Southwest Airlines Company (LUV) — Q1 2019 Earnings Call Transcript

Thank you, Cody, and welcome, everyone. Joining me on the call today, we have Gary Kelly, our Chairman and CEO; Mike Van de Ven, Chief Operating Officer; Tom Nealon, our President; Tammy Romo, Executive Vice President and CFO; and other members of our senior leadership team. Please note that our comments today will include forward-looking statements, and these are based on our current intent, expectations, and projections. As we noted in our earnings release this morning, we have made flight schedule adjustments through August 5 as a result of the MAX groundings. And the guidance we will provide today is based on our estimates assuming the grounding of the MAX through August 5. A variety of factors, in particular those that are out of our control in connection with the MAX groundings, could cause our actual results to be materially different from our current guidance. We'll also make references to non-GAAP results, which exclude special items. And for more information regarding forward-looking statements and our reconciliations of non-GAAP to GAAP results, please visit the Investor Relations section of southwest.com. So with that intro, I'll turn it over to Gary.

Thanks, Ryan, and good morning, everyone, and thanks for joining us for our first quarter 2019 earnings call. Overall, I am as proud as I have ever been of our people. They did an extraordinary job, produced solid results among industry-leading margins and despite the challenges of near-record cancellations. But for the numerous cancellation events, it would have been a blowout quarter. But still, rock-solid margins, returns, and cash flows, and a huge thank-you to our people for their resilience and for their perseverance. Based on where we are today and what we can see from today, the second quarter will be better. We're better prepared to handle the MAX schedule changes, prospectively through August 5, rather than the more chaotic daily cancellations. And our goal is to provide our customers a stellar experience during the busy summer, especially. Our on-time performance was solid in the first quarter, and it will be solid again here in the second quarter. Restoring the MAX to service as soon as it's ready is also a priority, of course. And assuming that happens within the next couple of months, we'll get back on our delivery schedule and our capacity plan. Mike, Tom and Tammy have prepared excellent briefings on our operations, commercial, and financial performances and expectations, and I don't want to steal their thunder, so I'm going to be brief this morning. But I did want to reiterate a couple of points. Despite the challenging year so far, first of all, we were once again named to Fortune's list of the World's Most Admired Companies. This year, ranked number 11. We were just ranked number 2 out of 500 companies on Forbes List of Best Employers. And all great companies start and end with having great people and being a great employer. So we're very proud of that. We were number 1 in the DOT rankings for 2018, Customer Satisfaction, again. And we're off to a great start in 2019. Our brand and NPS scores remain strong in 2019 and industry-leading as well. We have a balance sheet leverage of less than 28%. We have almost $3.9 billion in cash. We have an excellent, cost-effective and risk off fuel hedge in place for the next several years. Our Hawaii expansion is off to an exceptional start, and of course, that is despite having numerous distractions in the first quarter. Our technology plans for this year and next are ambitious, but they are proceeding well and on track. And then, finally, I expect us to make progress on our cost initiatives this year except for the capacity cuts effect, of course. And we're not giving up on our goal to expand margins and return on capital year-over-year. Despite the challenges, we may very well set records in some financial categories this year. But having said that, I admit that there's uncertainty surrounding a lot of things, certainly the timing of the MAX and, as usual, the economy and fuel prices. But we're off to a good start. And we're planning on having a good year and making a lot of progress this year. So with that very quick overview, let me turn it over to our Chief Operating Officer, Mr. Mike Van de Ven.

