西南航空 (LUV) 2012 Q2 法說會逐字稿

Welcome to the Southwest Airlines second quarter 2012 conference call.

My name is Tom and I'll be moderating today's call.

This call is being recorded and a replay will be available on Southwest.com in the Investor Relations section.

At this time I'd like to turn the conference over to Ms. Marcy Brand, Director of Investor Relations.

Please go ahead, ma'am.

Thank you, Tom.

Good morning, everyone, and welcome to today's call to discuss our second quarter results.

Joining me on the call today is Gary Kelly, Southwest's Chairman, President and Chief Executive Officer; Bob Jordan, Executive Vice President and Chief Commercial Officer and President of AirTran Airways; and Laura Wright, Senior Vice President Finance and Chief Financial Officer.

Today's call will begin with opening comments from Gary, followed by Bob providing an update on the AirTran integration and operations and then followed by Laura providing a review of our second quarter results and current outlook.

As a quick reminder, prior year consolidated results include AirTran results beginning May 2, the date of the acquisition.

In order to provide what we believe to be a more meaningful year-over-year comparison on today's call we will also be discussing specified current results and providing outlook commentary on a combined basis as defined in this morning's press release.

Please be advised that today's call will include forward-looking statements.

Because these statements are based on the Company's current intent, expectations and projections, they are not guarantees of future performance and a variety of factors could cause actual results to differ materially.

As this call will include references to non-GAAP results, such as combined results and results excluding special items, please reference this morning's press release in the Investor Relations section of Southwest.com for further information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results.

And with that, I'll turn the call over to Gary.

Thank you, Marcy, and good morning, everyone, and thank you all for joining us.

We are very pleased with our second quarter financial performance.

Excluding items second quarter profits of $273 million is an all-time quarterly record.

It's up 126% year-over-year.

Earnings per share of $0.36 is also an all-time record.

And it's up 140% year-over-year.

And also $0.03 ahead of Wall Street estimates.

The sluggish economy was no help.

High fuel prices were no help.

Although they at least were lower than the first quarter.

But I give all the credit to our people at Southwest and AirTran.

And once again, they did a great job of running a very high quality airline with solid on-time performance, excellent baggage handling, outstanding schedule reliability and at the same time our people at both airlines are doing an exceptional job of integrating AirTran.

And our people have done an extraordinary job of rolling out a lot of new initiatives, like our all new rapid rewards program, the Boeing 737-800, the evolve seating retrofit for our 700s and a number of other initiatives.

And in particular, as we outlined in the release today, the AirTran integration is very much on track.

The AirTran business was a significant contributor to our second quarter profit record.

A couple of things to note there.

First, I'm very proud of our team's efforts to get a deal with Delta and Boeing to place all of the Boeing 717s and retire them from our fleet by the end of 2015.

The operational and cost benefits are obvious with an all Boeing 737 fleet.

But the revenue benefits are huge given that we've got 26 more seats with a 737 at essentially the same trip cost as a 717.

So after gathering up all the one-time accounting charges for this deal in 3Q, the ongoing rental expense versus sublease income is essentially a wash once we start delivering the 717s to Delta and Laura's going to cover all of that in more detail in a few moments.

Further, we have significant technology work underway related to the AirTran integration.

Our top priority is an international reservation system implementation that's on track for a 2014 deployment.

Next is the systems capability at both airlines to connect the networks and the itineraries and that work is on track for a first quarter 2013 deployment.

In addition to core AirTran profits, that acquisition is contributing profit synergies in line with our expectations and we continue to target $400 million in synergies from that for 2013, which is more than double the current run rate that we have.

Still related to AirTran, each airline continues to make aggressive but prudent schedule changes.

International cities are being added in AirTran.

Small cities that don't fit the Southwest model in this high fuel cost environment are being closed.

During the second quarter, Southwest picked up additional slots at Washington Reagan.

We received authorization from the City of Houston City Council to proceed with an international facility at Hobby Airport.

That's targeted for 2015.

And work at Dallas Love Field is on target, on schedule and on budget.

All of that is in anticipation of the full ride amendment repeal in October of 2014.

So needless to say, there's a lot going on at Southwest.

It is already bringing significant shareholder value and there's a lot more to come over the next several years.

I want to thank our Board of Directors for their hard work and their devotion to driving shareholder value.

In May they increased our authorization to repurchase shares to $1 billion, of which half of that repurchase has been completed.

And they also more than doubled the quarterly dividend to $0.01 a share.

Our strong cash flow, our leverage is low, our annualized return on invested capital for this quarter actually exceeded our 15% requirement.

So, you can see why the Board took these actions by all of these strong positions and strong performances.

And then finally, while we remain cautious about the domestic economy, our business seems to be holding up well.

Fuel prices, at least right now, are no higher than they were in the second quarter.

Hopefully, they will be lower this quarter.

But we're keeping our capacity roughly flat this year and next until we're comfortable with our earnings performance hitting our 15% return on invested capital target.

Of course, this quarter's results were a great step forward in that regard.

So Bob, without further adieu, I'll turn it over to you.

Thank you, Gary, and thanks everyone for joining us.

I'm really pleased to give you a report on AirTran.

We continue to make great progress on the integration front.

Five AirTran 737s have been converted to the Southwest livery and we've got another one in progress.

We plan to transition 11 737s this year and the majority of the remaining 41 will be transitioned in 2014 once international capabilities are in place at Southwest.

As Gary mentioned, the recent agreement with Delta and Boeing Capital to transition out of the AirTran 717s is a great deal for us.

While that was not anticipated at the start of the acquisition, the opportunity to replace 717 flying with 737 flying offers -- that offers significantly more seats and, therefore, of course revenue opportunity at essentially the same trip cost makes just perfect economic sense for us.

