and I are articulating here, which is to continue to operate an all-Boeing 737 fleet, to continue our expansion in North America and do that at a steady pace, under that basic scenario, it feels like this is a pretty peak level of CapEx, especially given that we've accelerated these retirements. We have heavy spending to replace these retired airplanes here especially in 2017. So it feels like this is a peak year. The non-aircraft surge that we're seeing in addition to the airplanes in 2017, is real estate-oriented. Mike is building a new flight training center, which is a strategic move. That’s in the hundreds of millions. We have other airport projects that we're investing in that are bumping up our real estate spending. The technology spending, I believe, actually begins to level off in 2017. That is largely because the bulk of the spending for the reservation system is behind us. I'd like our technology spending to continue to be robust but not at the levels that we have been spending. So we got a lot of technology desires here over the next several years but that spending should be leveling out. We also have a very significant technology investment underway that will complete in 2017 related to our maintenance recordkeeping. That is tied directly into the new MAX aircraft. Those are just a couple of examples. For future years, we'll have other technologies that are being deferred right now. We'll continue to have spending there but especially with the real estate, I think that spending will come down and then obviously, as we do as you are well aware of, the aircraft spending will be significantly less after 2018.

Yes.

Excellent. Maybe Tammy, just a follow-up on the question on the guidance, the 3% CapEx guidance, does that include training and any transition costs associated with the implementation of the system or the fleet transition? Or will there be some expectation of special charges on top of the 3% guidance?

It includes the costs associated with the transition to the new reservation system, as you pointed out. There are some training costs that will occur, but we've incorporated all of that into our guidance. So we are working through just on your question about special items; obviously those are always difficult to predict and if any. If we had some special items, as you know, last quarter associated with our classic fleet, just down on some of the leases that we bought out the equity on a few leases, because that was what made the most of it because we were working through how to effectively retire aircraft. Outside of that, there's, I think, normally what we anticipate going into any year would be just a normal fuel hedge adjustment to get to economic fuel prices.

Thank you very much. Hey Gary, in a world where Delta, United, and American have all said that they need a basic economy fare to compete effectively against the ULCC competition, why does Southwest not need something like that?

To be honest, we think it's more a question for them as to why they think they need one as opposed to why we think we don't need one. We have a very powerful brand, and Tom, Mike, and I and all of our leaders are very strongly aligned on this. There is huge value in offering all of our customers – 100% of them – a great product. We like to say at Southwest, there is no second class, there is no second class. In addition, we strive to keep the customer experience and just the product offering as simple as possible. Anytime we contemplate offering customers a choice, we debate that heavily, because complexity drives confusion and it clouds the brand. At Southwest, you have a very strong brand positioning in customers' minds that we stand for friendliness, reliability, and low fares. The whole free bags and no change fees become a very powerful component of all that. We don't feel like we need it, but if we were to undertake a basic product, the only thing we could do is take away from it. We wouldn't let you make a change; you'd board last, you couldn't take a bag; you couldn't bring a carry-on. Well that complicates the message, and we've spent 45 years educating our customers as to what to expect when they come to Southwest. I think that would be a huge mistake. Now, you look at our current results competing against all array of competitors, and there's just no empirical evidence that we're missing anything. Again, I just point to eight quarters worth of very strong performance relative to the group, even in the face of our competitors adding a significant amount of capacity overlapping us, and we're still producing these guys' returns, so I feel really good about where we are. We’re excited that we're always going to make it better, and we certainly don't see a need to pursue a strategy like that.

Okay, thank you for that, Gary. I think this is a question for Bob, if he's on the call.

Yes, I'm going to kick it back to Tammy for more detail. But generally, we're seeing strength all across the board. That's cards on-up, six new members that retail strength. Obviously, a piece of the deal we chase depended on the cards, as you see large fluctuations with the economy that would drive changes in things like retail spending. So of course, right now we're seeing upside there with the strength in retail spending on the card. But generally, the story has been across a very long period of time now that the card business, the card acquisitions, new members, spending on the card has continued to be very strong for a long period of time and actually outpaced the base business. It's been a tremendous success; but today we are not going to provide any more detail.