Well, thanks, Gary. The first quarter reinforced a couple of things that I already know. Most important being that our people will absolutely rise to meet any challenge. And we had our fair share of challenges to start the year. The prevalent operational themes for the first quarter were launching our Hawaii service, and then, of course, the unanticipated maintenance rise up and our MAX groundings have impacted our operations. So, as you all will remember, the quarter started the minute the government shutdown in the middle of our ETOPS authorization. We had worked on some contingency plans, and despite losing about a month of timing, we were still able to launch Oakland to Honolulu service in the first quarter as planned. And since then, we've added an Oakland to Maui, and we're going to launch service between Maui and Honolulu on Sunday. The service startup went extremely well. Our onboard experience has received high customer marks, and we are continuing to add service during the second quarter. Beginning in mid-February, we started to experience disruptions to the operations with unexpected maintenance write-ups. And just as that was returning to normal levels in mid-March, the MAX groundings occurred. Those combined items created unexpected, irregular operations to the last half of the quarter. So, we were operating in a daily environment that consisted of canceled and delayed flights, aircraft swaps, crew reroutes, high volumes to our call centers, maintenance demand and logistics associated with the grounding and, of course, the customer anxiety at the airports. But our people, across the board, again, rose to the occasion and they took superb care of our customers and produced a very solid operational performance in spite of that environment. Our on-time performance for the quarter was 78.7%, and that was just a tad lower than last year's 79.3%. And if we adjusted for the maintenance and the MAX impacts, our on-time performance would have modeled in the 83% range, and that would have put us second in the industry from a marketing carriers perspective. That's a good indication that the network design and our operational approach are in sync and we have a strong operational foundation as we move forward. Southwest had the top ranking for fewest customer complaints for domestic marketing carriers in 2018, as measured by the DOT. And as Gary mentioned, we maintained that position in both January and February, which are the latest results. And again, that's just additional evidence that our people are really leaning in to providing great hospitality and service to all of our customers. And our people have really owned the disruptions that these issues have caused our customers. Cumulatively, the weather and the maintenance write-ups and the MAX groundings, they caused significant cancellations. We canceled more than 10,000 flights during the quarter, roughly 4% of our published schedule. That was significantly more than we would have expected going into the quarter and, in fact, that's the highest level of cancellations since the third quarter of 2001, which was impacted by 9/11. Of course, we got much higher load factors and fewer seats to reaccommodate impacted customers today. But over the years, we've made significant investments in several operational recovery tools that minimize the impact on our customers for those issues. So, in the first quarter environment, 97.5% of our customers got to their destinations the same day as scheduled. And that's compared to 97.8% last year when these issues didn't exist. So a very solid, very customer-service-driven result, given the unexpected challenges. Turning to the MAX. We have 34 MAX aircraft grounded, 33 of them are in Victorville, California. We still have the one aircraft in Orlando that had the engine issue during the ferry flight. We're in the process of doing an engine change on that aircraft. It will be ferried to Victorville sometime over the next week. Having all the airplanes in one place improves the efficiency of our maintenance program for the aircraft as well as relaunching the fleet when we're able to do so. We're using this additional downtime to do any necessary inspections or planned work so that when the fleet can be relaunched, it's as close to being a new delivery aircraft from a maintenance perspective as possible. Getting all 34 aircraft to relaunch and back in service is expected to take a month or so. We're still working on those detailed plans. The aircraft will need software upgrades as well as make-ready-to-fly work, and that includes things like unsealing the aircraft, oil and fluid checks, required inspections, system checks, cabin cleaning, those types of things. Of course, there will also be additional FAA pilot training requirements that will also need to be completed. As Gary and Ryan mentioned, we've removed the airplane from our scheduled service through August 5. Assuming that the airplanes are cleared to fly before then, we'll pragmatically bring them back into our operational fleet and will utilize them as spares to support the network. They will begin to fly in a normal scheduled service pattern beginning August 6. And of course, if the groundings continue past that date, we'll need to make further adjustments to the schedule. So, as we move into the second quarter, our operational theme is to provide an exceptional customer experience over the summer. Our unexpected maintenance events are behind us since we agreed to the tentative agreement with AMFA. AMFA's in the process of educating our mechanics on the agreement. We expect the voting results in the second half of May. The MAX flights have been pulled out of our schedules and all impacted customers have been contacted, and are in the process of being reaccommodated. And given the related capacity pull down, we are left across the busy summer travel period so that we can provide exceptional service. We're focused on getting our customers the safe, reliable, on-time and fun experience that they're accustomed to on Southwest. And so with that, I will turn it over to Tom.

