西南航空 (LUV) 2013 Q2 法說會逐字稿

Welcome to the Southwest Airlines second quarter 2013 conference call.

My name is Tom, and I will 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 would like to turn the call over to Ms. Marcy Brand, Senior Director of Investor Relations.

Please go ahead, ma'am.

Thank you, Tom.

Good morning, everyone.

Welcome to today's call to discuss our second quarter results.

Joining me on the call today is Gary Kelly, our Chairman, President, and CEO, Tammy Romo, Senior Vice President of Finance and CFO, Bob Jordan, Executive Vice President and Chief Commercial Officer and President of AirTran Airways, and Mike Van De Ven, Executive Vice President and COO.

Today's call will begin with opening comments from Gary followed by Tammy providing a review of our second quarter results and current outlook.

We will move to the Q&A portion of the call following Tammy's remarks.

Please be advised 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 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 now I'll turn the call over to Gary for opening remarks.

Marcy, thank you very much and good morning, everyone, and thank you for joining us.

We're very pleased to report a strong second quarter earnings performance, and we had record earnings, record earnings per share, record revenues, the first half results are records as well.

As with a year ago, we produced very strong operating and net margins and strong returns on capital.

Our cash flow from operations was also very strong and we were able to repurchase $251 million worth of stock as well as quadrupling the quarterly dividend.

The domestic economy was worse than what we have assumed in our second quarter plan.

And really, that is for the fourth year in a row.

Fuel prices were nicely below planned, and that provided a nice offset at least.

To start with, I want to thank all of our employees for a very strong quarterly performance.

I also want to thank them for the tremendous progress that we're making on our strategic plan and especially our five strategic initiatives.

Just to mention those very quickly, as we have outlined in the press release, we are on track with our AirTran integration.

We've got the networks connected, we have got city conversions well underway and aircraft conversions well underway.

And the retirement of the Boeing 717 begins next month, also as planned.

As far as our All-New Rapid Rewards program that we have rolled out in 2011, we are continuing to see very strong result and a very strong performance from that new program.

On the 737-800 front, we have 43 of those units on hand in the fleet as of the end of the quarter, on track to hit 54 by the end of the year.

They are performing as expected and are producing higher than system load factors, which is a real tribute to our scheduling and for the quarter, they were a meaningful profit contributor also ahead of our plan.

Next we have our fleet modernization initiative, which for second quarter was principally the EVOLVE retrofit on the 700s and the 300s/ And that was also a very significant contributor and also ahead of plan.

So all told, the fleet modernization initiatives along with the 800s contributed $89 million of incremental revenue in the quarter.

And then finally, our initiative to implement a new reservation system beginning with international reservations technology continues.

It is right on track and planned for implementation in 2014.

We have a major technical milestone on that project this fall, and I suspect we will provide a more in-depth update on the project at that point.

Be only 2013 project that is off-track is our O&D management system.

Technology was delivered on time as planned, but the results from that new product are not what we really want and need.

So, we are redirecting that effort and still expect to drive a significant benefit, but not until we have a revised approach with that in 2014.

Having said all that, again, the economy has been worse than what was assumed in our plan.

That has impacted our performance and it may continue to, and that simply reinforces our very careful outlook with regards to capacity and fleet expansion.

We have lowered our expectations regarding 2014's available seat miles, for example.

We have significant opportunities to grow the network after next year with the repeal of the Wright Amendment and the introduction of international capabilities.

And of course, those opportunities are in Dallas and in Houston and really to all points in North America.

So, our financial priorities continue, and they are to achieve and sustain a minimum of 15% pretax return on invested capital, reduce our balance sheet leverage and maintain investment-grade credit ratings.

Maintain a total liquidity on average at least of $3.5 million, including our line of credit and of course, continue to enhance shareholder value.

And so with that very quick overview, I would like to turn it over to Tammy Romo.

Thank you, Gary, and thank you, everyone for joining us today.

In spite of the weak revenue environment, our second quarter net income excluding special items of $274 million was a record performance.

Our earnings per share of $0.38 was in line with consensus expectation, and that is up 6% from last year's record results.

To achieve these results with all the strategic initiatives we currently have underway took much hard work, and I would like to join Gary and recognizing our employees for their outstanding efforts during the quarter.

