Southwest Airlines Company (LUV) — Q3 2017 Earnings Call Transcript

Thank you, Tom, and welcome, everyone to our third quarter earnings call. Joining me today we have Gary Kelly, Chairman and CEO; Tom Nealon, President; Mike Van de Ven, Chief Operating Officer; Tammy Romo, Executive Vice President and CFO; and other members of senior management. 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, which excludes special items, please reference this morning's press release in the Investor Relations section of southwest.com for further information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results. We will begin here shortly with Gary providing an overview of our performance, followed by Tammy providing a more detailed review of our third quarter financial performance and 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'd like to turn the call over to Gary.

Thank you, Ryan, and thank you, everyone, for joining us to discuss our third quarter results. I want to start out with a shout out to all the Southwest people. We've had really unprecedented storm challenges, fires, the Las Vegas situation, and I don't know that we've ever had a 60-day period in our history where we had to deal with so many different external events like that. They did a phenomenal job. And of course, I'm very proud of the response that Southwest had for the communities that we serve. We're continuing to keep all the folks that are impacted in our thoughts and prayers and continuing to do our best to support them in their recovery efforts. So despite all of these challenges, it was a very strong quarter, and the fourth quarter looks better. 2018 is also set up very well for unit revenue growth as well as margin expansion. I found the third quarter and fourth quarter a bit challenging to interpret, and there were a lot of moving parts. We have a new reservation system. New labor contracts went into effect in the intervening 12 months. Hurricanes, earthquakes, we grounded the 737-300 fleet, and the year-ago comps have some items in them as well. I would say that applies to both revenues as well as costs. So Tammy is going to cover it in more detail, and I suspect that we'll be redundant on some of these points, but hopefully that will be helpful to you. First of all, I just want to start out on revenues. Unit revenues were down 0.5 percentage point in the quarter, and there's no real surprise there. Without the $100 million hurricane impact, RASM would have been flat. What is not new news is that the new reservation system created a temporary one-time drag of roughly 0.5 point, a little bit more than that for several reasons: school calendars, our new reservation system, just the number of aircraft deliveries that we were accumulating in August. We extended our summer schedule farther than we typically do, and that proved to be a drag as well of roughly 0.5 point. That's not something I anticipate we would repeat next year. Taking all those things into account, it was a good result. The third quarter was more challenging on yields than the second quarter was. But overall, a very solid quarter, and I think we're positioned well now for the fourth quarter. The yield environment in the fourth quarter appears improved compared to where we were in the third. The onetime effect of the new reservation system should not be repeated in the fourth quarter. The storms, the fires, the Las Vegas situation are certainly improved from where we were in the third quarter, although there are still some recovery efforts taking place, especially in Las Vegas. Our revenue outlook for 2018 is stable as well. Our goal, which I believe is realistic, is positive unit revenue growth for 2018 compared to 2017. Our new reservation system synergies of $200 million for 2018 is intact. So a solid revenue performance and a solid revenue outlook. On the unit cost front ex-fuel and profit sharing, we were up 3.3%. There's no surprise there, maybe perhaps some good news compared to what we were expecting. But overall actually a very good performance. So just remembering that the new labor contracts went into effect after last year's third quarter with snap-ups. That was 3.6%, meaning that unit costs would have been down, except for the new labor contracts. More important for your analysis is the one-time effect of the storms on the third quarter, which was about 2%. So if you take those two things into account, a very good cost performance for the third. As for the fourth quarter, we expect unit cost ex-fuel and profit sharing to be in the range of flat to up 1.5%. That's somewhat higher than our previous expectations, and I would say it's mostly timing. There is still a year-over-year effect in the fourth quarter of roughly 0.5 point and a little bit more from the new labor contracts. We'll realize a nice benefit, as I mentioned earlier, from the grounding of the classics fleet. But our schedule is not fully optimized because we are trying to maintain as many flights with a fewer number of aircraft in the fleet. I would expect that to be more optimized by the time we get into the second half of next year. Overall through the first nine months, now almost ten months into the year, I'm very pleased we have successfully deployed our new reservation system. We've successfully launched international flying out of a new terminal in Fort Lauderdale. We retired 67 airplanes from the classic fleet in the third quarter, which was a huge effort and done very successfully. Of course, we launched the MAX on October 1. Our growth is very manageable, both for this year and for next year. There's only about 3% of our system that we define under development, and I feel very comfortable with that. The energy price outlook for the near term and for next year looks pretty favorable. I'm very happy with the hedging position that we have built for the next several years. No change in our growth plans, no change in our fleet plans. We're just getting to work on Hawaii as you all now know, and we'll have more to report on that in the first quarter. So with that very quick overview, I'd like to turn it over to our Chief Financial Officer, Ms. Tammy Romo.