Thank you, Mike. As you all know, we ended 2018 on a strong note and entered 2019 with significant momentum. Despite facing several major challenges, we have achieved robust revenue growth in the first quarter. We reached record first quarter operating revenues of $5.1 billion, and our year-over-year unit revenue performance is anticipated to be among the best in the industry. Additionally, I want to emphasize the efforts of the Southwest Airlines team, who excelled during a particularly difficult quarter. We dealt with numerous cancellations and reaccommodations, yet our employees provided our customers with the warmth and kindness we are known for. It has been a tough quarter, and everyone did an outstanding job. In our March 27 investor update, we shared the details behind the drivers of our revised Q1 RASM forecast, which we said would be up 2% to 3% year-over-year. And we ended the first quarter at the high end of that guidance, with RASM growth of 2.7%. So let me start the quick recap of Q1, and then I'll cover our outlook for the second quarter. So, in January, we were expecting Q1 RASM to increase in the range of 4% to 5%. And just as a reminder, there were several key factors that went into that original guidance: first, a continuation of the strength in the base business trends that we experienced in Q3 and Q4 of 2018; second, the benefit from November's system-wide fare increase; third, continued strong performance from our Rapid Rewards program; fourth, 1.5 points year-over-year RASM benefit from our new reservation system; and finally, a 1.5 RASM tailwind from Q1 2018's suboptimal flight schedule. We also planned for a roughly $40 million shift in the revenue from Q1 to Q2 due to the Easter shift. And we also planned to grow our Q1 capacity by approximately 3.5% to 4%. So that's what the plan was based on. Let me quickly recap what's occurred since our earnings call in January. So first, as we shared previously, we quantified the impact of the government shutdown to be roughly $60 million. And obviously, government-related business travel was the most easily identified. But we also began to see a clear trend change and leisure demand softened with the prolonged shutdown. And this continued pretty much throughout the quarter. Versus our original Q1 RASM expectation of plus 4% to 5%, the shutdown impact is what caused us to revise our Q1 RASM guidance down a full point to plus 3% to 4%. Second, the unscheduled maintenance events were another large contributor, resulting in a little more than 0.5 points reduction to Q1 RASM. And this essentially lasted from mid-February through mid-March. Third, the March 13 grounding of our MAX fleet was the next largest revenue drag. It was a slight benefit, actually, to our Q1 RASM. And fourth, softness in leisure demand in yields, which is really related to the government shutdown, was approximately 0.5 points negative impact to Q1 RASM. I think it's important to call out right now that this trend has changed and we're seeing leisure demand and yield strength in the second quarter. So, we ended the quarter with over $200 million off our original revenue forecast, and we ended the quarter about 2.5 points below our capacity plan. Now part of the RASM impact we saw, particularly in February and March, was due to having less inventory available for higher-yield close-in bookings. We had to use a lot of this close-in inventory to reaccommodate our customers due to the maintenance disruptions and the MAX grounding. Now, in contrast to the unscheduled maintenance disruptions, which were very unpredictable day in, day out, and very difficult for our employees and our customers, we were much better able to get out in front of the MAX cancellations to minimize the impact to our customers. And we were much more proactive in reaccommodating our customers several days in advance of the flight date. So having said all that, our close-in yields remained strong year-over-year. Business travel demand continued to be strong as well. But we took fewer close-in bookings simply because of the reduced inventory per sale. Our revenue management capabilities continued to perform very well and drove a 1 point year-over-year RASM benefit in the quarter, which was slightly lower than our original expectation of 1.5 points. And this is due to the softer trends I just mentioned as well as the reduction in inventory. Our industry-leading Rapid Rewards program is performing extremely well and is continuing to grow double digits, both in terms of the size of the customer portfolio as well as in terms of the total loyalty revenue. We are continuing to see tremendous strength across every metric of Rapid Rewards, and this was on an already strong base. In Q1, we saw record acquisitions in new Rapid Rewards members. We also saw our highest ever acquisition of new co-brand credit card holders. And we're also seeing very high retention rates, which is a great combination. So again, our Rapid Rewards program continues to perform extremely well. Our customers love the benefits and the value of the program, and there is a lot of runway in front of us for continued growth. In terms of our ancillary products, they also contribute to the first quarter's RASM performance, also with strong double-digit performance in our boarding products, including continued strength in the variable pricing of our EarlyBird product that we implemented last fall. That pricing structure is working very well and it's meeting all of our expectations. I think EarlyBird also benefited from our improved merchandising capabilities on Southwest.com. And we will continue to invest in our industry-leading, direct-to-consumer Southwest.com platform. Our international markets are also doing very well and continue to develop and mature. Though this is only 4% of our system capacity, we are really pleased with the performance that we're seeing. RASM, yields, load factors are all strengthening, and our international business is developing as planned. And we're also seeing noteworthy performance in Puerto Rico and the Caribbean. Finally, we launched our service to Hawaii on March 17. We began our initial flights by connecting Oakland to Honolulu and Maui. And as you know, we began our Hawaii flights with very low initial pricing. And if you look at where we are today, we are moving up the pricing ladder to what we consider to be normal pricing levels, and we're seeing very strong demand in bookings. And while it's a small sample set, the early feedback from our customers, as Mike alluded to, is absolutely exceptional, and their satisfaction with the in-flight experience is actually higher than the rest of our system, which, as you know, has always had an extremely high Net Promoter Score. I think this clearly speaks to the strength and the quality of our economy product, and not just on short- and medium-haul trips, but on long-haul trips as well. So, in summary, for Q1, a lot has happened over the past 3 months. Several things have happened that we certainly did not anticipate, but a lot of things also happened that we did expect. We saw a 1.5 point year-over-year tailwind in the Q1 2018 suboptimal schedule. We saw a continuation of strong year-over-year close-in yields. We saw another very strong performance from Rapid Rewards, and we saw a healthy year-over-year RASM benefit from our revenue management enhancements. And just as a footnote, this is our highest year-over-year quarterly RASM since the third quarter of 2014. So that's it for Q1. Now, let's talk about the second quarter. So we are expecting strong year-over-year Q2 RASM performance in the range of up 5.5% to 7.5%. And this is based on the current booking curves and pricing trends that we're seeing. This is a strong year-over-year improvement as well as compared with Q1. And recent demand and yield trends have stabilized and are improving. Earlier this month, as you know, we republished our schedule for April 7 through August 5, and the intent was very simple, to get us back to a schedule that we knew we could fly with the 700s and 800s that were in our fleet. As we removed MAX flights from the schedule, we're doing it in a way that maintains the integrity of our network and the strength of our schedule. And until the MAX is back in service, we intend to operate a slightly reduced schedule, but with the reliability and the hospitality that we're famous for. It's a better and more efficient way to run the operation, and that's what our employees and our customers need from us. Now, keep in mind that because of the MAX grounding, we'll have less close-in seat inventory just because we're having to reaccommodate impacted customers on new itineraries, which by definition is being done with close-in seat inventory. So this will have an impact on close-in, higher-yield April bookings. We saw improvements in bookings in yields for Easter, and we're also seeing improvement in both May and June. The demand that we're seeing is solid for both leisure and business travel, and close-in fares are holding up very nicely, and we're seeing a continuation of strength in close-in yields year-over-year. So, the bottom line is that we're encouraged by the improvements that we're seeing in Q2. And just as a reminder, we had a 3-point RASM headwind in Q2 of 2018 and 2 things drove this. First, we had a 1-point impact from the suboptimal flight schedule and, second, we had a 2-point impact following Flight 1380. So this equates to a 3-point RASM tailwind for Q2 2019. We also had a 0.5 points year-over-year RASM benefit due to the Easter shift into Q2. So, similar to the first quarter, we expect around 1 point in year-over-year RASM benefit in Q2 from our reservation system, and this is in comparison to roughly 0.5 points of RASM benefit in Q2 of last year. And we expect about a 1-point RASM benefit in Q2 due to lower capacity as a result of the MAX groundings. And finally, we expect another strong performance from our Rapid Rewards program in the second quarter as well as continued strength and growth in our ancillary revenues. As we said, Hawaii is off to a great start. It has exceeded our expectations in March, due to the overwhelming demand in our initial flights. And despite a very short 2-week booking window, our first flights sold out very quickly. In fact, initial flights were sold out before we were even able to get the first e-mail out to Rapid Rewards members. So, this coming Sunday, we'll continue. We'll begin in and around service between Honolulu and Maui, and we'll connect Honolulu and Kona on May 12. On May 5, we'll launch service from our second California gateway, San Jose, to Honolulu, and on May 26, we'll connect San Jose to Maui. We have more Hawaii service to come, and we are very pleased with how these markets are performing. And the expansion of Southwest service into Hawaii is our primary route development focus for 2019 to 2020. And that will also include more inter-island service. So, to wrap it up, first quarter was challenging across many fronts, certainly for revenue. And I am very proud of our people and I'm very proud of our first quarter results. And we are off to a solidly positive RASM performance for the year. Our goal to grow 2019 RASM in excess of 3% year-over-year has not changed. We're dealing with some unforeseen circumstances, but we are focused on those things that we can control. The strength of the Southwest brand remains very high. Our customer service and our brand NPS scores continue to be at the very top, the very top of the industry. We're continuing to grow our customer base, in particular, our most valuable customer segments, as well as in key markets. So, we have a lot of momentum coming out of Q1 and our immediate focus is on solid execution in Q2. And just like in Q1, our outlook for Q2 RASM should be at or near the very top of the industry again. So, with that, let me turn it over to Tammy to take us through the financials.