The first 717s will transition in August of 2013 with the entire fleet exiting by the end of 2015.

On the labor front, the majority of our unions have seniority integration agreements in place and we're making really good progress on the two that remain.

We continue to transition AirTran employees to Southwest.

The first groups of AirTran pilots and flight attendants have completed their moves and over 1,000 AirTran employees have transitioned to Southwest and that number is rising each and every month.

Airport transitions continue with ground operations folks beginning that transition at six stations last month and AirTran's operations in Seattle and Des Moines fully convert to Southwest this quarter.

Of course, optimizing the combined networks continues to be a major focus.

We added several new AirTran international markets to the route map during the second quarter and those were primarily funded through redeploying capacity from closed small cities and I'm just very pleased with the performance of those new markets.

They all look very strong and I'm extremely pleased and thrilled that the Houston City Council cleared the way for Southwest to build a new five gate international terminal at Hobby Airport.

Construction there is planned to begin next year with flying to destinations such as Mexico, the Caribbean and cities in central and South America beginning in 2015.

We're making great progress towards implementing connecting capabilities during the first quarter of 2013, as Gary mentioned, and that of course opens up significant opportunities in the combined Southwest AirTran networks ahead of full integration.

On the operation front the AirTran operation continues to perform very, very well.

They are posting stellar DOT results in all three categories.

And for example in May, which is the most recent month of results published, AirTran ranked first in the category of customer complaints, second in mishandled bags and third in on time performance overall.

So I'm just extremely pleased with the operation at AirTran and could not be more proud of our people there.

Overall, AirTran's business continues to improve solidly year-over-year and while still underperforming Southwest revenues on a nominal unit basis, positive RASM and yield trends continue.

We realized net synergies in the first half of this year of approximately $80 million and our plan continues to call for reaching $400 million total pretax synergies in 2013 based, of course, on our current network and fleet plans.

So, in summary, I am very pleased with our integration progress and timing.

Our synergies are on track.

The 717 deal is a great long-term deal for the Company.

And the AirTran folks are posting stellar operational results and I think that's pretty darn good and I'm very proud of our AirTran folks and their excellent work.

With that I'm going to turn it over to Laura Wright to walk us through the details.

Thank you, Bob, and good morning or afternoon, everyone.

Excluding special items, our second quarter operating profit was an all-time record quarterly performance of $485 million.

Revenue was solid throughout the quarter, producing record revenue results and our non fuel operating costs came in better than expected.

Although fuel prices on average were still very high, we benefited from the decline in market prices that occurred during the quarter, as evidenced by a roughly $60 million decrease in our economic fuel costs compared to both the second quarter of last year as well as to our expectations back in May.

We also have a $28 million year-over-year reduction in our nonoperating expenses excluding special items.

And all-in, this led to a net income of $273 million excluding special items or $0.36 per diluted share, both quarterly records.

For the 12 months ended June 30, our pretax return on invested capital was 8%, and as Gary pointed out, our June quarter standalone results exceeded the 15% annual target.

And overall, I would reiterate Gary and Bob's comments that we're very pleased with the second quarter results, particularly the improvements from a year ago.

Our passenger revenues increased over $400 million or 11.5% from last year's $3.9 billion.

On a combined basis our passenger revenues grew a solid 5.1%.

On a unit basis, passenger revenues were up 6.4% versus combined results and total unit revenues grew 6%.

Our present strength came primarily from our yields, they were up 6.7% on a combined basis.

And as Bob noted, we continue to significantly improve AirTran's year-over-year revenue performance.

However, on a nominal unit basis, we still have significant synergy opportunities yet to be realized on AirTran's network.

Southwest's mix of full serve passengers was 17%, which was slightly down from first quarter's 18%.

However, business traffic indicators that we monitor suggest that our business traffic has remained steady.

Our business select fare product contributed approximately $25 million in incremental revenues in the quarter and our ride amendment revenues also continue to contribute significantly.

We had $74 million of incremental revenues in the second quarter from ride amendment.

Our 800s and Evolve flights, which were just introduced in the second quarter, are already producing great results and they contributed millions collectively in 2Q '12.

All new Rapid Rewards continues to perform well.

We had approximately $75 million incremental cash sales from our business partners compared to the second quarter of last year.

And cumulatively, our business partner cash sales from our frequent flier program increased in excess of $300 million for the 12 months ended June '12, compared to the 12 months ended June 2011.

While the vast majority of this is still being deferred from a P&L perspective, thereby increasing our air traffic liability, we did recognize about $50 million additional incremental passenger revenue from the frequent flier business partner sales in second quarter '12 over last year.

Thus far our July passenger unit revenue growth was solid.

We do not expect our July passenger unit revenues to be up as much as June's 6% year-over-year increase, due to softer July 4 holiday traffic, which is to be expected when July 4 falls in the middle of the week.

Our bookings in place thus far for the quarter look good.

And overall, we expect another solid third quarter unit revenue performance, but do not expect the year-over-year growth to exceed second quarter's 6%.

Our freight and other revenues were in line with our expectations.

And we currently expect that our third quarter freight and other revenues will decrease slightly from third quarter 2011's freight and other revenues, primarily due to AirTran's fees trending lower year-over-year as their capacity is moved over to Southwest.

Our second quarter economic fuel price per gallon was $3.22, that was down a nickel from the prior year combined.

The $3.22 includes a net $0.04 unfavorable cash settlement from the locked in losses from our legacy hedging portfolio.

Our premiums in the quarter were $12 million, that's down from $26 million in the prior year.

And our economic fuel costs were about $0.13 per gallon better than the last guidance that we provided in mid-May of $3.35, and that was really due to the $6 drop in oil prices since that time.

