Southwest Airlines Company (LUV) — Q3 2019 Earnings Call Transcript

Thanks, Chad. Thank you all for joining us today. Joining me on the call we have Gary Kelly, our Chairman and CEO; Mike Van de Ven, our Chief Operating Officer; Tom Nealon, our President; and Tammy Romo, Executive Vice President and CFO. A few quick notes. We will be making forward-looking statements based on our current expectations of future performance, which could differ from actual results and we will make reference to 2019 results to compare to prior year non-GAAP results, which exclude special items. We have more information regarding forward-looking statements and a reconciliation of non-GAAP results in our earnings release from this morning. Also, given the ongoing MAX groundings, just a reminder that the timelines and current estimations we are sharing today regarding the MAX are based on Boeing's targeted regulatory approval of the MAX return to service in the fourth quarter of 2019. Any changes to current estimations could result in additional adjustments to our flight schedule beyond February 8th, as well as further aircraft delivery delays and additional financial damages. With that, Gary, Mike, Tom, and Tammy will provide updates before we open it up for Q&A. So I will turn it over to Gary.

Thanks, Ryan. And thank you all for joining us for our third quarter 2019 earnings call. All around, it was an outstanding performance and I am prouder than ever of our people. We told you last quarter we were going to adjust to the MAX and operate a great airline, and our people did just that. Our customer feedback reflects that. It was just a great performance in terms of reliability and hospitality. So I am very, very proud and very thankful for our people. We also told you we would adjust for the MAX and produce satisfactory financial results and I think we under-promised. These results are stellar, strong revenues, better cost performance, record earnings, EPS was up 13.9% and even without the $31 million tax benefit, EPS would have been up over 9%. And of course, our EPS would have been up over 43% were it not for the MAX grounding. Our operations frontline employees have delivered exceptionally well. I also want to give another special shout out to our planners, or as I've termed them last time, our replanners who continue to toil through ever-changing scenarios in network planning, operations planning, and financial planning, just to name a few. They continue to work very long hours and produce amazing results—that’s just truly heroic. I talk a lot about the importance of being prepared for the unexpected as Herb taught me and really all of us to do. And we talk about the importance of low cost, ample cash, low debt levels, sensible growth, and sensible capital commitments, but we can never talk too much about the importance of having great and talented employees and a very strong culture. An element of that culture, we call the warrior spirit and their resilience. So we are truly blessed to have such great people. I want to talk about what’s next. In addition to continuing to run a superb airline operation and deliver solid financial results, we want to do a couple of things. We want to conclude our discussions with the Boeing Company regarding compensation for the MAX related damages. And secondly, we want to safely and methodically return the MAX to service. Regarding the timeline, the FAA has revealed this week that they have received the final software and related system documentation for the MAX from Boeing and they are in the process of certifying the changes with the certification flight weeks away. While the FAA has been very clear and careful not to commit to a date, working with Boeing we've assumed an ungrounding date of around mid-December, which translates to a MAX in-service date for us of February 8th in terms of our flight schedule. We will roll our schedule yet again if we judge that that date won’t be met. Overall, our plans and our outlook for the fourth quarter are very solid. We’ve got a schedule that’s stable, if not optimal. Travel demand continues to be strong. Fuel prices are remarkably stable and moderate, and our cost outlook is below our original plan. We have given you guidance for the fourth quarter regarding our expectations and RASM, and we are more bullish about our outlook for the fourth quarter performance. Bookings look pretty darn good, and we are expecting our RASM to be up during the quarter, maybe as much as 2%. This is on capacity that is down just slightly versus a year ago. Regarding next year, we are redoing our plan as we speak. I don’t have a capacity forecast for you, except to say I can’t imagine that it will be double-digit growth compared to 2019. Our 2020 market priorities will continue to be Hawaii, which is going extremely well, and based on what we have published so far, we will have an emphasis on Denver, Baltimore, and Houston. We are looking forward to having the MAX back to restore a lot of depth that is currently missing in many of our markets. With that, I’m going to turn it over to our Chief Operating Officer, Mr. Mike Van de Ven, to kick this off.