Thank you, Tom. And hello, everyone. Gary, Mike, and Tom have outlined the challenges that we've been managing through since the beginning of the year, and I'd like to add my thanks to all of our hardworking employees for their resilient focus today addressing and taking good care of our customers and for their unwavering commitment to Southwest. Despite the significant headwinds, we are off to a solid start to the year, with almost a 10% pretax margin, and we continue to consistently generate strong cash flows and shareholder returns. I want to also thank our people for their focus on cost control in the midst of all the challenges. Our first quarter nominal cost, excluding fuel and profit sharing, were relatively in line with where we expected them to be at the beginning of the quarter, despite the numerous headwinds. On a unit basis, excluding fuel, special items, and profit sharing, our cost increased 8.1% year-over-year. Relative to the approximately 6% we were expecting back in January, there were two primary drivers of the higher year-over-year growth. First, the flight cancellations that we experienced reduced our available seat mile growth in the first quarter by about 2.5 points year-over-year. And combined with additional cost pressures from maintenance-related disruptions and weather increased our CASM-Ex by about 3 points since we didn't have opportunities to shed costs that were predominantly fixed at close-in. Second, we had a $30 million increase to salary, wages, and benefits due to our tentative agreement with AMFA, which represents a higher compensation for our mechanics compared with the previously rejected TA from last fall. This created another point of year-over-year CASM-Ex increase in the first quarter. This 4-point negative CASM-Ex impact was offset by about 2 points due to better-than-expected completion factor, employee productivity, and health care trends, as well as the shifting of advertising and airport costs out of the first quarter and into future quarters this year. This resulted in an 8.1% increase in our first quarter CASM, excluding fuel, special items, and profit sharing year-over-year. So, to recap, if you exclude the impacts from the unexpected events, first quarter 2019 CASM-Ex growth would have been in the 4% to 5% range year-over-year. Looking to the second quarter, our expectations back in January were for year-over-year cost inflation excluding fuel and profit sharing in the 6% range similar to our initial first quarter estimates. As a reminder, the key drivers of our initial expectations were the underutilization of our fleet in the first half of 2019 due to the delay in our service to Hawaii and the resulting one-time startup cost; higher airport, labor, and ownership costs; as well as the timing of maintenance events and technology investments. While those drivers are still relevant, the reduced capacity from our MAX grounding for the second quarter is now driving an additional 5 points of inflationary pressure, net of some flight crew and landing fee efficiencies from proactive flight cancellations beginning in early April versus our immediate cancellations in March. And we have about 0.5 points negative impact from advertising and airport cost shifting from first quarter. As a result, we now expect second quarter CASM, excluding fuel and profit sharing, to increase in the 10.5% to 12.5% range year-over-year. Looking to the back half of this year, we initially expected flat CASM-Ex. With our MAX groundings extended through August 5, we now estimate about 3 points of incremental unit cost pressure in the third quarter of 2019 based on flight cancellations to date. And while we hope this doesn't persist any longer, there is still uncertainty around the timing of the MAX returning to service. That said, based on what we know today, we continue to expect sequential improvement in the year-over-year CASM-Ex fuel and profit sharing from second to third to fourth quarter. For full-year 2019 costs, under the assumption that MAX groundings do not extend beyond August 5, we currently estimate CASM, excluding fuel and profit sharing, will increase in the 5.5% to 6.5% range year-over-year. This includes about a 2-point headwind from lower capacity as a result of the MAX groundings and 0.5 points of headwind due to the TA with AMFA. Of course, I will keep you updated as we learn more. Moving on to fuel. Fuel prices have increased since the beginning of the year with fixed Brent crude up 25% in the first quarter since January 1. Also, our fuel efficiency improvement has been impacted by the MAX grounding. That said, our first quarter economic fuel price was in line with our most recent guidance, at $2.05 per gallon. We have great fuel-hedging protection in place this year with 78% hedge in the second quarter and 60% to 65% hedge in the second half of the year. Our hedging premiums for this year remain at approximately $95 million or about $0.04 per gallon. Our 2019 hedging protection produces modest gains at current market prices and kicks in more materially at a 75 Brent crude equivalent. So we are very well-prepared should we continue to see rising energy prices. And as a reminder, our 2019 hedges are a mix of WTI and Brent crude. Our hedging portfolio continues to be structured so that we fully participate in any market declines. For the second quarter of 2019 and full year 2019, based on market prices as of April 18 and given our current hedge, we expect our fuel price per gallon to be in the $2.10 to $2.20 range. Fuel efficiency improved a modest 0.5% in the first quarter, which was understandably lower than expected with the grounding of our 34 most fuel-efficient MAX aircraft in mid-March. Also, heavy winter weather also drove a higher fuel consumption than we had planned. Second quarter fuel efficiency is expected to be flat to down 1% year-over-year as the MAX has been removed from the entire second quarter flight schedule. For the full year, 2019 fuel efficiency is now expected to be flat to up 1% year-over-year. That said, fuel efficiency improvement remains a material part of our longer-term cost story once the MAX is back in service, and more fuel-efficient aircraft will comprise a growing percentage of our total fleet. Turning now to our industry-leading balance sheet. Our strong financial position earned us an upgrade to A- from Fitch during the quarter, which we are thrilled about. We ended the quarter with ample cash and short-term investments of $3.9 billion, with our $1 billion revolver fully available. We adopted the new lease standard as of January 1, 2019 on a prospective basis. And as a result, the primary impact was to the balance sheet. We recognized a $1.5 billion operating lease right-of-use asset, which is primarily comprised of aircraft operating leases and airport operating leases and a corresponding liability. We also removed $1.7 billion of assets constructed for others and the related construction obligation of $1.6 billion for completed airport terminal projects such as Dallas Love Field, Houston Hobby, and Fort Lauderdale. The net impact was approximately a $270 million reduction to the balance sheet. The impact to the income statement was immaterial. We have very manageable debt obligations and capital spending plans for 2019. And at this point, we continue to expect 2019 CapEx in the $1.9 billion to $2 billion range, based on the remaining Boeing deliveries scheduled for this year. On non-aircraft CapEx, we continue to make significant investments in technology, and we are making good progress on a new maintenance system. Our significant airport investments in LAX, Kansas City, Baltimore, Nashville, and Boston are underway, and progress is being made on our maintenance hangar investment in Houston, Phoenix, and Denver. We expect our investments to help drive incremental revenue and productivity as well as support longer-term cost objectives and our growth plans. We had strong cash flows in the first quarter, allowing us to return $678 million to shareholders through share repurchases and dividends. Lastly, on fleet and capacity. We ended the first quarter with 753 aircraft in our fleet, taking delivery of 3 leased MAX 8 aircraft so far this year. We are currently working through the delivery delays with Boeing, but we don't have any updates to share at this point. Although our 41 remaining aircraft deliveries this year are on hold, the majority of them are back half loaded. As a reminder, we have 28 owned MAX aircraft from Boeing and 13 additional leased MAX aircraft in our order book for 2019. We are evaluating our fleet retirement plans, but at this point, we continue to expect to retire as many as 18 aircraft this year, but that will obviously be subject to the duration of the MAX groundings. Our retirements helped with our fleet modernization efforts, improving efficiency, reliability, fuel burn, and reducing our maintenance burden. In the second quarter, given MAX flight cancellations, we now expect capacity to be down in the 2% to 3% range year-over-year. And for full year 2019, based on what we know to date, and given MAX flight cancellations through August 5, we now estimate our annual 2019 capacity will increase in the 2% to 3% range year-over-year. Our schedule is currently published through early November, and that includes the first phase of our Hawaii plan, as Tom covered. And we'll evaluate further flight schedule revisions based on the duration of the MAX grounding. So in closing and as a quick recap on what we shared today, despite the ongoing MAX groundings, our employees continued to rally and take great care of our customers. Our revenue management system is producing revenue gains and performing exactly as we expect it to, and we are expecting strong year-over-year RASM growth in the second quarter. We have great fuel hedging protection for our 2019 and beyond in place to mitigate rising fuel prices. Flight cancellations and lower capacity are putting pressure on our non-fuel unit costs, though we continue to focus on strict cost control and being nimble. Based on what we know today, we continue to expect solid margins in 2019, with the opportunity to deliver stellar returns on capital. We continue to make important investments in our people, our fleet, the airports we serve, and technology, which will support our scalability and many future growth opportunities, including Hawaii. Another huge thank-you to all of our employees who are managing through a lot and continue to do a terrific job. With that, Cody, I'll turn it back to you now to take questions.