Thank you, Gary, and welcome, everyone. I would like to start off by congratulating Mr. Kelly on his well-deserved Wings Club's Distinguished Achievement Award last week. I'd also like to begin by thanking all of our employees for their incredible efforts during the quarter. Our thoughts and prayers are with all of those who have been impacted by the hurricanes and earthquakes, the Las Vegas community, and those affected by the fires in California. While our third quarter operations were certainly impacted by the unprecedented number of natural disasters, we were very pleased to report a strong third quarter profit of $503 million. Excluding special items largely related to the retirement of the classic fleet, our third quarter profits were a strong $528 million, which earned our employees $127 million in profit sharing. Jumping right into revenues, our operating revenues were a strong $5.3 billion, despite the significant impact from the hurricane. Our third quarter RASM decreased 0.5% year-over-year, which was in line with our most recent guidance. This included a revenue headwind from the implementation of our new reservation system of less than 1 point. The minor issues from the reservation system that caused the revenue impact in the third quarter have been remedied, and we don't expect an unfavorable impact here in the fourth quarter. The third quarter started off with a positive year-over-year RASM growth in July. However, August and September were both impacted by the significant weather events and the competitive fare environment impacting close-in yields. As we noted in the earnings release, the hurricanes and natural disasters caused approximately 5,000 flight cancellations in the third quarter, which negatively impacted our revenue by $100 million. Nearly 15% of our system ASMs touch Houston and other stations in Texas that were impacted by Hurricane Harvey. About 25% of our system ASMs touch Florida and other states nearby as well as near international destinations that were affected by Hurricane Irma. However, both our Houston and Florida operations and employees are resilient, and the impacted stations and passenger demand have rebounded quite well. All things considered, including our difficult year-over-year comparisons due to our strong industry outperformance over the last few years, we are very pleased with the overall resiliency of our revenue performance. Our freight revenues were also solid, and third quarter other revenues increased approximately 13% year-over-year, driven primarily by the continued success of our Rapid Rewards loyalty program. Although the fare environment remains competitive here in October, it does appear to be stabilizing. October passenger revenue yields are currently trending up nicely year-over-year, which is an improvement from August and September year-over-year yields. I will just point out that November and December are expected to have more challenging year-over-year unit revenue comparisons due to the boost in travel demand and yields last year, particularly between the holiday periods. While the December holidays fall similarly year-over-year, we are monitoring whether we'll see any negative impact from school holidays beginning later in the month, which may postpone more travel into January, but it's a little too early to tell. Overall travel demand for the fourth quarter is solid, and we are very pleased with our current outlook for positive year-over-year unit revenue in the fourth quarter. Based on current bookings and revenue trends so far in October, we currently expect fourth quarter RASM to be up slightly to up 1.5% year-over-year. We also expect both freight revenue and other revenues to increase year-over-year in the fourth quarter. Turning now to cost. Our third quarter cost performance was within our expectations. Our third quarter economic fuel price per gallon was $2, which was at the lower end of our guidance. The retirement of the classic fleet and other ongoing fleet