Our revenues for the quarter were an all-time high and benefited significantly from our strategic and other initiatives.

We realized $95 million in net synergies during second quarter from the AirTran acquisition with approximately two-thirds of that coming from net revenue synergies.

With connecting capabilities now in place, we have significantly strengthened our ability to optimize the Southwest and AirTran networks.

Second quarter earnings included $40 million from incremental co-chair revenues, and we were obviously pleased with these results.

Thus far in July, we are also very encouraged by the bookings on new itineraries created from the ability to connect and sell across both networks.

Business Select revenues were approximately $20 million and we recognized approximately $17 million in incremental passenger revenues for our Rapid Rewards Program.

We are on track with our expected $300 million EBIT improvement this year from our fleet modernization efforts with close to half of that already realized in the first half of this year.

Our Wright Amendment revenues were also strong producing $75 million in the second quarter.

Overall, very pleased with the second quarter benefit from our initiatives that largely contributed to our record revenue performance.

On a unit basis, our revenue trends declined in the 2% range compared to second quarter last year on a 3% increase in ASMs.

The increasing capacity was primarily a function of our increased gauge on our aircraft in conjunction with our fleet modernization efforts.

While the 4% year-over-year increase in our seats per trip put pressure on PRASM, the significant unit cost benefit is driving our expected EBIT improvement.

In response to the weak industry yield environment, we launched aggressive sales to stimulate demand, and that led to record second quarter traffic and strong load factors with yields down just a little over 2% versus second quarter last year.

The weakness in yields really crossed off air categories, but our business travel trends measure by closed-in traffic were clearly impacted.

However, unit revenue trends did improve nicely throughout the quarter.

April was down year-over-year in the 4% to 5%, May was down 2% and June was close to down 1%.

For the month of June, trends in the back half were stronger than the first half, and trends have strengthened further here in July with the July 4 holiday being particularly strong year-over-year.

Based on current bookings, we expect July's unit revenues to grow 3% year-over-year and current bookings for August and September also look good.

But please keep in mind, year-over-year comparisons will be impacted the timing of Labor Day this year.

Switching to freight revenues and other revenues, our freight revenues were also at record levels benefiting from increased fuel surcharges and expanding our cargo network with the introduction of Southwest cargo on AirTran flights during the second quarter.

Other revenues decreased 3.1% year over year, primarily due to lower AirTran fees as we continue to transition the AirTran network over to Southwest.

Earlybird revenues to increased 30% year-over-year to $52 million, and we recognized $83 million in other fees, including $4 million from A1 through A15 premium boarding positions at the gate.

We currently expect our third quarter 2013 freight and other revenues combined to decrease from third quarter 2012.

Turning to fuel, our second quarter economic fuel price per gallon was $3.06 per gallon, which was in line with expectation, and this was 5% below second quarter's 3 -- second quarter of last year's $3.22 per gallon, and that was driven primarily by lower jet differentials as the decrease in print was offset by the increasing crack spread.

Our ongoing fuel conservation and fleet modernization efforts improved our second quarter fuel burn by approximately 4% and lowered our second quarter fuel cost by approximately $50 million.

Our second quarter hedging premiums were $12 million as we expected and for third quarter, we are approximately 80% hedged with 70% of our positions at varying Gulf Coast jet fuel equivalent prices and the majority of our protection beginning at $3.10 per gallon.

Our fuel hedging premium cost for third quarter is estimated to be approximately $22 million and based on market price as of July 22 and third quarter hedge position, we currently expect our third quarter 2013 economic fuel price to be in the $3.05 to $3.10 per gallon range, which is well below what we assumed for third quarter fuel price in our 2013 plan.

For the full year, based on fuel derivative contracts and current market prices, our 2013 forecasted economic jet fuel price per gallon is $3.10 to $3.15 which, again, is well below our 2013 plan, which was $3.25 to $3.30 range.

And our totaled 2013 premiums are still estimated to be approximately $60 million, so no change there.

Our unit cost excluding fuel special items and profit sharing increased 1.7% year-over-year, and this modest increase is noteworthy considering those estimates we are making through fleet modernization and our other strategic initiatives.

Clearly, our efforts to control our costs in accordance with our 2013 plan are working.

The year-over-year increase that we saw was primarily driven by increases in salaries, wages and benefits and airport costs, and that was partially offset by lower maintenance expense.