Gary, hypothetically, how many consecutive quarters of stagnation, from a capacity perspective, would you be willing to tolerate before possibly considering nonorganic growth opportunities?

We've received various versions of that question, though not precisely that one. Right now, I’ll ask our team to stay focused. We have a solid plan for 2019 and aren't in a position to make any significant changes. The MAX situation is currently our primary concern. I haven't instructed the team to consider any contingency plans. I don’t have a clear answer to that question. We are all working with the expectation that the MAX will be back in service within a reasonable timeframe. Whether we return to normal operations in the third quarter or start the fourth quarter doesn't significantly impact the bigger picture. Our more pressing concern is that if the situation persists too long, we have a retirement program in place. From an operational standpoint, we have planned retirements, which would indicate a decrease in capacity. We certainly don't want that, and unwinding our retirement plan would require considerable effort, which I prefer to avoid. We're focused on more productive initiatives. You raised a broader, strategic question that represents an unlikely scenario, and I don’t believe it’s something we'll be addressing now. Strategically, we're in a growth phase, as is the industry. We need to expand, and we definitely don't want this stagnation to last too long. However, I still don't have a definitive answer to your question. I don't think that scenario is probable.

Yes. That's very helpful, Gary. No, I appreciate it. A quick follow-up. In the event that the FAA does not require any sim time, and it seems to be moving in that direction, but other regulatory agencies do or other pilot unions do, whether here or abroad, is this a scenario that you've discussed with SWAPA at all? I mean, is there a risk that even if the FAA goes with an iPad-training protocol, just the public scrutiny and/or union pressures might lead you to nonetheless pursue sim-based training as a part of the return to service, because that would obviously slow the process down possibly quite a bit.