At current market prices we expect that our third quarter economic fuel price, including taxes, will be in the $3.05 to $3.10 per gallon range, that's based on the July 17 forward pricing.

This estimate includes an estimated $0.03 per gallon fuel hedging penalty and again, this relates to the locked in losses from the legacy hedging portfolio.

Our third quarter hedge does provide protection if WTI prices average above $100 per barrel, as illustrated in this morning's press release.

However, we also participate in the third quarter fully and falling prices until we reach WTI prices below $75 per barrel, again as illustrated in this morning's press release.

Our third quarter premium expense is also expected to be about $17 million and that's down from $36 million last year.

For the fourth quarter of 2012 and looking out into 2013, our current hedge portfolio provides a meaningful protection in a rising fuel price environment, again, with that protection kicking in at $100 of WTI price and above.

In the event prices drop from current forward levels, we will continue to participate in lower fuel prices fully until we hit a $75 per barrel WTI price in fourth quarter as well as 2013.

Our second quarter unit costs, excluding fuel and special items, were up 4.3% year-over-year on a combined basis and excluding profit sharing were up 2.7%.

This was better than we expected and that was primarily due to lower maintenance, airport depreciation and advertising costs.

Maintenance was less than expected due to fewer Evolve seating conversions and fewer heavier maintenance events than planned.

Our airport costs benefited more than we anticipated from airport settlements we received during the quarter and depreciation came in lower due to some of the changes we had in our aircraft retirement schedule.

And finally, advertising was under plan as we deferred some of the spend that we had previously planned for second quarter to the back half of 2012.

For the third quarter of 2012, we're currently anticipating our non fuel unit costs, excluding special items and profit sharing, will increase in the mid to high single digit range compared to third quarter 2011's $0.0727.

While we've had more modest cost increases in the first half of this year than expected, we do anticipate higher costs in the back half, primarily from maintenance including Evolve, airport costs, depreciation, and the deferred advertising.

We remain focused on controlling our core costs with significant opportunities ahead with our fleet modernization plans.

On the nonoperating cost side, we have significant year-over-year improvement.

Our net interest expense for 2012 is expected to be down by $70 million on a combined basis due to paying down about $1 billion of debt.

And as noted in the fuel discussion, our 2012 fuel hedging premiums, which are recorded in other gains and losses, are expected to be down approximately $65 million from 2011.

Let me provide a quick recap of our balance sheet and cash flow.

Our cash and short-term investments at quarter end were $3.3 billion and as of yesterday were $3.7 billion.

For the first six months of the year we had $1.4 billion of cash flow from operations and over $800 million of free cash flow.

Our leverage, including our off-balance sheet aircraft leases, is approximately 45% and it's expected to decline to the low 40% range by year end.

And from August of 2011 through the end of the second quarter, we repurchased approximately $500 million or 59 million shares of Southwest common stock under our current $1 billion authorization at an average price of $8.44.

I'll move to fleet and capacity.

We had 14 737 classic retirements during the second quarter, three of these were lease returns and the remainder owned aircraft, ending the quarter with 695 active aircraft.

Of the 34 800 deliveries planned this year, there are 15 remaining.

And we're still planning for 40 total classic retirements this year, which would put our fleet count around 692 at year-end.

In terms of our capacity plans, our 2012 available seat miles will be comparable to 2011's combined ASMs.

For 2013, we don't plan to grow the fleet and we're planning for modest capacity growth compared to 2012.

Although we are increasing the aircraft gauge in 2013, with 800s and the additional six seats on our 700s, we have capacity offsets with planned classic and 717 retirements.

And currently our capacity for the first quarter is expected -- of 2013, is expected to be relatively flat to slightly down year-over-year.

I will end with an update on the current status of our fleet modernization initiative.

Back in January you'll remember that we provided estimates for EBIT contribution over the next three years as a result of our fleet initiatives.

Since then, we've made a few changes.

We announced $1 billion of deferral of capital spending in new airplanes and most recently we announced that we will sublease or lease all 88 of AirTran's 717s to Delta.

Replacing AirTran's 717 flying with 737s as they transition to Delta is expected to benefit our annual pretax results by approximately $200 million after all of the 717s are transitioned to Delta and replaced with 737 flying.

The primary source of the benefit is from the revenue contribution of more seats as the nominal trip cost of the 717 compared to our 737s is approximately the same.

And as a result of this opportunity to retire the 717s from our fleet earlier than the head lease obligations, we have made adjustments to our retirement schedule of our classic fleet to be able to replace the 717 flying as they transition to Delta.

Because we're replacing the 717 flying with adjustments to our classic retirement schedule, this agreement does not increase our near-term capital spending plans or future aircraft needs.

Collectively the 717 deal and the aircraft deferrals announced in May have not changed our EBIT estimates for 2012 through 2014, which were $70 million in '12, more than $300 million in 2013, and more than $500 million in 2014.

For 2015, however, we're expecting that the EBIT contributions from our fleet initiatives will exceed $700 million and the $200 million increase in 2015 is largely the result of the replaced 717 flying.

Overall, the improvement in EBIT and by replacing the 717s with 73s coupled with the reduction in our invested capital that comes from the aircraft deferrals, as well as the early retirement of the 717 leases, significantly improves the return on investment of the collective fleet modernization plan.

In the third quarter, we expect to record an accounting charge of approximately $140 million.

It's primarily associated with the costs that were contractually assumed by Southwest to convert the AirTran aircraft to Delta's livery and configuration.

The charge will be included in our AirTran acquisition and integration costs, which are treated as non-GAAP special items.