modernization initiatives drove nearly a 2% improvement in fuel efficiency year-over-year. Since our last call, crude prices, as you know, are up. For the fourth quarter, we are estimating approximately $2.10 per gallon based on market prices last Friday and our current fourth quarter hedge position. This fourth quarter fuel cost estimate includes a $0.25 per gallon hedging loss. At the end of this year, our fuel hedging losses will burn off, providing meaningful tailwinds in 2018. All of our hedges in 2018 and beyond are call options and call spreads with no floor risk. Excluding fuel and special items, our unit cost trends improved sequentially, as expected, with the continued benefits from the retirement of the classics and the wind-down of costs associated with the implementation of our reservation system. With the retirement of the classics, we recorded two special items during the quarter. We had a $63 million aircraft grounding charge related to the remaining lease payment. We also recorded a $20 million lease termination charge related to the acquisition of four of our classic aircraft previously under operating leases. These charges were contemplated in the estimated $200 million EBIT improvement that we've been communicating from accelerating the classic retirements from 2021 to 2017. Excluding fuel, profit sharing, and special items, our third quarter unit cost increased 3.3% year-over-year, which came in at the lower end of our guidance. The year-over-year increase was driven by the hurricanes and wage rates from labor contracts, partially offset by classic retirement benefits. Looking to the fourth quarter, we continue to expect our unit cost inflation to ease considerably as compared with the first three quarters of the year. Our investment-grade balance sheet remains very strong and continues to differentiate us in the airline industry. We are very proud of our recent rating agency upgrade from S&P to BBB+ in August, which is on the heels of our upgrade to A3 from Moody's in June. Our liquidity is strong with cash and short-term investments at quarter end of $3 billion. And our cash flows remain healthy with operating cash flow of $3.4 billion for the nine months ended September 30. Our CapEx guidance for 2017 is unchanged at $2.3 billion, which allows for healthy returns for our shareholders. In August, we repurchased $300 million of common stock through an accelerated share repurchase program, leaving $1.7 billion remaining under our current $2 billion authorization. Thus far in 2017, we have returned $1.5 billion to shareholders through share buybacks and dividends. Our leverage, including off-balance sheet aircraft leases, is approximately 30%. Our goal remains to keep leverage in the low to mid-30% range. Moving on to fleet, I am very proud of the many employees involved in retiring our classic fleet. We started the year with 87 classics and retired 69 in the third quarter alone as planned. That brought us to 687 aircraft at the end of the third quarter after the delivery of 21 new and used aircraft during the quarter. We are thrilled to introduce the MAX 8 into our network. We have 10 of them in our fleet currently and will have 14 by the end of this year. We continue to expect to end this year with 707 total aircraft and our fleet plans remain unchanged in 2018 with 750 aircraft. In terms of capacity, we continue to expect fourth quarter capacity to increase in the 1% to 2% range year-over-year. Our investment in ETOPS will affect growth in the second half of the year. As a recap, our return on invested capital for the last 12 months is a strong 26.8%, and 2017 is shaping up to be another stellar year. I am excited about 2018, including our future plans to serve Hawaii. I want to thank our employees again for their hard work and perseverance in a challenging quarter and for all that they do on the front lines each and every day, and congratulate them on these great results again. With that, Tom, we are ready to take questions.