Our EVOLVE retrofits contributed less than 0.5 point to our second quarter cost inflation, and with 700 retrofits now complete, the second half of this year will experience minimal cost pressure related to our EVOLVE retrofits.

Based on current cost trends including our fleet modernization and other cost control efforts, we expect our third quarter unit costs, excluding fuel, special items and profit sharing, to increase slightly from third quarter's 2012 $0.0772.

This tracks in line with 2013 nonfuel chasm plan that assume a 1% year-over-year increase on our nonfuel unit cost, excluding special items and profit sharing.

On the nonoperating cost side, our net interest expense declined year-over-year, primarily as a result of continuing to pay down debt, a trend we expect to continue in third quarter.

Turning to the balance sheet and cash flow, we had strong cash flow generation during the quarter to end with $3.4 billion in cash and short-term investments.

Through the first half of 2013 we generated over $1 billion of free cash flow and in May, we made several announcements that acted on what we communicated our December investor day in regards to our focus on aggressively managing our invested capital and seeking ways to return value to our shareholders with our cash flow generation.

As Gary mentioned, our board of directors quadrupled our quarterly dividend and increased our share repurchase authorization to $1.5 billion.

And the authorization included an accelerated June repurchase program, which was completed in June.

Our repurchases under the ASR program totaled $250.5 million, or approximately 18 million shares.

Through the first half of 2013, we returned $394 million to shareholders through share repurchases and dividends and over $1 billion since May, 2011.

We made approximately $50 million of debt payments during second quarter, and we have approximately $100 million in debt and capital lease schedule payments for the remainder of the year.

Our $314 million of total debt payments planned this year include $139 million of prepayments for AirTran aircraft backed secured loans made this year.

Based on our scheduled debt payments, our leverage including off balance sheet aircraft leases, is expected to decline to the high 30% range by year-end, and there has been no change to our 2013 capital spending forecast which remains in the $1.4 billion range.

Before we open it up for questions, I will provide a quick recap of our fleet and capacity plans thus far.

We have taken delivery of 9 of 18 planned -- 800 firm orders and 2 leased --700 aircraft.

And on the retirement side, we are still expecting to transfer 16 717 to Delta this year and combined with our classic retirement schedule, we continue to manage to a relatively flat fleet.

On the capacity side, we continue to expect our 2013 available seat mile capacity to increase modestly in the 2% year-over-year range.

And for 2014, we currently plan to keep capacity in line with this year.

We are on track with our plan to implement Southwest international reservation system by the end of next year, and we will then be able to complete the transition of our AirTran --700s while continuing to transition the 717s out of our fleet.

All this while continuing to retire our less fuel-efficient classic fleet.

Overall, 2014 we'll see a lot of movement within our fleet composition, however, we remain focused on keeping our fleet relatively flat in 2013.

In conclusion, we are making great progress on our 2013 plan and while revenues in the first half were softer than planned, recent revenue trends are encouraging.

Our strategic initiatives are largely on track with our 2013 plan with one exception.

Migration of the ONT revenue management system has begun as planned.

However, we are not yet fully comfortable with the results being produced versus our current method.

So, we have chosen to continue our cautious rollout in a way that is even more gradual than we originally anticipated.

As a result, we are currently expecting sizable incremental revenue benefit to fall in 2014 rather than 2013, which is what we originally planned.

That said, our 2013 plan assumed many of our other strategic initiatives would contribute more significantly in the back half of this year.

Further, our efforts to control our unit cost are working, and fuel prices remain below last year and below our plan.

Again, our 2013 plan assumed fuel prices higher than we are currently running and a stronger economic environment than we have experienced thus far.

Together, these trends have created a potential shortfall against our plan And while our outlook in the second half of the year is encouraging, our first half results were significantly impacted by the economic weakness which makes our ability to achieve our 15% pretax return on invested capital planned this year more challenging and less likely.

However, we are not giving up nor losing focus on our plan and our expected results for the first half of the year, while short of our plan, are solid and provide great momentum.

Based on our current outlook, while we may not hit our 15% by year end, we are making excellent progress and we will not stop until we reach our goal.

And with that, we are ready to take questions.

Thank you.

(Operator Instructions)

John Godyn with Morgan Stanley.

Thank you for taking my question.