With respect to these aircraft transition costs, we expect to only spend approximately $100 million in net costs and the difference between that expected $100 million net cost and the $140 million GAAP third quarter special charge is a result of financial assistance that is being provided by the manufacturer that will be recorded on our financial statements as a reduction in aircraft basis on future deliveries.

The $100 million of net conversion costs are about $50 million higher than we expected to incur if we would have integrated the 717s directly into Southwest.

So as a result, this will increase our estimate of total acquisition and integration costs from $500 million to approximately $550 million.

In regards to the net rent expense, as aircraft are transitioned from Southwest to Delta, our book rental expense is eliminated and the sublease income offsets, basically offsets that.

So in summary, we're very excited about the opportunity to retire the 717s from the fleet early.

And we're confident that the net economics of the transaction better support our strategic, our operational, as well as our financial goals.

With that, Tom, I believe we are ready to take questions.

(Operator Instructions).

Our first question from John Godyn with Morgan Stanley.

I just want to follow up on your comments about third quarter RASM likely being solid.

It definitely helps to put some boundaries on it to know it won't exceed the second quarter, but I think investors are still a little bit confused about how to interpret it.

Just given the tough comps throughout the quarter, if July isn't as good as June and comps get a lot tougher in August and then again in September, it seems plausible that PRASM might go negative in September.

Is this the sort of ramp throughout the quarter that would be reasonable or am I missing something about how the months shape up from here?

Yes, I think I'm looking for the comps, John, but certainly we think July, the fact that you had July 4 on a Wednesday produces a tougher year-over-year comp than what we expect in August and September.

I think we also have July is just a very optimal month and I think we've noted in the past that some of the sub-optimal months, we just have more room to grow revenues than we do in the peak, peak periods like July.

But overall, our bookings for the quarter look solid and we don't see anything for August or September, but we would admit that July is impacted by 4 of July.

And Gary, when we think about Southwest historically, capacity growth, demand stimulation and solid returns have gone hand in hand.

But as you've gone through this tougher phase here, the answer has been slowing capacity growth until returns improve.

That makes sense.

But as we look forward and you mention that you're going to keep 2013 capacity flat, is flat or minimal capacity growth the sort of new normal or do you envision getting back to a world where you see capacity growth, demand stimulation as again sort of aligned with maintaining solid returns from here?

Well, we definitely have some opportunities to stimulate demand, but I think that will be perhaps a bit more tactical in the future than it has been in the past and it also has to be at a revenue production level that hits our 15% return requirement.

So I think step one is just restoring our profitability to those levels, number one.

Number two is to make sure that we have the capabilities in place to pursue expansion opportunities, which we're doing.

That's adding the 737-800, that's investing in international capabilities, those kinds of activities.

We'll have access to airplanes to be able to grow the airline.

So all of those necessary pieces will be in place and then it's just a matter of, again, making tactical decisions about what new markets we might want to add.

Because it's tactical, I think we just have to wait and see when we're ready to add aircraft, what opportunities are available and that will be a function of capacity in a market and the price in a market.

So Bob Jordan and I both highlighted Houston Hobby and the international opportunity there, which is a perfect example to your question.

I'm hopeful that we will be hitting our return requirements so that we can add aircraft, because there is a significant opportunity to lower fares and grow the market in Houston Hobby internationally, as one example.

There are plenty more examples like that, but I think we just don't want to get the cart before the horse.

The first thing is we need to hit our profit targets and then we'll be in a position to make those kinds of choices.

Great.

Thanks a lot.

We'll take our next question from Helane Becker from Dahlman Rose.

So my first question, Laura, is my usual Wright Amendment question.

Can you just update us on the Wright Amendment revenues year-to-date.

And then the other question that kind of goes along with that is I've noticed that some of your -- some of the other airlines are adding service to Love Field from their hubs using 50 passenger jets.

So, can you just talk about the opportunity that you have to -- as 2014 approaches, to do a lot of that service with larger aircraft and the potential for revenue benefit.

Thank you.

I'll take the first one.

So in the quarter, Wright Amendment revenue was $74 million.

That was versus $63 million a year ago.

Year-to-date it's $134 million, first and second quarter.

So very strong.

And Gary, I'll let you talk about --

Well, Helane, I'll try to answer your question here.

I think first of all, by federal law, Love Field will be limited to 20 gates.

I guess it is limited now, but certainly the new airport construction will be 20 gates.

We have ample access to those 20 gates to support our operation.

We'll be able to grow from here.

We have a very strong business in Dallas, as Laura just reported to you.

That is very nice growth in what is a pretty tough economic environment, so we're very pleased with our business here out of Dallas.

We always take the competition seriously, but I think we would be delighted to compete head to head against regional jets every day.

So in the grand scheme of things, our big competition out of Dallas is coming from DFW Airport, not Love Field.

Great.

Okay.

Thanks very much.

We'll go next to Dan McKenzie with Rodman and Renshaw.

Bob, I appreciate the AirTran commentary.

But the one thing that stands out is the $2 million operating loss at AirTran.

So it does look like roughly 15% of Southwest's business is losing money, at least prior to the synergies.

And I guess as I looked at the operating costs, individual line items seem pretty much the same if not better than AirTran standalone historically.

Dan, let me just interrupt you there.

That is a 2011 required presentation.

So that -- first of all, that's not this year.

That's last year.

I'll defer to Marcy as to what we'll have on our IR website for AirTran, if anything, separately.

But we are having a harder time separating the profits between AirTran and Southwest as time goes by, because they just -- they begin to blend more and more together.

But again, I'll defer to Investor Relations over the next several days or weeks.

But there was a significant operating profit from AirTran in the second quarter.

That's fact number one.

Of the $485 million operating profit, which was an all-time record ex-items, I don't recall off the top of my head, but as Bob Jordan mentioned earlier, the operating margins at AirTran lagged Southwest margins some, but they're not far off.