Taking your question at face value, yes, I believe that getting pilots back into the simulator for an event would be challenging and time-consuming. The type of training required is important because our pilots are highly trained. As a layperson, my understanding is that we already conduct the training that would be necessary to return the MAX to service. I wonder how many MAX simulators exist globally. The key point is that managing the aircraft in a runway stabilizer situation is something we already train for and, as far as I can tell, has already been addressed. We are uncertain about what this would specifically entail, but currently, we are not hearing that this will be a necessity. We pride ourselves on being the most experienced 737 operator in the world, hiring pilots only with significant experience, including captain experience. Regardless, we will do what is necessary, but we are also awaiting the Boeing service bulletin and the FAA directive to clarify what will be required.

So maybe I'm reading too much into this sentence. But the CapEx reiteration for this year has this clause of 'assuming no prolonged grounding of the MAX aircraft.' So is that to suggest that you might not take delivery of aircraft that you're scheduled to in the back half if it's still grounded and that CapEx would actually come down?

No, I want to be clear. We are not taking any deliveries right now, and as a result, we're not making any payments. If we consider your scenario where no more MAXes are delivered in 2019, our capital expenditure would be significantly reduced. However, Boeing is currently unable to deliver any airplanes. The planes they are manufacturing are still at Boeing Field, not being delivered, and we are not paying for them. Did I convey that correctly, Tammy? Tammy is the one responsible for disbursing the payments. So, I just believe she...

We will be writing our check as they are delivered.

There you go. So hopefully, that answers your question.

And then, just with respect to the longer-term cost profile. At the start of this year, obviously, there was some first half pressure. There's been a lot of noise and changes around this grounding. But you had talked about a flattening of the cost profile into 2020. Given the extra cost pressure that you're seeing this year, can you just update us on your thoughts of what the cost profile might look like into 2020?

Yes, sir. What I was trying to convey at a high level is that we're asking all of our departments to stick to their budgets. Where there is spending based on activity, we expect them to stay under budget. For example, we're using less jet fuel and incurring fewer landing fees and rentals. We anticipate our departments will manage variable costs accordingly. We have several cost initiatives aimed at improving efficiency, which are ongoing. Assuming the MAX returns to the fleet this summer, I expect us to meet our cost plan for the fourth quarter. By that time, our schedule should be back to normal, and we’ll have our entire fleet operational. Year-over-year cost comparisons should look favorable. Tammy and Ryan frequently receive questions about projecting costs for 2020, and based on the assumption that we've reinstated MAX flights this year, we do not foresee any changes in cost performance for 2020 at this moment. However, the comparisons will depend on the final outcomes for 2019. Overall, the cost outlook should remain stable according to that report.

Yes. So, certainly, by the time we get to the fourth quarter, we would expect to be on a good trajectory assuming the MAX are back in service at that time. So completely agree.

Now if Jamie's question all of a sudden becomes more of an issue, there's extra training or the training delays the MAX flying or whatever it might be, you understand that I'm not incorporating those unexpected events into that kind of a comment. It's assuming that we're back up and running as per normal with that kind of an outlook.

Thank you for the insights shared during the call today. Following up on Duane's question, can we assume that the underlying ASM production for your 2020 CASM will be based on last year's baseline plus the reductions from the MAX groundings this year? Would it be accurate to think of it as a 4% or 5% baseline increase, plus an additional 2% to 2.5% related to the MAX groundings? Is that a reasonable perspective as you consider the CASM outlook for next year?

Yes, we designed the airline to support Ryan's 775 airplanes by year-end, and we have about 25 more arriving in 2020. We aim to get those airplanes and operate them. For our capacity at the start of this year, we plan to fly according to our 2020 expectations. While there are still uncertainties about the MAX's return to service, if everything goes as planned and we receive all the airplanes as agreed with Boeing, we will proceed with the 2020 plan we established at the beginning of the year.

I'll ask Mike to speak to the operational aspect and Tom to talk about the distribution.

We are not experiencing any significant operational issues with the 800. We are very comfortable with the airplane. However, we anticipated that due to its range, we might need to limit the number of seats, especially when dealing with strong headwinds. This has been our main operational challenge. We are effectively scanning bags, and the weight balance program is functioning well. We have things organized, and our staffing at the stations is complete. The team is enthusiastic and efficiently turning the airplanes. We are improving our navigation through Honolulu airport, especially regarding taxi times on the ground. Overall, the operation, maintenance, support, and crew for the airplane are all proceeding as expected.

Hunter, on the distribution side, we began service in March and have been actively involved in community outreach in Hawaii for over a year. This has helped us establish strong roots within the Hawaiian community for our new operation. Regarding distribution, our approach aligns with what we typically do at southwest.com. I was pleasantly surprised by the brand recognition; many residents of Hawaii travel to the mainland and are familiar with Southwest. We've engaged in significant local marketing and have built a strong presence, leading to a very positive reception of the Southwest brand on the islands. That's how I'd best address your question.

First, I just want to clarify regarding some of the CASM questions from earlier. If capacity growth next year is significantly higher due to the MAX timing, shouldn't CASM actually be considerably lower, perhaps flat to down, compared to the 1% to 2% range you mentioned earlier, Gary?

I don't think I quoted a number. Well, I know I didn't quote a number. So I think all I was trying to communicate at this point, and so this is April, so we've got a ways to go before we get into 2020. But whatever CASM we were expecting in 2020 before the events of this year, that's what I would be expecting next year. How that will compare to 2019, I don't think we're ready to say yet. Clearly, we're running higher on CASM here in the first half and that'll probably dribble into the third quarter. Well, it will because we've already reduced our flight schedule through August 5. So yes, you're going to have an easier comp because of all of this. But I don't think we are prepared today to give you any insight as to what that would be. If you thought it was up 1 to 2 before, yes, I agree. It's going to be something less than that, I just don't know how much less yet.