Hi. Sorry. Can you hear me?

I can hear you now.

Sorry about that. Okay, thanks. So 2018 costs, Gary, you said you feel good about the RASM outlook for 2018. That's great. I would imagine you guys are enough through the budget process at this point to give us a preliminary look. Do you feel like having the expense behind you with the PSS cutover that we should start thinking about CASM ex-fuel next year as being down?

I do feel really good about the cost outlook for 2018. Tammy, would you like to go through that?

I would be delighted to. So yes, Hunter, we're still finalizing our 2018 plan. I'm not prepared to provide guidance today. We plan to cover that on our January call. However, I'd be happy to provide you some thoughts and goals for 2018. On the cost front, we're still working through our multi-year plan, including how we want to invest in technology and other areas of the business. We have some wonderful tailwinds in 2018 related to benefits and depreciation, maintenance, and aircraft rentals from the classic retirement and one-time costs associated with Lone Star, as well as significant tailwinds for fuel with our hedging losses burning off this year. With the classic retirement and launch of the MAX 8, we should have a meaningful fuel efficiency improvement in 2018. As we move through our planning process for next year, some headwinds have materialized, including costs such as landing fees. As our -700 aircraft age, of course, we'll have some increasing maintenance costs as well, and just other typical inflationary cost pressures. Netting all of this out and considering that we will still be transitioning through the classic retirement as far as the network schedule goes, I think CASM excluding fuel, profit sharing, and special items would be a reasonable goal for us versus 2017. We will continue to look for ways to manage those costs down. I think down year-over-year cost per available seat mile excluding fuel, profit sharing, and special items would be a stretch based on what we know today. Overall, I am quite pleased with our early outlook for 2018. On the revenue front, we're working hard to realize the benefits from our investments in our new reservation system and will continue to be diligent on the cost front. With the tailwinds I mentioned there and our goal to grow RASM, I think we are well positioned to expand our margins next year, and certainly costs are a big part of that story.

Okay. That's helpful. Thanks, Tammy. And, Gary, on the positive RASM comment that you made, what gives you the confidence about that? How much of that has to do with your view on industry conditions versus some of the Southwest specific stuff? Is it a load factors play? Is it a yield play? What are sort of the components of that that give you the confidence to put that out there at this point in time? Thank you.

Very fair questions, because nobody has a crystal ball. I think it is just recapping some of my opening comments. It's our view that the economy will continue to be stable. The travel demand will continue to be strong. Of course, we're looking at the competitive supply of seats out there. We're looking at what we have in the pipeline. Of course, you all are well aware of our one res synergies that we've been talking about for some time. Then looking at current trends, there's a lot of strength throughout the Southwest system. I'm very happy with the progress that our development markets are showing. Andrew Watterson and his team have been very active in pruning out some of the non-performers in our system. We continue to be active in managing the network, taking some risks, being aggressive, but overall, it feels like we're set up very well. Next year is much more stable. We just don't have as many moving parts. We are just working on Hawaii now, and I think that will be less ambitious than what many of these other things have been. Hats off to our folks for managing it well, and I think they'll continue to manage it with better tools next year.

Okay. Thanks.

Hey, guys, good afternoon. Thank you for the time. Just to clarify, Tammy, on your comments on the CASM outlook or framework for next year. I think you said you're not expecting it to be – I think you said down year-over-year will be a stretch. But I didn't hear your exact comments on your outlook for 2018 CASM ex. Could you just maybe go over that again a little bit?

Sure, Jack. Just on our CASM excluding fuel, profit sharing, and special items, as I said, getting down might be a stretch. But I do think that a flat CASM excluding fuel, profit sharing, and special items is a reasonable goal versus 2017.

Okay. That's helpful. I just wanted to make sure that that was out there great. And then just sort of as my follow-up question, going back to the $200 million in pre-tax incremental profitability from the new reservation system next year, could you help us think through the cadence of how that will flow through the P&L as we move through the year? Is that going to be sort of evenly distributed throughout 2018? Or is it more second half weighted? And then how should we think about that incremental profitability coming from revenue or cost? Just trying to think through how that's going to show up in the P&L next year.

Sure, Jack. First of all, we are focused on implementing the new reservation system. We remain pleased with the rollout. We're aiming to cover additional breakdown of the $200 million EBIT in our January call. But the ramp-up suggests you'll see more of that in the back half of the year. Breaking it down further, I can’t do that until we finalize our plan and will come back with more information likely on our January call.

Okay. That's great. And one quick housekeeping item if I could squeeze this one in. Could you provide us with the hedge asset or liability as things stand today for 2019 if that's possible?

Yes, absolutely. For 2019, it is just about $50 million.