So they were a substantial portion of that $485 million.

And they're better year-over-year.

They're better year-over-year.

There's progress along the way here.

I apologize for the misinterpretation there.

But that was a 2011 chart that was required at the time for combining financial statements.

I think it's because it was split between -- there was AirTran standalone for a month and Southwest owned it for two months and that's the only reason that's in there.

But I agree with you, that it is somewhat confusing.

Thank you for clarifying that.

I apologize for the confusion on my part.

I guess if I could just ask my next question.

If I can just focus on productivity perhaps a little differently than what's stated in the press release.

I didn't see block hour stats in the press release.

I guess I'm wondering, first, what that average block hour time was in the second quarter and then how does that compare to second quarter block hour time historically and if you could just talk a little bit about the potential productivity improvements there.

Well, for the most part our utilization is still very high and especially in relation to prior years.

Since 2007, we've concentrated more of the flying into the meat of the day, sort of 7 AM to 7 PM.

The block hours per day are down somewhat year-over-year, but I think that probably suggests, Laura, that maybe we have some opportunities to add more flights outside of the mean part or the meaty part of the day.

And then there is (inaudible).

2Q '12 11 hours and 24 minutes was the block time average for the quarter.

Last year was 11, 41.

But in '10 it was 11, 11.

So it's -- I think we peaked at around 11, 50 back in '07 so it's still very high.

Okay.

Thanks.

I appreciate that.

We'll take our next question from Duane Pfennigwerth with Evercore Partners.

Can you give us an update on the Evolve project, how many aircraft have been completed and the rate at which you are converting those over and when you think that is done.

We had 50 converted through June.

We expect to convert about 200 more, about 100 in the third quarter and 100 in the fourth quarter.

And we will be done in the second quarter of 2013 with all of the 700s.

And then just on fuel efficiency, I guess as we think about whatever that line is in the model, ASMs per gallon, it kind of feels like that should accelerate a bit as you do this Evolve program and as you layer in more of these 800s.

Can you give us any sense for the sort of year to year gains we can expect going forward?

Duane, you're talking about the fuel efficiency and all the economics.

We haven't provided anything in 2013.

As you know, the Evolve seats we're actually expensing.

They're not being capitalized.

So that's actually adding to some of the cost pressure and why you're not seeing net improvement in the 2013 timeframe, but certainly -- or 2012 timeframe.

Certainly as we get into 2013 and have the majority of the fleet, we'll see some nice gains on the fuel efficiency and just the overall CASM from those.

But we haven't provided any 2013 guidance yet.

And if I could just sneak one more in.

Could you just clarify your comment about capacity growth next year?

Yes.

So we expect capacity growth in 2013 to be modest.

That's going to become as a result of the extra seats from the 800 and Evolve.

First quarter will be flat to relatively down, but full year will be a modest increase.

Thank you.

We'll take our next question from Mike Linenberg with Deutsche Bank.

Two quick ones.

Back to capacity growth, Laura, you gave us next year.

Did you give us the third and fourth quarter of this year?

I did not.

I think I told you that for the full year we're going to be relatively flat with last year.

I think the reads down about a 1 point, 1 percentage point.

Weren't we down about a point, Mike, here in the second quarter?

I think it is pretty consistent.

1.2.

(multiple speakers)

Pretty consistent in the third and the fourth quarter.

My second question, on the $1 billion of CapEx that you saved, 2012 to 2014, Laura, how does that break out per year?

Is it evenly across the three years or is it front end loaded?

No, it's actually weighted towards 2013 and 2014.

2012 our estimates are about $1.3 billion.

So it was modest.

But the real difference is in '13 and '14.

Right now, '13 is $1 billion to $1.1 billion and that had been in the $1.4 billion range.

So it's definitely the next two years where you see most of it.

Very good.

Thanks.

We'll take our next question from Ray Neidl with the Maxim Group.

Gary, I think you said on CNBC this morning that your ROIC goal is 15%.

You've stated that previously.

And I'm just wondering the components of that.

It looks like it's coming from cost reductions, reconfiguration of your aircraft, resuming growth, which you're not doing for the next three or four quarters.

So realistically speaking, is that a goal that's well beyond the year 2013?

In other words, about a year and-a-half out or more?

Well, we're -- the 12 months ended June of '12, we hit an 8% return on invested capital.

I believe that's in the press release.

This quarter if you annualize the second quarter it would be over 15%.

And that's not my prediction for the next four quarters, but it just at least puts in perspective the kind of progress that we've made towards that goal.

If we can sustain the current core earnings and then drive the values that we're targeting from the AirTran acquisition, from the all new rapid rewards roll-out, the fleet initiatives, I think the way Laura categorizes those in her mind probably includes the 800s.

Sometimes I separate them in my own mind.

In any event, what we have detailed for you in the press release shows very significant pretax earnings contributions coming from this collection of fleet initiatives.

The 800s, the Evolve, the swapping of the 717s in favor of 737s, I already said Evolve.

By the way, back to Duane's earlier question, we will likely retrofit 100 of our classic aircraft with Evolve seating as well.

But that won't meet the timeline that Laura shared earlier.

So all told, those more than take us from our current levels to a 15% return.

So we've got a very nice portfolio of opportunities that will bring very significant value.

And with respect to your specific point about 2013 and whether it's well beyond 2013, I don't think we're prepared to say at all that we won't hit our target next year.

That's good to hear.

One other macro question, Gary.

The industry's probably going to change here with the American bankruptcy one way or the other and is that going to have any effect at all or a major effect on Southwest if -- when American comes out of bankruptcy to begin with and if they did merge with US Airways they might become a larger, more aggressive competitor.