Well, thanks, Gary, and good morning, everyone. I spend a lot of time talking about the importance of teamwork, especially in our industry where our customers are completely dependent on our people to take good care of them. Our people do take a lot of pride in that. They jump through all kinds of routes to take care of our customers in light of the MAX groundings throughout the second quarter. And it wasn't until June that we finally had the MAX out of the schedule and a sufficient number of spare aircraft incorporated into the network. So the third quarter was really the first clean quarter without having to scramble operationally due to the MAX impacts. It was important for us going into the third quarter to deliver operational reliability, hospitality, and efficiency that our customers have come to expect from Southwest. And our people were just magnificent. They delivered the best overall operation that Southwest has produced in at least a decade. Our on-time performance for the quarter was 83.4%; that’s the best since 2011. We carried 30.5 million bags in the quarter and 99.6% of those were handled just as they were checked, which is the best performance in our history. Our customers certainly noticed all of that. Two out of three of them were net promoters of Southwest based on our survey results, which is the highest it's been in five years. Overall an exceptional operational performance and we accomplished those results with the lowest amount of aircraft time invested in blocks and turns in the industry. Regarding our turns, we had a heavy focus in the third quarter on rolling out bag scanning technology. We introduced the scanners and trained 10,000 plus ramp agents in all of our domestic locations over a five-month period. This foundational investment will help us track our bags with more accuracy and provide more customer service. We expect this operation's reliability to continue. Currently, in October, our on-time performance and bag handling is shaping up again to be the best in years. The operation is solid, and our biggest unknown at this point is the MAX return to service timing. As Gary mentioned, we’ve pulled MAX related flying from our schedules through February 8th. We previously planned for an early November return to fly, and our expectation to split at least a month. Now, Boeing has confirmed yesterday that their target is to return the MAX to service in the fourth quarter. We are in continued conversations with Boeing and the FAA as they complete their milestones in the process and we'll have a clear picture of when the aircraft may be cleared to fly. If we don't have certainty of the mid-December return to service, we may have to push our cancellations out further. Our assumptions now include a 30 to 40 days processing of returning the aircraft to operational status, and we believe that we can manage that at a rate of about 5 to 10 airplanes per week. In closing, I am grateful to all of our employees. They are the heartbeat of Southwest Airlines. The operational results for the third quarter were superb, and our focus remains on running a safe, reliable, hospitable, and efficient operation. With that, Tom, over to you.

Okay. Thank you, Mike. Good morning, everybody. I want to echo what Gary and Mike said—we just had tremendous third quarter operationally and our service and hospitality were incredible. We are at the very top of the industry in terms of service and we delivered great financial results. I really do believe this is absolutely because we have incredible people. They are just so committed to what Southwest Airlines stands for. So I want to thank each of you for the great performance. So, let me jump right into the third quarter. Our RASM growth of 4.2% year-over-year was in line with the guidance we gave on our July earnings call and reaffirmed back in September. Throughout the quarter, we saw continued strength in passenger demand trends. Both leisure and business travel were strong, leading to strong year-over-year passenger yields. We were significantly impacted by the removal of the MAX from our schedules, resulting in our capacity decline of 2.9% in the quarter. We modified several schedules to optimize around these conditions. Even with the MAX challenge, we generated record third quarter passenger revenues, operating revenues, and record RASM performance. Our commercial team did a phenomenal job of minimizing the MAX impact. We also experienced roughly two points of temporary year-over-year RASM benefit for Q3 comparing original plans before the MAX grounding. Our other revenues increased 8.6% year-over-year for the quarter primarily due to the continued strength of our Rapid Rewards program. On a year-to-date basis, other revenue is growing at 11.4%. We are seeing growth in our credit card portfolio, with new credit card acquisition growth rates in double digits year-over-year. Our Rapid Rewards program continues to perform very well. In early August, we announced our plan to expand into global distribution systems with agreements with Travelport and Amadeus. This will make it easier for travel management companies and corporate travel managers to do business with Southwest. We expect our GDS capabilities to be up and running by mid-2020 and initial ramp-up will contribute $10 million to $20 million of EBIT contribution. For the fourth quarter, we are focused on maintaining the integrity and strength of our network. Given our capacities and constraints, we’re solving to optimize our public schedules while smoothing our flying during peak and off-peak times. Overall, we expect to maintain quality of our product and operation while producing strong financial results. The estimated fourth quarter revenue penalty from the MAX grounding is expected to be greater than the third quarter due to more MAX aircraft in the original plan. However, our base business trends remain solid, and we’re expecting a solid fourth quarter RASM performance. We’ve implemented a systemwide $5 one-way fare increase, which is expected to support yield momentum. Demand for our services to Hawaii continues to be very strong, and we are planning for additional flights in 2020 to continue building off our initial success. Looking forward to 2020, we’ll focus on a measured ramp-up of the MAX aircraft as it returns to service. Beyond our current investments understanding in Baltimore, Denver, Houston, California, and Hawaii, we have a long list of attractive growth opportunities. With that, I will pass it over to Tammy.

Thank you, Tom, and thank you all for joining us today. We had another solid quarter of earnings and EPS growth along with margin expansion, which is notable considering the extraordinary challenges resulting from the grounding of the MAX. I'm extremely proud of how our Southwest family rallied together to produce strong results despite a significant reduction in our capacity this year due to the MAX. Turning first to our non-fuel cost performance, the largest driver of the 7.6% year-over-year increase in our third quarter CASM excluding fuel and profit sharing was an estimated 6% to 7% impact from the MAX groundings and the resulting flight cancellations. Our third quarter capacity growth was approximately eight points lower compared to our plan, which will also apply in the fourth quarter. Excluding the MAX related unit cost pressure, the remaining modest year-over-year increase was driven largely by increases in salary wages and benefits as well as maintenance expense. While these cost pressures were anticipated, we came in favorable to the latest guidance of 8% to 10%. Overall, we expect fourth quarter 2019 CASM-Ex to increase in the 4% to 6% range year-over-year. Key drivers are increases in salary wages and benefits, maintenance expense, and airport costs. While we continue to face significant pressures, our employees have done an incredible job managing our costs. We currently expect our full-year non-fuel costs to increase approximately 8% year-over-year. Looking ahead, we are focused on returning to normal capacity and achieving our long-term unit cost target of below 2% annual growth. Regarding our full year 2020 expectations, based on the information available, we will adjust our plans to reflect the return to service costs and expected incremental maintenance and operational efficiencies post-MAX re-entry. Thank you all for your support and continued interest in Southwest Airlines. With that, I will turn it back over to Chad.