Yes, really nothing has changed from our last comment. We are setting aside all the noise from the unanticipated first quarter events, and our long-term unit cost target remains unchanged. So there is no new update here today.

Yes. So what I meant earlier was just a nominal amount, not a year-over-year amount. So what else can we do for you?

And then on the RASM side, Gary, I think you've laid out some objectives earlier in the year. There's been a lot that's moved around. Can you just refresh us on where you are with sort of hitting those targets and whether or not, and this may be for Tom, do you think you can keep some of the momentum that you're seeing in 2Q going into the back half of the year such that there's not this massive step down, if you will?

Let me make a brief comment, and then Tom will likely want to add to this. In his remarks, he mentioned that our goal is to achieve over 3% unit revenue growth for 2019 compared to last year. I intended to also point out that we started the year aiming to improve margins, which we received some assistance with due to lower fuel prices. This remains true as we look ahead; we have lower year-over-year fuel prices. Our fuel consumption numbers are somewhat inconsistent due to the MAX benefits we were previously receiving. However, aside from that, the fuel outlook is currently positive. We aimed to enhance our operating margins, net margins, and returns on invested capital. This is not yet happening in the first quarter, but I'm optimistic about the second half of the year and for the full year. Our teams are managing costs effectively. The first quarter was quite challenging, with operations incurring higher costs per flight despite fewer flights, due to the irregular operations we experienced. I believe performance will improve in the second quarter because, as you and Tom mentioned, we have taken steps to address this, allowing for a more organized rescheduling of the airline. Tom, would you like to discuss the RASM?

Yes, I would like to reiterate that our 3% goal is firmly in our sights, and we are actively pursuing it. Thus far, we can see positive signs. As you're aware, the first quarter was quite uneven, a point we've discussed frequently. However, we are moving past that, and we're witnessing a solid stabilization of trends. Demand and fare conditions are normalizing, aligning well with our expectations. It's unfortunate that we are facing issues with the MAX, as the business environment is quite favorable. Our corporate travel sector, which serves as a strong economic indicator, remains healthy. I do wish we had more inventory available for immediate sale, but we are managing effectively in this regard, which reflects the overall economic vitality. Business bookings are holding strong, but again, I wish we had more capacity to sell. That summarizes my thoughts on the current situation.

I think that's excellent. I want to emphasize that despite the various rumors about our brand and customer dissatisfaction, our business is performing really well. This success is largely due to our employees' hard work in serving our customers. While there are always impacts on a company's brand from external events, our brand remains incredibly strong, which is well earned. Our operational integrity is sound and appears very solid, with no signs of weakness specific to Southwest following our first quarter, and we are all very proud of that. Again, I am very proud of our people for achieving this.

And the only other point I would add on to that is the flexibility and the strength of our network is tremendous. And I think you are seeing that in our results as we work through all these cancellations. So I'd just put an exclamation point there. And then I would also just point out that we have a new reservation system, new revenue management tools, which are also helping us manage through all the challenges. So just the strengths of Southwest just really do go on and on.

And the network changes, I think as some of you all have recognized, they were just masterfully done. So while we had to trim some capacity out, it was done in a way that, again, that also maintained the integrity of our customer offering. I'm very, very proud of that.

Gary, just to start off with you. It certainly sounds like Hawaii flying is off to a great start, both in terms of customer demand and also the experience. So now that you've got a couple of months under your belt in terms of booking trends, I'd just be curious to get your view on if the ramp time around those routes to get them towards system-level profitability has changed at all or if your sort of thoughts there have changed, given what you've experienced the last couple months.

Well, I'll let Tom address that as well, but I'll share my perspective. Firstly, we excel at forecasting, and in my experience, our market forecast has been surprisingly accurate. This is largely due to our extensive customer base in California, which is the target for these routes. Additionally, Hawaii is a fantastic destination currently absent from our flight schedule. We haven’t really discussed our international operations, which make up a larger part of our system than Hawaii. That segment is growing very well, and I was pleased with its performance in the first quarter. In contrast, I believe our potential in Hawaii is much greater and more accessible than the challenges we face in international markets due to our comparatively limited strengths and lesser brand awareness. However, I don’t see anything discouraging us; we’ve just started, and the fact that flights sold out before we even issued a press release was surprising. What are your thoughts?

I believe I've mentioned this before, and while I’m not certain if I've done so during an earnings call, we have a naturally strong customer base in California eager for travel to Hawaii. I expect this market to grow faster than typical new markets. You may have observed our international efforts where we lack this built-in customer base. I'm very pleased with our current position. I conducted some competitive research on fares yesterday and am satisfied with where we stand. We're still in the early stages, and our pricing, while competitive and below the market, remains solid and strong. If you compare our pricing on our website to that of our competitors, you'll see we’re progressing well. Once you factor in the bag fees for the first, second, and third bags, there's a significant difference. Our cost structure allows us to be profitable at these price points, and we're confident in this strategy, which embodies the Classic Southwest Effect. Overall, I feel optimistic about our situation, Jack.

I just had a quick question regarding the 737 retirement plan. I know, Gary, you said that you would like to avoid having to unwind the retirement plan for 2019. And I was just wondering if Southwest intends on doing any short-term leases of 737 NGs or just going out to the used marketplace? What are you seeing in the market in terms of pricing and availability, especially with the release on 737 flight capacity currently? Thank you.

