Southwest Airlines Company (LUV) — Q1 2018 Earnings Call Transcript

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.

Thank you, Ryan, and good morning, everyone. And thanks for joining us for our first quarter earnings call. 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 we all mourn her passing. It was a dark day, but the compassion, 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. 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. 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. 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. 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 make 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 the first quarter to manage against overly aggressive discounting. We have several major enhancements to revenue management taking effect midyear relating to our new reservation system that you all are already aware of. Of course, finally, we will be optimizing our flight schedule roughly every 60 days as the second half unfolds. 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. 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 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.

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 margin was a solid 11.8%, in line with first quarter last year. 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 the 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 the 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. 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.

Okay. Thank you, Tammy, and good morning, everyone. 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. 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 the growth of our Rapid Rewards program and business partner revenues, which are both performing very well. 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 in 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, largely the result 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, 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. 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. 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. The final factor was the competitive fare environments. 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. 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. That's a good formula. We are very well prepared to compete, and we will succeed. The combined RASM impact of the sub-optimal schedule and 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. Having said that, I think we have several unique factors impacting our second quarter RASM, which gets us to a guide of down 1% to 3%. 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. For context, in the first week since the accident, we've seen somewhere between a 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. The full revenue impact isn't totally clear, but we do expect there would be 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. That included all television, all emails, all paid search, all paid display, and all paid social, everything. That is significant as those marketing vehicles drive a lot of traffic to Southwest.com. We only began to slowly bring our marketing back up this past weekend. 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. 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 the Q1 update. It will be present throughout the second quarter, but we will begin to see that diminish in the third quarter as we bring new planes into service. 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 will succeed financially with our Southwest customers. Now on the other side of the equation, we're also still on track to see a $40 million to $50 million benefit in the second quarter from our new reservation system, as we discussed in the past. We continue to feel very confident that we'll capture the $200 million annual benefit we discussed with you in the past. So while we are clearly off 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 improve in the second half of the year. We'll begin to rebalance our fleet with new aircraft deliveries. We'll begin to re-optimize the schedule with the new aircraft and will see the increasing benefit with the reservation system. And as you expect from Southwest Airlines, we are very focused on solid earnings, strong 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.

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 the 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. For full year 2018, we currently expect our economic fuel price per gallon to be in the $2.15 to $2.20 range. That includes an estimated $0.06 hedging gain and a $0.06 hedging premium cost. Our 2018 fuel hedge position is 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 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 costs related to an extended operating day driven by our Classic retirement and our current fleet deficit; as I mentioned earlier, costs shifting from the first quarter and other more minor costs. 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. 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.

Okay. Thank you, Tammy. Here's what we know from the NTSB so far. We had a failure of the number one engine, and there’s a fan blade partially missing; that's blade 13 of 24. There was a remnant of the blade that was still attached to the fan hub; when it was tested, it was found to be fatigued. 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. The loss of a single blade inside the engine just shouldn't have caused such dramatic impact. 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, which would’ve meant in accordance with 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. As Gary mentioned, we have had no findings of subsurface cracks. So, this is really 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. 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, diligent, and committed work. So with that, Tammy, I'll turn it back to you.

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 the 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 from 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 the 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 the third quarter of 2017. Our fleet deficit will recede when we get into the third quarter of 2018. We'll have significant 737-700 retirements over the next 10 to 15 years, and this order book refresh we covered with you in the earnings release and that Gary also mentioned, 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; 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 positioned to expand our net margin for 2018, excluding special items. We are already realizing meaningful benefits from tax reform, and I am pleased that we can continue putting it to work by investing in our business, rewarding our hardworking people, and giving back to our shareholders while keeping our costs and fares low for our customers. With that overview, we are ready to take questions.

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?

Hi, Hunter. No, you did not misinterpret the comment. 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. On the cost side, we feel pretty solid about that. If you consider 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 the 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. So really no change in our goal. We're just going to keep compounding away on the unit revenue side. I think that's 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 in the second half.

Okay. Thanks. 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?

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

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, the number is ten—there are ten additional firm deliveries in 2019, 2020, 2021, 2022. 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: we have exercised 40, and however they fall, what we are telling you today is that we would offset those with retirements.

Thank you.

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.

Well, hey, Jamie. This is Tom. If you don't mind, I'm going to try and take that one. 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. 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 fun, and we just don't think it's appropriate yet to bring that back up online. We're working really closely with Linda Rutherford and her comps team, listening for the sentiment, when does it feel appropriate for us to go back into the market? But just in terms of your direct question, we are going back and referencing prior events and what we saw happen with our traffic. 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.