Hey, good afternoon. I'm a little mad at Tammy. She beat me to the punch on the Wings Club Award, coming from somebody, Gary, that's also known you for over 25 years, I sincerely hope that you accept my congratulations as well. Very, very cool. A question on Hawaii, and I know you're not ready to discuss routes and schedules and all that. But when I think about the time of day that most flights depart the West Coast to the number of time zones you cross, the implied arrival time back in California or on the West Coast, if you did maybe a 60-minute, 65-minute turn. I sketched out several single aircraft patterns. In most of the scenarios, it looks to me like you’d have adequate time to do some interisland turns. Southwest's bread and butter is shorter-haul flying. I know you're not going to say whether you would consider inter-island, but can you point me to anything in the work rules, the pilot duty regulations, anything that would at least allow me to rule out the feasibility of running a couple of turns before you turn back to the mainland?

Yes. There's nothing that would rule it out. Now that we are public with this exciting topic, it is an item of interest for customers in Hawaii. Of course, it's something that Andrew and his team are intrigued with as well. Step one, of course, is getting from California to Hawaii, but it is certainly something we’ll consider, even if we don't do that initially. It's something that we will obviously continue to think about in the future. This is very high-profile work, and we can't keep it a secret, so we are letting the world know early that we're working on it. There are lots of questions to be answered, and we don’t have those answers yet. But I indicated in earlier remarks that first quarter we might be in a position for details, but nothing prohibits us from doing that.

Okay. I appreciate the sanity check. Second, regarding pricing, I want to confirm that the older system put some limits on your ability to price match by channel. The new system does give you more flexibility. So if an ultra-low-cost competitor has a single daily flight at noon, you can match on your 12:20 departure, but you don't need to match at 9 in the morning or 5 in the afternoon. Is my understanding of the new system correct? And if so, is this what you're broadly doing or not? I'm not asking about future pricing, just what's in the current market.

Our folks have done an amazing job managing revenues. I don’t think it's a fair characterization to say that we could not do certain things. It is I think more accurate to say that we have far better tools now to do things along those lines than in the past. Whether that will show up as a material difference in the future, I'd rather not comment on. But it is accurate to admit that we have much better up-to-date tools today compared to what we've been using.

Okay. Perfect. And sorry again to miss you last week, Gary. Congrats.

Thanks. Good afternoon. Just on the international side, I was wondering if you can provide an update on how that expansion has gone, and any opportunity to be a bit more aggressive in growing in those regions?

It's gone very well. Clearly those markets have similarities to domestic markets in the sense that they struggle a bit when we start, and then over time, if we're managing it well, they develop nicely. We have a little over 3% of our available seat miles trans-border. The capacity increase in the third quarter year-over-year was just under 19%, and revenues far outpaced that. RASM was up on a stage length and gauge adjusted basis, almost 8% year-over-year. We're feeling really good about that. We have opportunities to grow there. We have a wealth of opportunities in domestic and international. We've done a full assessment after Hurricane Irma, and all systems are go for Turks and Caicos, which is our final destination we’re adding. We'll try to be as coy as possible about further announcements, but we have many options to grow.

If I might follow up on that, Gary, so next year, I think your previous comments said you'd be accelerating domestic growth while letting international digest itself. Is that still the case? What level do you think we'll see acceleration?

I think that's very fair. We haven't opened anything beyond Turks and Caicos. We'll continue to wait until the last minute to commit, but that's been our focus for the first half of the year and may not add any new destinations, except for Hawaii, which is the primary focus right now.

Thanks. Can you talk about the next maybe two, three, four IT systems that are in the pipeline? What's the most material contribution from those would be? Now that you've got the big reservation migrated, what are your next two or three priorities?

The reservation system is still a huge focus for us. We have a major release coming out next month. Let me allow Tom to take you through that.

In mid-November, we'll be releasing release 2.5, which will help clean up operational revenue leakage issues. The next set of big investments isn’t on the commercial side. It’s going to be more on the operational side. We are replacing our aircraft maintenance portfolio, upgrading flight planning and scheduling, and improving crewing systems. These are the three big platforms we’re focusing on.

These systems that Tom describes will create opportunities for greater operational efficiency. We've changed a lot over the last 15 years, and some operational systems struggle to keep up. There will be investment, but I'm hopeful that tangible financial benefits will flow from these enhancements.