The only thing I might offer up, which I think fits in with your earlier comment or question, is that we think we really got something here. We relaunched completely redesigned the program and launched that back in 2011. So now, coming up on six years in March, six years later, we are ecstatic with the success that we have had, and we really feel like our team nailed it. So what's driving that? First of all, the program itself, which is well known. It's all public, you know how it works. Second is the overall brand of Southwest. In other words, does a customer want to put their chips on the Southwest and take a Southwest credit card? Yes, if they like Southwest. If we start tinkering with the brand, we start offering the basic economy, blah, blah, blah. It would risk the revenue stream and the loyalty that we have with that frequent flyer base. So just another argument of why we want to be very thoughtful about tinkering with any changes. We don't have any plans to change our seating configuration and add bigger seats compared to little seats. It just goes back to we want everybody to have a great experience at Southwest, and that is our greatest strength. So we go into the market; you name the big city, what is our biggest opportunity? Especially the every other competitor, they lavish attention on elite customers and they ignore the rest, and that is our biggest opportunity because we don't ignore anybody. We just don't want to change that. So now you look at our current results competing against all array of competitors, and there's just no empirical evidence that we're missing anything. Again, I just point to eight quarters worth of very strong performance relative to the group, even in the face of our competitors adding a significant amount of capacity overlapping us, and we're still producing these guys' returns, so I feel really good about where we are. We’re excited that we're always going to make it better, and we certainly don't see a need to pursue a strategy like that. So my report to you is we don't have any thoughts about any radical changes to the program. We also don't have any radical thoughts about changes to the brand. The growth that we continue to see, I think has been very, very significant and very exciting, and obviously, we hope that that's going to continue.

Thanks for the time. Can you hear me okay?

Yes, we can hear you.

That's great. Not a telecom analyst, but an airline analyst, so I figured out the phone. Thanks for letting me join this call. Regarding the IT tools that you're implementing this year and scheduling variability. Can you talk about where Southwest is today in terms of its ability to shape capacity by day of the week and perhaps seasonally within the month? And how the tools you're implementing will change that, and what the timeline on those changes would be.

Yes, I think it's really about incremental improvements that we have. The ability today to shape passively, obviously, within a day, within a week, and across longer time periods, you see. Yes, we vary the schedule. As opposed to the old days when Southwest ran the same schedule every day, we do vary the schedule across the days of the week. You also see us making more changes to the schedule post-publications. So maybe not as much as I would like to keep a fairly stable schedule for our customers, but we do make post-publication changes. The tools coming are all about incremental change. They are more than drastic change, so we will have the ability to make – include more variability within the day and more variability within a week to add things like red eyes if we were to choose to do that over time. And this will all layer on post-implementation. I do think we need to be careful with that, because one of those things that I think customers value about the brand is that we have a strong schedule offering and a fairly stable schedule offering. So we will walk into that over time, post the implementation.

Duane, this is Mike. Just to follow on with what Bob was talking about, I've been mentioning a little about some of the operational infrastructure investments we need to have. I think we'll have good commercial capabilities to have variation, and we also need to make the same operational capability. So we'll need to be able to vary our staffing at the airports, vary our maintenance programs with aircraft availability. Those are some of the things, when Tom was talking about building an operating infrastructure that is scalable and flexible. Those are the kinds of things that they are investments in our infrastructure designed to give for us.

The other thing I would mention just strategically here is that we decided before we deploy this new system that we were going to focus on the bases. And that really took on two forms. Number one, we wanted our technology resources focused on delivering a really good reservation system, period. Secondly, we wanted to allow our frontline the opportunity to get trained and then become proficient on the basic replacement. We opted not to be more aggressive in pushing for value-added changes that would complicate the technology deployment and it would complicate change management. In a different way, we just need to get this reservation system replaced and we need to do it really, really well, and it is a gigantic project. We sort of are under-promising for the benefits right now, but the opportunity that you mention is something that we will absolutely want to press for as a follow-on. The way to think about it here in 2017 and particularly in the second quarter is that we are just replacing our reservation engine, and that is plenty. It's going really well; release one was extraordinarily well done. Release two is virtually done as we speak and will be spooling up our training here in about thirty days. I think it's all rolling out exactly like we had hoped and desired.

Okay, thanks for the time.

Thank you, Tom. Welcome to the members of our media here on this afternoon's call. Let's get started with the media Q&A portion, Tom, if you could give them some instructions on how to queue up for questions.

Good afternoon. Probably Tammy, this is for you. Maybe I missed it in all of the news releases, but there was a lot of discussion on the call about you were expecting 3.5% capacity year-over-year additions for 2017, but what did you say, or did I miss it? What is your 1Q capacity growth going to be?