Just to tie in, again, Ray, on your 15% question, we've had a 15% target for 25 years, so that hasn't -- I don't see that changing.

So there's nothing new about that.

On American, I think we agree with you, that certainly what we have to plan for is a much stronger, much more viable, much more cost effective competitor in the future.

The old American's gone and it will be replaced by something, so we agree with you.

So we're gearing for stronger competition in the future and that certainly provides the kind of discipline that we need to keep our costs low and our service levels high.

Whether the reorganization of American results in some kind of opportunities for us, that's pure speculation right now on our part.

But just like we were able to move very quickly to pick up a couple of slots at Washington Reagan, we know what we want to do with the airline over the next 5 to 10 years and I think we've got the horsepower to move and if some opportunities present themselves I think we can decide and move quickly.

Great.

Good quarter.

Thank you, sir.

We'll go next to Jamie Baker with JPMorgan.

From the time you announced the merger my assumption was that the product AirTran was at that time would eventually become the product that Southwest is today, basically the Southwest way would prevail in terms of the passenger experience, single fleet type, IT pricing and so forth.

I'm curious now that you have a more thorough understanding of AirTran's operations and procedures, is there anything that they did better or different than Southwest that might actually continue?

Could be as simple as red eye flying, for example, or maybe something much deeper than that.

Any thoughts?

Just so I don't confuse anyone, our plan for integrating AirTran is unchanged from what you initially described.

In other words, we will follow through with moving all of the AirTran operations into Southwest Airlines with the product that you know and love today at Southwest Airlines.

Absolutely, we've learned a lot from AirTran.

I think they do operate differently and they are an outstanding operator.

They have very strong on-time performance, outstanding baggage handling, and they have a different method of scheduling than we do and they manage their fuel loads different than we do, so there's a number of things that are still queued up for us, I would say, as opportunities to continue to explore.

We don't like to make massive changes to our operating procedures.

Safety's our top priority.

We want to make sure that people are fully trained.

And before we undertake a very large change there, we're very measured and very reasoned about how we go about that.

But those are a couple of items that I'm very excited about that I think over time Bob Jordan and Mike Van de Ven have been looking at and some things I'm sure we will implement.

The biggest value, I think, that they have brought to us, besides just seeing how another Company works, is international.

Because our ability to research international fares and profits is much, as you know, is much more difficult than what we're able to do domestically.

So this gives us not only just the operating expertise and experience and we admit, at Southwest we're novices to this, so we get that from AirTran and in addition to that we get very meaningful insight into those international markets.

And of course these are markets that are expansion opportunities for us, so all of that is really invaluable.

But they're very fine people and they're very excited to be joining Southwest Airlines.

We've added a lot of former AirTran folks into our leadership team and again, I can't say enough good things about our AirTran family members.

They're doing a great job.

Very helpful.

And a quick follow-up for Laura.

I'll recheck my notes related to last year's FAA shutdown.

Did you disclose what the estimated third quarter benefit was?

It's fairly easy to compute what your net benefit was for that at that time, but of course not all the revenue fell all at once.

It was spread across two quarters.

I'm going to let Marcy correct me, but I believe the July benefit was $36 million last year.

So again, I think going back to John's question earlier, that could be playing into some of the comps year-over-year in July as well.

And do you have an August and September figure since revenue recognition would have affected those months as well?

We disclosed those.

So Marcy or Ryan will follow up.

All right, sorry to waste your time with modeling questions like that.

Okay.

Thank you very much.

Take care.

We'll take our next question from Savi Syth, Raymond James.

First question is I understand out of the $700 million, $200 million is coming from the 717 transition.

Could you break out the $500 million between the six seat and the 800 transition?

I don't know that we've broken it out, Savi, but what we have disclosed is with the Evolve, the six extra seats, that's conservatively a couple hundred million a year just from some pretty easy math on that.

You've got the benefits of the 800s and the classics being retired.

That would really make up -- all three of those together make up the $500 million.

And then just a quick follow-up.

Could you provide what early bird and the pets unaccompanied were in the second quarter, as well as what those two and business select was in the first quarter?

So in the second quarter, our early bird was $40 million.

That was up from $36 million last year.

I'll get you first quarter in a minute.

Pets, UMs and excess bag charges were $19 million.

That was -- this is Southwest, again, standalone, that was equal to last year.

And I don't know if I have 1Q in front of me.

Again, I think that's something we can follow up with you, Marcy and Ryan will give you a call.

Thank you.

Operator.

We'll go next to Glenn Engle with Bank of America.

A couple questions.

First, on the 737 classics, now that you're pushing out the retirement of those, does that mean that maintenance is going to remain elevated for a few years?

Well, let me just -- while Laura's thinking about your maintenance question, just to clarify, we had an original useful life planned for our classics.

We accelerated the retirement of those.

Then when we reached the -- in our planning.

Then when we reached the deal for the 717s, we pushed some of the accelerated retirement dates back a bit.

But they're still earlier than what they would have been had we kept them the entire useful life.

So I don't know that that's meaningful to your question.

The depreciation impact that you talked about earlier in the year will be somewhat less than you previously said?

Yes, there's just a lot of things that are going on in our fleet estimates and retirement dates and then are we going to have a 717 deal.

I think all that now is finally settled and Laura has also updated salvage values and just a number of things related to all of the depreciation charges.

But on the maintenance --

Glenn, I'd say to Gary's point, some airplanes still are accelerated, some weren't.

We have 40 classics retiring this year, which is a significant number.

We do expect to see benefit.

All in all, when we look at the total operating cost of the 717 on a nominal basis, compared to our 737s when you look at ownership, maintenance, all the operating costs, they're about the same.