Thank you. Appreciate all the uncertainty around next year. But based on what you just outlined, if we assume you hit your stride by the third quarter, is low-teens growth in the ballpark of what your plan would be?

No. We'd be below 10% easily. You agree, Tammy?

Yeah, for the full year.

You're talking about for the year or for the quarter, Duane?

For the third quarter, for the back half essentially. Yeah.

I don't have a number in my mind. What do you think?

And it is premature. Yeah, it is premature. We're not prepared, Duane, to give you capacity guidance at this point for all the obvious reasons. I'd be happy to kind of walk you through how we're thinking about the full year 2020.

I think we'll be something less than 10% for the year, and we'll judge the return rate based on several factors.

All very fair. I agree with your comments and your praise for your planning and replanning teams. Can you talk a little bit about how the network response evolved from the initial shock to the system of the grounding and maybe how you’re thinking about the fourth quarter? It feels like initially you were giving up all sorts of traffic, and over time it feels like you figured out how to retain your highest quality traffic.

Well, Tom, do you want to comment on that first?

Yeah. I think we've been looking for a—looking for how do we streamline our networks leveraging what we have. We haven't taken long-haul segments out, but we have and that allows us to connect traffic. We are seeing more short and medium-haul flying, which means we are getting a lot of aircraft utilization and that’s a pretty high-quality flying. So we’re doing a good job of optimizing the network given what we have.

I think your idea is a decent one; I don’t think it would be correct to assume that we have lost share on 100% of our system. I agree with your logic there. Without studying a little more market-by-market, I'm reluctant to agree that there’s a large percentage we haven’t lost.

Thanks for the thoughts.

Hi everybody. Thanks. Two questions on the same topic. What are the gating items for getting your fares on Sabre, and how much of an incremental pre-tax income should we expect if you're able to come to terms with them?

Well, we've worked with Sabre for a long time, so their importance is obvious. We just weren't able to get to commercial terms with Sabre, which is unfortunate. However, we have two good partners with Travelport and Amadeus...

I think the first piece is we'll be paying segment fees, and we are competitive in pricing.

Hey, good afternoon everybody. So, given the current return to service assumption for the five to 10 aircraft, are we getting back to sort of hitting your fleet stride by midyear? It sounds like ex-fuel CASM challenges are going to persist fairly materially in the first half of next year.

We expect to have a ramp-up unit cost penalty in the first half of 2020, and while we’ll do what we can to mitigate the financial impact, the penalties are significant and certainly grow as the fleet deficit grows.

Can you put any numbers on first half or second half ex-fuel CASM?

It is honestly too early to do that.

The issue is the timing of achieving the spirit of what you’re asking. We’re reluctant to say third quarter is going to be really clean yet. As I did say earlier, we are focused on two fundamental things. We’re focused on settling up with Boeing and getting the MAX back to service.

And thank you for the kind words. I hope that’s some made off the hook for having this build Southwest a couple of quarters ago.

There's a lot of truth — Herb always said here I wish all timers, which means he always carried the grudge.

Yes. Hey good afternoon guys. Question here on I think Tom you mentioned about some of the growth you would be focused on Denver, Baltimore, and Houston. Those markets are focused because you can get gates there?

I think we're looking at this strictly from the proximity of where Denver is, where Baltimore is, where Houston is, and how they fit our networks.

Well Mike, yeah I think you probably know what the corporates are. So I don't know that we have anything new to share on that point today.

Hey, good afternoon. If I think about next year, is Hawaii still kind of a large part of next year's growth assuming you can grow as you want to grow?

That's not going to be a massive portion of our capacity. We want to continue investing in Hawaii; we are committed to Hawaii.

Can I assume that CASM growth is linear with cost growth?

We would expect the year-over-year unit cost penalties to continue as we ramp back up, but our goal is to keep our annual unit cost growth below 2%.

Gary and Tom, you've teased us with some new revenue initiatives for 2020. Are there any other of these initiatives that are getting ready for primetime that you might care to share with us today?

No, I'm pretty excited about our revenue pipeline, but GDS is the big one in the pipe for 2020. I expect that will be a foundational piece for us.

Just to ask quickly about the fleet diversification review, is that right and what kind of factors and metrics you will be looking at as part of this review?

In terms of looking at different aircraft, it's no different than what we've ever done. The obligation is to debate having a sole-source vendor and one fleet type. That is different.