Well, it's a great question, and I think it's a short, easy answer. The answer is no, we are not contemplating going out into the used market. I think the only thing that would, Mike, make sense to me is if we wanted to add some NGs to the fleet is we would unwind some of the airplanes that we already own or lease. And again, we don't have a plan to do that. Tammy, I think you've got 18 retirements planned for 2019.

For 2019.

Tammy mentioned that her plan at this point is to follow through with at least most of them. There might be a couple of airplanes that we decide to keep. All of this is based on the assumption that the airplane is ungrounded in the relatively near future, so we won't have to address that issue. If it remains grounded for an extended period, we will need to develop a plan. Frankly, I don't think that would involve going into the used market. To be honest, we're not focusing on that scenario because we don't see it as a worthwhile effort or a likely situation. If that scenario does occur, I'm confident we can respond to it and manage it, but it’s not something we're currently working on.

Yes. We've been out of the used market for the last couple of years. We've got most of the NG airplanes out there that we like. It just doesn't make a lot of practical sense for us to go out and search the market for a used or leased NG when we already have NGs on the property that are already in our maintenance program, already in our maintenance profile. It'd just be easier for us to extend that than it would be to go out and get a new airplane. So we're not looking out in the market at all for NGs.

We prefer to continue retiring those airplanes instead of bringing another one into the market. While unwinding the retirements would be easier than introducing a new airplane, we have already established a maintenance program for each aircraft. Modifying our maintenance plan to accommodate keeping the aircraft longer would add unnecessary work for our tech ops department, which already has other priorities. Therefore, it makes more sense for us to proceed with the retirements and replace them with new airplanes.

I just had a question regarding the 737 retirement plan. I know, Gary, you said that you would like to avoid having to unwind the retirement plan for 2019. And I was just wondering if Southwest intends on doing any short-term leases of 737 NGs or just going out to the used marketplace? What are you seeing in the market in terms of pricing and availability, especially with the release on 737 flight capacity currently? Thank you.

Well, it's a great question, and I think it's a short, easy answer. The answer is no, we are not contemplating going out into the used market. I think the only thing that would, Mike, make sense to me is if we wanted to add some NGs to the fleet is we would unwind some of the airplanes that we already own or lease. And again, we don't have a plan to do that. Tammy, I think you've got 18 retirements planned for 2019.

I have a couple of quick questions for Mike. Mike, I wanted to ask you following up on the Leap engine question, are you finding a degrading of any of the parts like the fuel nozzle sooner than you would've expected on those planes due to the coking? And my second question is, what intrigued you enough about the A220 that you actually went to Airbus to take a look at the plane?

Well, starting on the fuel nozzle issue, Mary, I don't know if it's any sooner than we expected. Coking is not unusual. If there is a good thing about coking on fuel nozzles, they built over time, their trends are detectable and you can clearly create monitoring and inspection and repair or replace procedures to take care of all of that. As Boeing learns more about it, as they monitor their worldwide fleet, I'm certain that they will have design changes or design improvements that they will get into the production line and it will mitigate the inspections that we'll need to do on a go-forward basis.

And I think that's key, Mary. Mike mentioned learning, and it was from CFM, not Boeing. However, with anything new, there will be lessons learned. There are things that were designed or intended to operate in a specific way that may not. That was the point I was trying to emphasize earlier in the analyst call. This is definitely happening here.

Yes. So, Mary, our fleet team was down in Europe and visiting, but that's not anything unusual. We have relationships with all the OEMs, most of the lessors around the world. And we're just always out there trying to discuss and evaluate economics and opportunities in airplanes. And I had an opportunity to go out to the Paris Air Show last year. And it was a great opportunity for me because I got to talk with Boeing and GE about the MAX. I got to learn a little bit about Airbus and NEO. Bombardier was out there with the C Series at that time. I talked to Embraer. I talked to Pratt & Whitney. And it was just a great way to go, just gather information about the marketplace out there. Every one of those people have great products and great airplanes and really, that was just nothing more than our fleet team trying to gain a little understanding of what's out there.

So just to follow up a little bit on those comments, Gary. At what point would you consider making any additions or changes to your fleet? I know you have about 250 or more MAX on order through 2026. When would it be reasonable to consider adding any other models and what might those be?

We're not planning to add a different type of aircraft to our fleet. I want to emphasize that. Our focus is on growing our airline primarily with the Boeing MAX over the next several years. Adding a different aircraft type would require significant work, and that wouldn't be accomplished within 12 months. I don't want to speculate on a timeline since we're not actively pursuing it and I'm unsure how long it would take. I hope this gives you some context. We're not discussing what we might do 10 or 20 years from now. For now, our intention is to grow our fleet with the MAX. I'm not ready to say this will be the case indefinitely, and the timing is unfortunate.

Sure. And just, Gary, you mentioned that there has been no indication so far that there might be additional simulator training for the 737 MAX for when it becomes ungrounded. Is that just from what you gather from your discussions with Boeing and the FAA? Are you hearing anything from the union at all with regards to that?

Correct. That's from all parties we've talked to. And certainly, I put great reliance on our pilots, on our flight operations leadership, our pilot union. And they are very confident in what we do as an airline, how we train. We just made a $250 million investment in our flight training facility, which is absolutely state-of-the-art and a huge source of pride here. And they are the litmus test for me, and they are confident in the airplane, in the training, in the return to service with still some questions to be answered, admittedly. But if they were not, then I would not be. But the fact of the matter is they're very comfortable with the plan as we currently understand it.

Thank you, Cody. If you all have any follow-up questions, as always, our communications team is standing by for you, our online newsroom at swamedia.com or by calling us at 214-792-4847. Thanks so much.