Thanks. Can you speak to when the flight planning and scheduling systems would go live? And maybe next year or three quarters from now what improvements it will provide to you?

It's early, but this won't be a big bang rollout like the reservation system. It will happen incrementally over time, and we’re fairly well into it. I cannot give you a more definitive answer than that.

In the near term, we will continue to implement follow-on releases of the new reservation system. Finishing what we started there remains a priority.

Hi, guys. Thanks for your time. Have you seen legacy carriers, United and American in particular, deploy their basic economy product and scale in your markets? If so, do you believe you are gaining market share in those markets as a result?

I get the implications. We can argue this from both ways in theory. Is it good for us or bad? So far, I don’t sense it’s moving the needle one way or the other. I can assure you that it is helping our brand. We have many fans, and we're trying to be their most loved airline. But I’m just giving you an honest answer. I don’t sense it's moving the needle significantly for us.

I completely agree.

Hey, good afternoon, everyone. Thanks for taking my question. Gary, I want to come back to the pricing comments you made. You said it seems like fares are improving in your markets from August into September and into the fall. Do you think that's just a function of improving demand, or are capacity dynamics playing a more impactful role in your network relative to others?

From month to month, I don't know that the markets are dynamic. I think it's just pricing, to be blunt. Pricing is very dynamic and hard to predict from one carrier. Overall, the yield environment is better in October than it was during the third quarter. We have a very low cost structure, a diverse route system, and we can handle any ups and downs that occur. Currently, we're seeing an improved yield environment compared to the third quarter. The holiday travel for November looks strong. We are looking for improved yields and good comparisons versus a year ago.

I appreciate the thorough response. One follow-up question: You are going to be in an asset position on your hedge book. Does that change your philosophy on pricing or thinking about fares in 2018? I know you want positive unit revenues, but…

We're not going to go crazy. We want to be disciplined about how we manage our growth and set expectations for revenue production in our markets. Our goal for next year is positive unit revenue production. Even knowing our CASM will be down, we want to boost our unit revenues and maintain that discipline. We are leveraging fuel prices, but we will not ignore potential fuel price changes. So that remains our goal and is realistic.

Good afternoon. Can you provide a bit more color on what you’re including in your 4Q RASM guide? Are you reflecting demand hedges from places like Houston and Vegas? Is there a calendar hit in there? I think, Gary, you mentioned something about elongated schedules. Can you provide additional insights?

All those factors are included in there. The only cautionary note I would offer is that Las Vegas isn't back to 100%. I'm assuming it will be back soon, but it’s not entirely back yet. Houston and Florida interactions looked better, but I think we are taking a cautious approach overall. But anything else to add, Tammy?

No, we have our best estimates incorporated in the guidance provided today.

The drag on the schedule from the retirement of the classics does present some headwinds, but we are looking to optimize the schedule as more aircraft deliveries arrive.

Okay. And those headwinds you're talking about, Gary, Tammy, is that like a point? Can you quantify that?

Yeah, 0.5 point on that particular item. Tammy, do you have a revenue number for Las Vegas, Houston, or Florida?

I estimated around $10 million to $15 million impact for Las Vegas.

Okay. And then just the second question. In terms of capacity growth in the back half of next year, what factors will drive that range?

We're not prepared to provide specific guidance today on the second half of next year. We’ll update as we publish our schedules.

There is no change in airplane counts. We're planning for stabilized growth expectations overall, but factors like Hawaii participation will have an impact.

Hey, thanks for squeezing me in. Gary, at this point, do you have the capability to do red eyes? If you can’t do red eye flying, is that something that you would want to do by the time you start Hawaii, or do you feel you can serve those markets without flying red eyes?

We're moving forward with Hawaii and won’t require red eyes. Gary, can you comment further?

No, there’s nothing else to add. Red eyes introduce operational complexity in crew scheduling and maintenance programs. We’ll eventually want that capability in the future but not right now.

So it’s not a priority for us and won’t directly impact our Hawaii service.