Gary, in some of your remarks you mentioned a pattern of economic weakness weighing on results and surprising you.

I am just curious, when you think about the customer segment that you serve, the nature of that segment, do you get the sense or do have the feeling that there are any kind of structural or secular overhangs on that segment in particular within the context of the economy?

Because after all, we have seen positive GDP growth.

It's admittedly been sluggish, but it has been positive for the last few years and we have seen it seemingly weigh on Southwest a bit more than peers.

I was just hopeful that you could comment on that and give some perspective.

Yes, I guess it is afternoon for you John, so good afternoon, and thanks for the question.

First of all I guess, just taking some of your thoughts in reverse, I wouldn't agree that it is weighing on Southwest any different than anybody else.

There is a long string of years, including most of the four year period that I was referring to in terms of the economic sluggishness where we outperformed the rest of the industry.

And I think Tammy mentioned in the way that you are thinking about how we compare right now, just make sure that you take into account the increase in the seats per departure that is going on right now.

That is a good 4% to 5% increase and creates at least an arithmetic drag on RASM comparatively.

The only point of all of that is I don't see that we are out of step at all with the industry.

If anything, over the last five years we have outperformed.

With respect to what secular changes might be taking place right now, I don't know that I really see anything going on there.

At least what we can report to you is that our trends were very solid and stable on a unit revenue growth perspective dating back to, I would call it September as a starting point, and all the way through most of February.

And then we were off of our sequential trends taking into account seasonality and the timing of Easter holidays, et cetera, beginning in March, and we really haven't regained a trend relative to that previous periods since.

Now, we have seen some encouraging signs here in July.

But Tammy, I don't know that I would say that July relative to June is a lot better than a normal June to July trend over history.

So it's -- even though we are seeing a nice comp to a year ago July, it is not like the June and July trend is a spectacular.

I think that the weakness is twofold.

I think it is both in the government/business travel segment as well as consumers.

We had a record monthly load factor for the month of June at 85%, but Bob Jordan and his team had us on sale quite a bit to drive that traffic.

I guess the bottom line, John, is no, I don't think there is anything that is all that unique going on here.

I think relative to a longer-term comparison, maybe 10 or 20 years, there's no question that they traffic in short-haul markets is less today than it used to be.

So, I think that's probably the only thought that comes to mind about a secular change.

And I am not ready to predict that the short-haul markets won't show improvement in the next decade, but clearly the growth within the airline business over the last decade has been in longer haul trips, which is why we are pivoting more at Southwest towards longer versus short trips.

And the medium haul market around 1,000 miles, interestingly enough, are relatively flat over the past 10 to 15 years.

So, absent that, which I would attribute more to increased fares because of increased fuel cost, I don't really see anything going on right now that would suggest some dramatic change.

We've got the federal sequestration and another debt ceiling fight looming, and I think we've all got to be very mindful of that in assessing what happens to air travel demand.

All of that uncertainty along with higher taxes this year I don't think it's any shock.

As you said, I don't think it's -- actually, we weren't shocked that the GDP was weaker.

Our point was simply that we built a -- an annual plan with -- we have to make assumptions, so we made an assumption about the economy, we made an assumption about the fuel prices.

And one of those is a good guy and one of them is a bad guy relative to our plan.

Thanks for that that's very helpful.

I'm just curious, I think its fair to say that your average customer is a bit more price sensitive than maybe the average customer of a legacy airline.

Do think that degree of elasticity is potentially a headwind on the margin when we find ourselves in a situation where the industry price umbrella continues to go higher?

Is there a volume drop-off that we need to think about as those prices go up that might impact you more than others?

Just your thoughts there would be helpful.

I don't know John.

Again, I don't know that I'd buy that, at least in 2013.

Maybe that argument made more sense in 1975.

Fares aren't cheap for a lot of Americans.

And so even though we are a low-cost, low-fare carrier, that could be where a lot of the short-haul traffic has gone.

So, we're the largest airline in America by a wide margin.

We have a very broad appeal across the United States, and I just don't see the argument that our customers are more price sensitive.

By that definition, I think you would see a lot more volatility in our traffic.

We can get the traffic.

We can prove -- we grew are available through seat miles 3% and we filled them up there in June.

So, I think bottom line no.

Now, in a more macro sense, you and we know that we are a low-fare brand, and we work harder to be lower than everybody else.