So when you think of it that way, we're not expecting to see maintenance increase as a result of this deal and we'll still get the benefit of the classics that have been accelerated from where they were.

So the current level of maintenance costs for ASM is something that's a good, steady state number?

You're looking at for 2013 and beyond?

Yes.

Yes.

We will give guidance on that as we put our 2013 plan.

But certainly with our fleet plans, Glenn, we expect to see improvements over time with the acceleration of both the 717s and the classics.

The tax rate was relatively low in the June quarter.

What will the tax rate be now for 2012?

Glenn, it was 38% in the quarter and we expect it to be in that 38% to 40% range for the full year.

Why would it pop back up?

Why wouldn't it stay down to 38%?

It all depends on what your nondeductible items are, as well as just what your full year [CBG] is.

That's why we're giving you a range.

But certainly 38%-ish range is reasonable.

Finally, the headcount was up over 5% year-over-year in the June quarter with capacity being down, what's driving that and when will that reverse?

I think that's the same question, same answer that we discussed perhaps as early as in the fourth quarter and the first quarter.

We had -- first of all, we introduced a new frequent flier program that simply required more support at our call centers.

Now as that -- we actually have seen our calls offered this year compared to last year come down substantially.

So I think some of the pressure that we had in our call centers is already behind us.

The other thing that we are always trying to manage, Glenn, is just the right balance of staffing and overtime and other forms of premium pay.

Last year I felt like it was a little bit pushed too hard and we had too much premium pay, so we have allowed for some of our staffing to increase in operating groups across the Company, primarily in the call centers, by the way.

But the overtime and the premium pay and all of those categories are down substantially and the overall unit cost performance in salaries, wages and benefits was quite good in the quarter as an example.

So, I don't expect our staffing to continue to increase.

It has slowed to a crawl.

If anything, for all the reasons that you point out.

So, now all we're doing is simply trying to optimize the cost and the service levels, understanding that we're trying to keep our fleet roughly flat and more importantly, our trips and capacity roughly flat.

And then --

Thank you very much.

Glenn, I was going to add to is on the AirTran side, Southwest is doing a lot of the ground service that AirTran had outsourced previously in the stations that we both -- and we're doing that much more cost effectively but it does mean we have more heads than we had on a combined basis.

Thank you.

We'll take our next question from Hunter Keay with Wolfe Trahan.

So a question, Laura, just to follow up on the CASM ex-fuel commentary for the third quarter.

You said mid to high single digits.

But that was, I guess, you said excluding profit sharing.

Assuming you have a higher profit on an absolute basis, which looks like it's going to be the case, should we expect that CASM ex-fuel off the 739 number to be actually closer to just straight up high single digits?

Am I thinking about that properly?

I think that's probably reasonable.

Let me just walk you through, Hunter, some of the items just so you can understand where the costs are coming from.

But to your point, 2Q on a CASM ex-fuel was up 4.3%, it was up 2.7% without profit sharing, just to put that in perspective.

What we've got in the back half of the year is, I think Dan asked a question on Evolve.

We've got 50 airplanes that were done in the first six months.

I think it was maybe only 40.

We've got 100 per quarter in each of the third and fourth quarters.

So that's going to be expensed and that's going to put more pressure on our maintenance expense in the third and fourth quarter.

But high return on investment on that.

On the airports, we've got some really nice credits that happened to hit in the second quarter.

So all in all, if we look at our airport costs for the year, they make sense but first half is coming in lower.

We are having some adjustments on our depreciation and ownership as a result of the myriad of things going on in the fleet side that are going to hit in the back half of the year.

And advertising is the other item where we significantly were under spent on advertising and deferred a lot of that.

So, again, that's an investment that's going to hit in the back half of the year.

Thank you for that.

That's really helpful, Laura.

Thank you.

And as you think about the buybacks, you guys got very aggressive on this after the announcement, which I think a lot of people appreciate.

Can you maybe give us some sense for the timing of those buybacks during the quarter, sort of obviously there's quiet periods or blackout periods where you can't buy the stock and how should we think about how you think about timing future buybacks?

Do you try to get opportunistic on pull backs or is it more sort of systematic, methodical approach?

Just anything in that area would be great.

I don't think we can give you any answers to those questions.

I think first of all we're managing the business and in particular our operating cash flow.

Secondly, we want to manage our operating cash flow in such a way that it drives free cash flow.

So we'll have -- we'll be thinking about having an available amount of money that we want to provide to our shareholders, but that -- again, that just depends upon the performance and the availability of that money.

I think the other way to think about the share repurchase and the reason that the Board did authorize an increase back in May is because we were anticipating that we would, before the next Board meeting, which is next week, that we would be completing the first authorization.

And we certainly wanted to acknowledge to you and the rest of the market that we're still willing to be a buyer, given the circumstances that I described.

But there is no deadline.

We'll certainly give no pricing guidance or timing guidance whatsoever.

We have time for one more question.

We'll take our last question from Jeff Kauffman with Sterne Agee.

My questions have been answered.

Thank you.

Thanks, Jeff.

At this time I'd like to turn the call back over to Ms. Brand for any additional or closing remarks.

Thank you, Tom.

As always, if anyone has any follow-up questions, Ryan and I are available.

Thank you all for joining us today.

Ladies and gentlemen, we will now begin our media portion of today's call.

I'd like to first introduce Ms. Ginger Hardage, Senior Vice President, Culture and Communications.

Thanks, so much.

Now is the time we would like to begin the media portion.

So I now will queue up the questions for you all to be able to pose those to Gary, Laura and Bob.

So will you please give those instructions?

Yes, ma'am.

(Operator Instructions).

We'll now begin with our first question from Matt Joyce with the Dallas Business Journal.