You're talking about our first quarter for this year, just to make sure. We are growing our capacity about 4% year-over-year here in first quarter.

I'm sorry if I missed this, but I know it's very early, but any color you can provide about the commentary on the pickup in business travel post-election, anything by market, by market share of ULCC anything.

No, I think Dave, as you know, in the overall economy it's very broad consumer – economic activity picked up, the markets picked up. I don't know that I can totally explain it. I guess one could believe the theory that first of all, there is certainty now you know who the president is. Second of all, there is some optimism about tax reform, that would be a boost to the economy and that regulatory reform et cetera. We're being swept up in a broader tide of optimism, and it's not unique to Southwest either. We've heard from our competitors with their public comments that they've seen the same thing. What has been pleasant for us is since early November, the pickup has been sustained. We ended up with a record load factor for the quarter and looking at very strong bookings here in the first quarter. With the traffic we've seen so far through January, it's also been quite strong. So I think that's the best I can provide.

I think you captured that perfectly.

Hi, thank you for taking my question. You mentioned that the Max is on track to arrive at the end of this third quarter. Can you comment though about whether Southwest will be the first operator of the Max? Other airlines have said they're going to begin operating the aircraft earlier and I'm just curious to get your thoughts on that?

Yes, I don't really know exactly what other airlines' delivery plans are or when they will be operating the airplane, but as we've been on record with, we're going to operate the airplane as soon as we have the classics retired, and that is because of some of the training differences and training challenges. So we'll have the classics retired at the end of the third quarter. At that point, we will launch service with the Max. If another airline operates before that, we will not be the first operator, but for us it doesn't concern me one way or the other.

Okay, do you anticipate Southwest will be the first to take the first delivery if not being the first operator?

Yes. I consider Southwest Airlines a large customer for the Max; we ordered the airplane. It's the first one off the delivery line; we are working closely with Boeing to make sure that it is operating as everyone intended. I feel like we are a major player in that.

You know, as we get this question, by the way. So there’s an interest in the answer. But we're not really focused on that; we know that Boeing has built planes that are for Southwest and that we have got our name on them. We don't need them for – flying until October 1. So aside from just readiness, when we get them, I don't think we care in the grander scheme of things. But as Mike said, we're the largest customer, regardless of when we take the first delivery.

Hi everybody, good afternoon. I was just wondering if you could provide a little bit of color on how you're thinking about your Max order? Anything specifically related to some other restricted airport you're operating out of like in Dallas LUV or Chicago Midway? Does the situation at the airport maybe lead you to take a look at upgrading some of your Max orders to something like the Max-9 or even the Max-10?

No. At this time, we are committed to the Max-8. We are the launch customer on the Max-7 which comes in 2019. And so that's it. We think that the Max-8 is the right airplane for us. We will use the Max-7, and it may prove to be a bigger player in our strategy over the long term, but right now, our focus is really on the Max-8. We don't have any need at this point for anything bigger than the Max-8 airplane, and there is not any effort within Southwest to explore anything beyond that – just to take the Max-8 and then the Max-7.

Okay, great, and then if I could ask just one follow-up question, could you maybe comment a little bit on the early performance and what you're seeing?

Yes, it's early. The load factors look fine. It is a weak part of the year seasonally. What I've been pleasantly surprised at is the demand from Cubans flying to the U.S. and back. A lot of times with our international routes, and again, you have to understand that we're new at this. We've only been flying international for about two and a half years. A lot of our markets have been built up with U.S. citizens only operating and coming back. In this case, we're getting a fair amount of local traffic coming to the U.S. as well. But it's way too early to tell; we need to go through a full annual cycle and see what this is like. I get asked all the time about whether it's meeting or exceeding expectations. I didn't have any expectations; I don't know how you would know because there hasn't been air service to Cuba for 50 years. The fact that we've got people on the airplanes, I think is really good. Just lastly, with the way we approach new markets, we’re very well prepared for the initial response to be rather weak. We have a lot of experience being patient in stimulating the market, getting people to notice that we're there and change their travel habits. We have had a lot of success, of course, under our belt with that approach. So I’m happy with the initial results; there’s nowhere near where we want them to be eventually, but at this point, I don't have any reason to believe that they can't get there.

Okay, thanks so much.

Thanks so much, Tom. Thank you all for your time and questions this afternoon. If you, as always, have any follow-ups, you can reach a member of our communications group at 214-792-4847 or via the online user at wamedia.com. Thank you very much.