And the -- close to the majority of the time that is going to be the case when people shop for Southwest Airlines, but those are still fares that -- they are just not as low as they used to be for all the reasons that we know.

Thanks, appreciate all the good color.

Helane Becker with Cowen and Company.

Thanks very much, Tom.

Hi guys, thanks for the time.

Just this one question, do you prefer higher yields or higher load factors?

I think that one is easy.

I think because we are a -- we start with serving our customers and think of ourselves as a low-fare brand, clearly we want to be the lowest fare going.

I think all of us would admit, if you asked [Mike Nanva], our operator who is sitting here, he would say it is certainly easier to manage an operation when the airplanes aren't quite as full.

But I think that is probably over thinking it a bit and clearly, we want to be the low-fare brand with the best customer service.

We like full airplanes.

Okay, and then -- so then you would prefer higher load factors would be you're answer right?

Yes.

And then can you speak to -- I think your comment that you are by far the largest airline in the US, can you speak to regionally what you're seeing?

Is there -- are you seeing better strength in your core Dallas, Texas West Coast markets than you are seeing in the Northeast or other markets?

Is there something that maybe you see share shifting or something like that, that would account for some of your disappointment on your first half?

No.

And again, my disappointment is in the economy.

The -- in terms of what I think we would be comfortable sharing for competitive reasons, the markets that are in more of a transition from AirTran through some step process into Southwest, those are the ones that are in more development.

So, if you think about the Atlanta, Baltimore, Milwaukee, where there is a lot of change taking place, those markets are not performing as strong as markets that aren't affected by that kind of transition.

That is very clear.

The other thing that I would mention is that -- and we have shared this before.

The government travel which is defined -- I am defining as a customer flying on a government fare, so it is something that we can readily identify, that traffic is down dramatically.

And Bob, I think you said as much as 50% at times.

I think a rule of thumb, Helane, would be down 35%.

There are markets where we do see some weakness along the East Coast where you can sense that there is a lot of military or government travel beyond what we can actually track on the fare, and that does seem to support that.

But I think we all know that sequestration is real.

I spent a lot of time in Washington and they're definitely managing through cuts and beyond that, I would say that the regions look pretty consistent across the country.

Okay, thanks for the color.

The only other question I have is, I think you guys have a $1.5 billion share repurchase program in place, right?

I don't know how far you are on it, but that is 15% of the market cap of your Company, and yet the market doesn't seem to care.

They don't seem to react to that maybe.

Maybe a dividend or bigger dividend is more of the right answer?

I don't know, what do you think about that?

Got a lot of thoughts on that.

The stock is up nicely in a one-year period, so there has been a move.

Pinpointing it to the cause is probably multiple reasons for that.

But number one, the stock has performed over the last 12 months.

We're managing our balance sheet, we are managing our liquidity, and it is a -- what you're saying is true.

It's a testament to the strength of the financial strength of the Company.

And through the toughest of times, we have been able to repurchase how many shares over the past five years?

100 million?

There is a significant amount of shareholder value that has been created.

And Helane, again, when you say that, you look at our valuation relative to our peers and the valuation is still very strong at Southwest Airlines.

I wouldn't conclude that we are not being rewarded, and it's just a matter of as to our shareholders being rewarded enough.

We do have a $1.5 billion share repurchase.

We have done about two-thirds of that, so we've got about $500 million to go.

I think all of that is in the release, maybe it's 525 million or so.

We're at $976 million, or 100 million shares.

Right, so we have got $500 million plus to go.

We have -- as you know, we have increased the dividend in two steps.

We have been paying a dividend at Southwest since the 1970s.

We have stepped it up, I think we doubled it last year and then we quadrupled it this year.

So, the yield is very respectable.

It is over 1 point.

Somewhere in the 1.2, 1.3 range, but that is just the background to your question.

I think the answer specifically is we are going to continue to monitor both of those and with the primary focus being on hitting a return on capital.

We're being very aggressive in the way we are managing the invested capital of the Company on the denominator side and have some very nice opportunities here to modernize the fleet and still access the preowned market which is just a lot more capital efficient these days.

Plus, we would love to take new deliveries from Boeing once the max is available.

All those levers are being monitored and pulled where we can, and like Tammy summarized, I think we are making outstanding progress and I think our folks are doing a great job on all those fronts.