Okay. That's excellent color.

I'll just add a couple of 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. This is certainly understandable for all the reasons Tom's taken you through with respect to our marketing. 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 precisely. We've already lost about a 1 point, as we pointed out in year-over-year RASM for the second quarter. 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.

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." 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?

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. 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.

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

Good afternoon. Thank you for the time, Gary. Do you still expect to be RASM positive this year? 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?

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. 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 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 for the same reasons on the RASM side. 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...

Well, Jack. This is Tom. First of all, I concur with what Gary just said. I also think, though, that we always look at how flights are performing. We'll probably take a more stringent look at how the shoulder flying is performing in terms of profitability. 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.

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. 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.

Okay, great. That's very helpful color. 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 get a new market once you start flying there to sort of system-level profitability? 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?

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. When we connect markets where we serve and the customers know us, it's typically a three-year turn from initiation to profitability. I'm sorry, I misspoke. Three years.

Three years.

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 on the West Coast. We have the largest customer base of an 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.

Okay, great. Thank you, again.

Just to add onto what Tom said, agree with the three years. Normally, what we see for 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 on the West Coast.

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. 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 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. The other little factoid I was going to offer 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.

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

Good afternoon, guys.

Good afternoon.

Good afternoon.

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? 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?

Yeah. Sure. Glad to do that. 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. 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. That's where the value comes from primarily in the $200 million a year. We deployed this, uh gosh, kind of late Q1 or mid Q1, and we are starting to see—so the team is kind of tuning it, 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.

And 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? And will that accelerate through the end of the year?

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

Okay. And in 3Q?

I'm sorry, penalty.

And will that accelerate through the end of the year?

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—we 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.

If I can ask Mike a quick question. Have all your maintenance procedures been reviewed, et cetera, and you're all in good shape there, if that's appropriate to ask?

You're asking if our maintenance procedures are in line with the service bulletin? Yes. We went back, we've been participating with GE and CFM since our first incident back in August of 2016. We have been in 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.

Very helpful. Sorry for the confusion, guys.

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? 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?

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 to be some impact on unit revenue. 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. 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. 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. 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. I think everybody knows how unique that was, but it was almost instantly profitable and with nary an impact on unit revenues. That was remarkable. But that is clearly the exception.

That's helpful. If I may, just a clarification on the 2018 capacity growth. How much of that can get skewed around on the timing 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 2018 capacity? Or depending on when Hawaii actually gets launched, could that capacity move around in the second half?

No, I think that's right. 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.

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. 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 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.

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. If we don't fly to 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. If we don't fly 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 those airplanes are going to Hawaii.

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

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?

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.

Okay. And then just the 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. I'm just wondering, does that cover some of the costs, mitigate some of the cost impact of these extensive blade checks?

Yeah, sure. We have our engines 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 is on power-by-the-hour. Yes, that does help us mitigate the cost of those because the risk transfer is back to GE, our service provider there.

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—it is millions of dollars? Is it hundreds of thousands of dollars? Or is it just too early?

It is a little early, but I would expect it to be in the millions of dollars, just to give you an idea directionally. 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.

Those would be mostly outside of the actual engine repair costs. That would be over time those kinds of things. The labor costs associated with doing the inspections, some other delay remodeling costs, those kinds of things.

Okay. Great. Thank you.

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?

Well, Duane, I think it's very fair to say that our primary focus is investing in Southwest Airlines. This year in particular we have a lot of our major strategic initiatives behind us. There's always work to do. But, particularly 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 basic things. We want to continue to grow the airline. We've got wonderful opportunities to grow, and tax reform obviously is a nice boost to our financing sources. There is no imperative that we need to be hunting for an acquisition. I think that’s different than where we were late 2000s; 2009, 2010. Clearly, this is our priority, 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's a good opportunity in our view, it's something 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.

Very good. Thank you.

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?

$40 million to $50 million.

$40 million to $50 million.

Thank you.

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

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?

Well, Duane, I think it's very fair to say that our primary focus is investing in Southwest Airlines. This year in particular we have a lot of our major strategic initiatives behind us. There's always work to do. But, particularly 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 basic things. We want to continue to grow the airline. We've got wonderful opportunities to grow, and tax reform obviously is a nice boost to our financing sources. There is no imperative that we need to be hunting for an acquisition. I think that’s different than where we were late 2000s; 2009, 2010. Clearly, this is our priority, 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's a good opportunity in our view, it's something we'll take a look at.

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