Southwest Airlines Company (LUV) — Q3 2018 Earnings Call Transcript

Thank you, Abby, and welcome, everyone, to our third quarter earnings call. Joining me today we have Gary Kelly, our Chairman of the Board and CEO; Tom Nealon, our President; Mike Van de Ven, Chief Operating Officer; and Tammy Romo, Executive Vice President and CFO. Before we get started, please note that our comments today will include forward-looking statements that are based on the company's current intent, expectations and projections. A variety of factors could cause our actual results to be materially different from our current expectations. And we also make references to non-GAAP results, which exclude special items. For more information regarding forward-looking statements and our reconciliations of non-GAAP to GAAP results, please visit our Investor Relations section of southwest.com, where you can find this morning's earnings release as well as our SEC filings. And now I will turn the call over to Gary.

Thank you, Ryan, and good morning, everybody. Thank you for joining our third quarter earnings call. First of all, I want to thank all of our employees for an excellent third quarter performance. It was a very nice recovery from the second quarter, which was down 3% on a RASM basis due to Flight 1380. That was a nice turnaround to the third quarter RASM performance of up 1.2%. Mexico was weak for us in terms of revenue, but our domestic performance, excluding all the international, showed solid RASM of plus 2.3% year over year. Overall, we had a sequential quarter-over-quarter improvement of 2 percentage points ahead of normal trends, so again, it was a very nice recovery. Our year-over-year comps always have noise, but I'm expecting another sequential trend improvement in the fourth quarter and a year-over-year improvement as we said in the press release of 1% to 2%. I want to provide an early look ahead to 2019. Although our confidence level in forecasting revenues is never 100%, our goal for next year right now is positive RASM of at least 3%. While it is a goal, trends and initiatives that we already have underway would support that goal. Our confidence level in predicting cost is much higher of course than revenues. The preliminary read is that unit cost ex-items will also be up at least 3%. But I’m not satisfied with that as I’m sure our investors aren't either, and Tammy will describe the cost pressures further. Our strategic initiatives have transformed the airline, but that time has come where our focus needs to be on efficiency and productivity and overall cost control. Again, that will be our number one priority. We have a very strong balance sheet with declining leverage below 30% and strong liquidity with cash levels well ahead of our target. We just reported record earnings for the quarter and expect very strong year-over-year earnings growth in the fourth quarter. We have an outstanding fuel hedge built for the next 24 months and very manageable growth plans for 2019. In terms of operations, we need growth to absorb investments that were made related to capacity like airports and training facilities. Our culture is unmatched and our ability to attract talented people in this environment is very strong. We continue our focus on excellent shareholder returns. With that, I will turn the call over to Tom Nealon to take us through the commercial side here.

Thank you, Gary. Good morning, everybody. As Gary said, we are very pleased with our third quarter performance and we are seeing continued strength into the fourth quarter in terms of passenger demand throughout the booking curve as well as continued strength in the pricing environments and very solid yield momentum. We ended the third quarter with a record $5.6 billion in operating revenues, which is up about 5% year over year. Our passenger yields increased 2.3% for the quarter. Our load factor was 83.9%, which was down about 1 point year over year. But we saw passenger growth of 2.5% and carried a record 33.9 million passengers in the third quarter. We had three RASM headwinds, totaling a 2 point drag on Q3 RASM. The Rapid Rewards accounting change was 1 point, about 0.5 point was from our summer fare sale, and the last 0.5 point of drag came from the suboptimal schedule. Those headwinds materialized as we expected in the third quarter, but we do not see them repeating in the fourth quarter. Our new revenue management tools contributed to solid RASM results, resulting in an EBIT benefit of approximately $75 million. We also saw meaningful benefit from our new pricing capabilities. Our ancillary revenue performance was strong. We recently introduced a new pricing structure for our EarlyBird product, and the results are proving successful. The take rates align with our expectations, resulting in incremental revenue. Our Rapid Rewards Program and business partner revenues continue to grow, driving a 6.6% growth in other revenues in Q3. Looking to the fourth quarter, we are seeing continued revenue strength, expecting RASM to increase by 1% to 2% year-over-year based on current bookings and yield trends. We remain very happy with our new revenue management capabilities and are achieving the expected benefits. So, I'm very pleased with the trends we're seeing as we move out of 2018 and into 2019. I will now turn it over to Mike for our operations update.

Thanks, Tom, and good afternoon to some of you all and morning to others. The third quarter is a transition period for the operation. We experienced a tough last half of July and early August with 2,200 weather-related cancellations. We expect to finish fourth in the DoT on-time performance for the quarter, an improvement of three spots over last year. We set a third quarter record for the lowest percentage of mishandled bags in our history. Our fuel efficiency is improving at about 1.1%, primarily due to our fleet modernization. We are also partnering with the State of Maryland to build a maintenance hangar in Baltimore, which will support our operations as we expand. We have plans to add both a pilot and a flight attendant crew base in Los Angeles to support our Hawaii efforts. Our goal remains to sell tickets by the end of this year and operate flights early next year.

Thank you, Mike. Moving into cost, our third quarter CASM, excluding special items, increased 4.1% year over year, driven in part by a nearly 9% increase in our hedged fuel costs. Our hedged fuel price per gallon remains steady at $2.25, despite an increase in market jet fuel prices during the quarter. For fourth quarter, we expect our fuel price per gallon to be in the $2.30 to $2.35 range. Our 2019 hedges are structured to fully participate in market price decline. We're expecting our full year 2019 CASM to increase at least 3% year over year. Key drivers for this will be operations, staffing demand, and healthcare inflation. We ended the year-to-date operating cash flow at $3.9 billion with $1.8 billion returned to shareholders through share repurchases and dividends. Overall, I'm very pleased with our continued approach to capital deployment and will focus on opportunities to drive further value while continuing to return value to our shareholders. I expect 2019 to be heavily focused on controlling costs and driving efficiencies.

Good afternoon, guys. Thanks for taking my question. Gary, could you talk through some of the specific initiatives on the revenue side that you think will help get you to margin expansion next year?

Great question Jack. We’re very motivated and we admit that the confidence level we have with revenue forecast fifteen months from now can't be that high compared to our confidence level on the cost side. But we believe we are well along in our planning for 2019. Tom can summarize the specifics, but our focus will be on executing our current initiatives rather than depending on any new initiatives that might come online in 2019.

We are seeing our ancillary products grow faster than our core business, and our corporate sales are a bright spot. The close-in current environment is strong, allowing us to effectively balance yield and load factors.

Good afternoon, a couple of questions on the unit cost side, Gary and Tammy. Is the 3% CASM increase target for 2019 an anomaly, or should we think of Southwest as having higher costs moving forward?

I want to be clear, while some of our costs are increased due to more customers per departure, we have initiatives that we're working on to keep costs at a minimum. But we need to focus more aggressively on managing costs in 2019.

Thanks, guys. As you think about Hawaii service for next year, when do you expect to see bookings for that?

We feel good about Hawaii, and once we receive our ETOPS certification, we’re ready to quickly publish our schedule and begin bookings soon thereafter.

Thank you all for joining us. If you have any follow-up questions, the communications team is standing by.