Helane, I wanted to make sure you had all the numbers that you were wanting there, just to summarize real quickly.

Under our $1.5 billion authorization, we are at $976 million, which is 100 million shares and over the last five years, we are at 220 million shares.

Great, okay.

That's great, thank you very much, you guys.

Have a great day.

Thank you.

Michael Linenberg from Deutsche Bank.

Hi Tammy.

Gary I want to go back to --you maybe comment on the O&D system, I guess the implementation didn't go as well and then it would be ready until 2014.

When in 2014 and can you elaborate on that?

What happened, was it just the rollout messing with your system?

Love to.

And again, I think the -- and Bob Jordan is going to describe this, but the way to think about it, Mike, is the technology was delivered.

It's not a technology or system thing.

We are trying to change from a segment-based revenue management system to an O&D revenue management system and with the understanding that going to O&D dramatically complicates the predictability of the revenue.

I am going to let Bob talk about that for a few minutes and at least perhaps explain better what pieces we are confident that we can deploy as we continue to -- I would call it not experiment, but just run in parallel the segment system compared to the O&D system.

Right now, in other words, it is not a failure.

What we're proving is that our current system works actually very well and better than the new system.

Although again, there is some really good things that we want to get in the new system.

Bob, you want to see if you can answer Mike's question there?

I might.

Hi, Bob.

The O&D system is really a couple of things.

There's a new forecaster, so that the ability to provide better data on demand, and that piece is going really well.

We are seeing at least what we expected or maybe even a little better in terms of having better data to predict the demand and then therefore, obviously managing that better and producing a better result.

That has gone very well.

The second piece has then using that data to now manage, as Gary said, the flight demand on an O&D basis versus a segment basis.

Using the new system to manage the inventory buckets and all that.

That's the piece that is a lot trickier, and there is a lot of science in it.

And we've got a number of dates that are being run by the new system, and we just want to watch across the demand curve, be a little cautious here and make sure that the new system is managing the inventory buckets and at the end of the day, producing a better result than our current system.

A lot of what it is doing is validating that the current system is pretty darn good, but I've got confidence that the new system will be even better.

We just want to be cautious here because there is a lot at stake and we've got a number of days in test.

And so I do expect a modest benefit here in 2013, and then the full benefit we have talked to you about in 2014.

I expect this fall we will see those test dates prove up and then we will move into a broader implementation here late this year and early in 2014.

But the larger driver of the value actually is a better forecaster, and that part is going very, very well.

Mike, I think one of the challenges that we were warned about is that our O&D combinations are -- they are not infinite, but they are so great and so complex compared to a hub and spoke carrier, and we are finding this.

We are finding that we're just not certain yet that that aspect of this technology will prove to be better than what we've got.

But like Bob was saying, there are some wonderful pieces of the technology that will prove to be beneficial and will be deployed.

And whatever Tammy says is that we think the value is still what we have hung our hat on here, which is, I think $100 million.

It just won't come now until we take it a little bit different approach with the deployment of the system and the benefits simply get deferred to 2014.

Gary, I would say I don't think there has ever been an O&D system adopted by a carrier with as dense a route network as yours.

You are exactly right, sir.

That's exactly right, really first primarily point-to-point carrier making the move to an O&D system, so it is very complicated.

We may be able to get 80% of the benefit, in other words, without going full up on O&D.

But anyway, we're working through that, and what you haven't had happen is the classic airline bust by moving to the new system.

So, we have not done that and obviously, I am very pleased about that or go

Good, then just one second one.

You talked about a milestone technology that you would achieve in the fall, but maybe it's something you can't elaborate on?

Or can you tell us what that is about or is that under wraps?

All I meant there -- no, no, I was talking about the international system, and that we have a major technical milestone related to that.

And I think that would be an appropriate time for us to consider a more robust update for you all.

Right now, we haven't told you a whole lot about the system or about when things will be sold and flown, et cetera, and it's just a little premature for that.

But we are making good progress right along our timeline.

If we meet that milestone in the fall, it will obviously be up to Tammy, but that is the next major event with that project.

Okay, great, very good, thank you.

Hunter Keay with Wolf Research.

Want to ask you about some of the activity you've made on the -- some of the change you've made to the AirTran network on the fee side since December.