I wanted to ask Gary what's your take on Spirit's expansion at DFW Airport and how it relates to the competitive field for Southwest.

Gosh, Matt, I don't know that I have any particular reaction.

Clearly, Spirit is one of just a very few airlines that are adding aircraft and expanding in this environment.

And so we're mindful of that and I don't know if you heard Laura's report earlier, but we're continuing to manage well, I think, out of Dallas Love Field and are looking forward to the day when all of our construction is complete over here and the Wright Amendment restrictions lapse.

But Spirit is adding -- they're adding airplanes and they're adding flights and I think that's a fact and they're a very fine airline and we take that competition very seriously.

Thank you, sir.

We'll take our next question from Kelly Yamanouchi with the Atlanta Journal Constitution.

I just wanted to ask for a clarification.

I think there was something I didn't understand about why is it that the net conversion, aircraft conversion costs are increasing by $50 million?

Well, very simple.

Because the cost of converting the aircraft is going to be higher than what we would have spent on it.

And for us to make a deal with Delta, we agreed to pay those conversion costs.

I would just -- just to further explain, we just amazingly found a home for all 88 of those aircraft.

And so you might think of it as a volume discount that we were willing to offer to induce our sublease customer here to take those aircraft.

But that's all it means is that the cost of converting the aircraft is going to be more with this deal than what we thought it would be.

And how -- as to how we make that work, again, Laura explained that the value that we get from not flying the 717s and instead flying the 737s is substantial.

So we'll pay for that conversion cost in the first six months.

When you say the cost of the deal was more than you thought it would be, you mean the AirTran acquisition, right?

No, no, I was saying just the cost to convert an AirTran 717 into Southwest, we were going to spend $50 million.

The cost to convert those over to Delta is going to cost $100 million, because we're spending more money on the aircraft conversion and there's also some modest accounting differences in subleasing the aircraft versus just using it ourselves.

But the fact is, Delta -- the Delta conversion cost is more than what the Southwest cost would have been.

Why is it not less if they're maintaining a front cabin.

Kelly, it really comes down to their design for the spec of the airplane.

So they're going to make more changes to the airplane than we would have.

Okay.

Thank you.

We have time for one more question.

We'll take our last question from Andrea Ahles with the Fort Worth Star Telegram.

I was wondering if you could give a little bit more commentary on your fares.

It looked like air fares were up 5% so you got about $150 is your average fare for this quarter.

If you could talk a little bit more about the fare environment and where you think it's going to be going heading into the fall travel season?

I think it's a little bit too early to tell what you what the fare environment looks like, at least for the second quarter, until we get all the earnings results.

I think we have some idea of what the rest of the airlines' revenue results are for the quarter and they were all pretty good.

I think the airline business right now has adjusted to the state of the economy and higher fuel cost, so I don't see that -- again, based on Laura's and my earlier report, we're looking for a solid third quarter.

We have some distortions with the 4th of July holiday falling on a Wednesday that she commented on.

I don't know if you heard that, Andrea.

I did.

Otherwise, I think our business looks like it's continuing along.

What I said earlier I will just repeat, which is I think it's prudent to be cautious in this environment, just given the state of affairs in the world and our domestic economy.

Aside from those normal cautionary comments, our business is continuing to be strong.

We have very full airplanes and at least no immediate threat of higher energy costs like what we were seeing in the first quarter.

That seems to have steadied.

I won't agree that these are low energy costs, which I heard some commentary earlier this morning on.

They're not low, they're very high.

But at least they're steady and we've adjusted our business to these levels of fuel cost.

And, Andrea, if I could add one thing.

This is Bob.

To Gary's note about just a little bit of caution, I think the second quarter for the first time in a long time was the first quarter where we had no domestic fare increases as an industry that stuck.

Just gives you a little view into how the industry, I think, is thinking about the pricing power and all that.

So that's a little bit unusual that we did not have any fare increases pushed through in the second quarter.

Thanks, Bob, for that added detail.

Gary, I was wondering, you mentioned low energy costs.

With the way you guys are being penalized with your fuel hedging contracts right now because oil has kind of steadied down and is not as high as had originally been anticipated, will that change your approach to fuel hedging contracts in the future since you continue to see sort of a negative impact from those contracts.

But, Andrea, I sort of had the same reaction.

Fuel costs aren't low and we're not seeing any significant penalty from fuel hedging.

Fuel hedging by definition is an insurance program.

And best case is we spend some money on that coverage and never have to use it.

So we had -- I think our folks have done a marvelous job of managing our fuel hedge position.

There was a $0.03 penalty in the quarter, if you want to call it that, $0.04, and that -- so we have positioned the fuel hedge this year to allow for declining prices and for the most part our folks have participated with all of the reduction in fuel prices.

With respect to our program going forward, we're about 30% hedged in the second half of this year, close to 60% hedged next year, about 50% in 2014.

We've got positions in '15 and '16, all that is in our press release.

So no, we'll continue to be very active in fuel hedging, because if you don't have the protection in place, it's an enterprise risk.

So it's really just that simple.

So then the challenge for our folks is trying to spend an appropriate amount on the program that doesn't penalize the Company.

We spent a lot less money on fuel hedging in 2012 than we have over the last couple years and again, I feel very good about our fuel hedging program.

We have substantial protection in place when fuel prices go back up, as they certainly will.

All right.

Thank you very much.

I appreciate it, guys.

And at this time I'd like to turn the call back over to Ms. Hardage for any additional or closing remarks.

We want to thank you again for participating today.

If you think of any additional questions you might have from the media, don't hesitate to call 214-792-4847 and we'll get those additional answers for you.

But thank you so much for calling in today.

And ladies and gentlemen, this does conclude today's call.

Thank you for joining.