You announced some higher bag fees for AirTran there.

And just last month, you raised change fees at AirTran.

I wonder if you could tell me what you have seen in terms of changes, some behavioral changes since those fees came on.

And maybe at a higher level, are you experimenting here?

Or if not, maybe just help explain the rationale for trying something like this.

Thank you.

Thank you Hunter.

I think -- no.

I'll just take your points in reverse, no, we are not experimenting.

I think what we are -- simply what we are doing is managing two different brands on this -- during this transition period until we can ultimately fold AirTran into Southwest.

Having said that, I would agree with the direction of your thoughts, which is there are things to be learned by having a different brand and having fees and clearly, we are trying to make those -- provide those insights and make those assessments and judgments while we have AirTran operating separately.

The other noise though, Hunter, that is taking place during this year is we have now connected the networks.

And if you -- because of the Southwest brand and the no fees approach if you do -- if you understand, I am sure you do, the co-chair, on the marketing carrier side of this, we don't charge those fees.

So, you do have AirTran itineraries booked through Southwest where there are no bag fees any longer and that is really distorting the -- you don't have a clean laboratory environment here to evaluate the revenue potential from a bag fee, in fairness to your questions.

Now, trying to go back in time a bit and evaluate AirTran performance with these versus Southwest performance without, there is no question that the Southwest without approach has been superior.

That was one of the main value drivers in acquiring AirTran in the first place is that they under perform on a revenue basis compared to Southwest, and that has certainly has been true since we've owned them.

Very helpful, thank you, Gary.

And a question for you as to how you hedge fuel.

Do you -- I noticed you loaded up on the hedges a little bit after the first quarter, you ended the year without much hedge protection.

Do you decide to buy more hedges when you see weakness in your demand?

With the anticipation that weaker bookings are going to forecast a weaker energy price environment or vice versa?

Because if feels like the hedging strategy is pretty dynamic.

Do you look at the two together?

Do look at one is a leading indicator of the other?

No, I think it is simply trying to -- again, the industry has an array of risk, and we try our best to identify what the enterprise risks are and then deployed mitigation techniques that are cost effective.

We have a hedging program which philosophically is viewed as insurance.

So, we try to spend no more than what we would spend on aviation insurance coverage in terms of premiums, and that is a significant element of answering your question.

And then just like we do in insurance and what you would do at home, if insurance is cheaper, it's an opportunity to buy more if you want to think about it that way and it is certainly the way we manage our aviation insurance.

When it gets more expensive, then you might try to manage that cost by taking on a little more risk.

Said simply, you might have a larger deductible.

We will think about hedging opportunities in that way.

I don't see that they are as directly linked to the revenue environment for one simple reason.

We're in the business of flying airplanes.

We have to have jet fuel to fly.

It is not a reach to say that we know we are going to be buying jet fuel in 2014 and therefore, we ought to be looking for opportunities to protect ourselves on price.

We are in this wonderful environment right now where the market is significantly backwardated.

I'm not enough of an expert to -- I'm not an expert, but I'm not enough of a student to know whether this is a record level of backwardation, particularly with the brand market.

But it does present interesting opportunities if you go out into the futures market.

The 2013 was real simple.

We went through a really coaster already this year, and I'll bet you our fuel price budget -- not budget, but forecast for the year has swung well over $1 billion from peak to trough.

We had opportunities to load up some coverage at a very low cost and protect AOP, if you will.

And that's what you saw taking place, I suspect, from some point to some point.

But yes, we're 80% hedged here in the third quarter and I believe, Tammy, are we 85% in the fourth?

That's right, and one other thing just to note in response to your question Hunter, we did, as you pointed out, we lighten our fuel hedge for the third quarter to 80% and with that move, we locked in $0.01 gained which is, of course, reflected in the guidance that we gave you.

Okay, thanks a lot.

Duane Pfennigwerth with Evercore.

Hi, thanks.

Tammy, have you given us your expectations for 2014 CapEx?

We have given you our aircraft CapEx, which is $1.2 billion.

And what are you typically assume over that level?

Well, what we have here in 2013, we have not given you 2014, but just as a benchmark, we are about $0.5 billion here in 2013.

We'll firm that up for you later this year.

Appreciate that.

Now, I just wanted to ask you, it's not a big needle mover in terms of revenue, but I believe you had an announcement around live TV in the quarter.

And if I follow this logic correctly, at one point you were charging it -- charging for it along with WiFi, and then you moved to a free model with a partner there.

So, that probably cannibalizes some from your Wi-Fi product offering.

I'm just wondering, how do you think about that value proposition to the customer?

It seems like it could be an opportunity to charge for something.

And how do you think about giving more value and what does Southwest get in return?

Well, the -- first of all, I think we did about $5 million in revenues, and that doesn't speak to the cost of providing the Wi-Fi during the quarter.

There's a $5 million revenue benefit, and that was a significant increase from year ago, although again, it's still a relatively small number.

It speaks to the point, which is the take rates are still pretty modest, the live -- our TV offering is a promotion, so we are not telling you that it is free into infinite.

And that is a partner arrangement that we have with Dish.

It is obviously intended to drive trial, and the television product is awesome.

So, I think we are hopeful that people will try it and like it, and we are not speaking today as to whether or not it will be free into infinity or even in 2014, for that matter.

So, hopefully that answers your question.

Okay, thanks.

Thanks for delving into that detail.

And then just respect to Atlanta, you are probably reluctant to give us this, but can you talk about unit revenue growth in Atlanta versus the rest of the system?

And then just your footprint there today, how much supply are you taking down in the back half, and when does capacity cutting in Atlanta stop?

Thanks for taking the questions.

Sure.

No, I won't answer the question about Atlanta specifically as to how it is performing; however, I will certainly tell you that it is very much in development and transition.

So, we have taken steps to begin the de-hubbing process, and that is sometimes painful to work through because you cut off flow, as you will know.

And then Bob has already published a schedule for November, which takes that final step, if you will, in AirTran to move the flight activity to be throughout the day rather than concentrated into two major bank.

An so there is a complete unhubbing at that point.

We'll still have a lot of connecting passengers, but it will be a shift to much more heavily weighted towards nonstop passengers.

So, our capacity plans are pretty we'll known, I think, Bob, based on that.

And what we will do with Atlanta after that will be dependent upon the results, obviously.

So, I can't -- at this point I am not really ready to handicap whether the flight activity goes up,down or stays the same, but at least with this initial step that we're taking in November, the total flight activity Bob is what?

Our schedule this fall is in the 165 to 170 flights a day, which is not significantly different than what we have had in the market for a while now.

What's different again, as Gary mentioned, is the type of schedule.

We're moving to much better local timings rather than a hub structure that has a lot of flights late in the day and very early in the morning.

It should be much better local market.

But the overall flight schedule in that 165 to 170 is not a lot different than what we have had for quite a while in Atlanta now.

It makes a very consistent with where we are in Denver, where we are in Phoenix, that is quite a bit larger than where we are in Dallas and actually, even Houston, which is an original city also.

That's a lot of flights, and I think that we will have a much improved schedule here beginning in November.

Okay, thank you.

Savi Syth with Raymond James.

On the connecting the network side, it seems like there are some operational hiccups associated with it may be on the bag losses and maybe some customer unhappiness if you book through Southwest versus if you book through AirTran.

Wonder if you could quantify what the impact from that has been, and have you been waiving any AirTran fees as a result of operational issues?

I wouldn't accept any of that.

I think that in terms of having an interim co-chair or network connection for the vast majority of our customers, what we offer works just fine.

As per usual, when we have irregular operations, in other words, flight delays or cancellations which happen infrequently, then it is more challenging.

But on the whole, it has worked out extremely well.

So no, we are not losing any more -- it is an undetectable effect of the issues that we have.

Understanding that everyday we have delays and cancellations and bag challenges.

So, there are a few more with this interim product, but nothing of anything that concerns us.

And yes, there has been some media attention to that lately, but again, that is a very, very few number of customers that are affected.

Okay.

And then on the -- a follow-up on the Atlanta question, what's the -- what should we see after this November implementation of the new schedule?

Where should we see -- how should we see the improvement in the earnings?

I think Atlanta has opportunities to improve.

It is not optimized today, nor is BWI or Milwaukee or Orlando, which are three other major overlap points.

So, all of those markets as we continue to optimize the schedule and transition flights out of the old AirTran approach into a new Southwest approach will probably have some risk that in the short term those markets will take a dip.

Especially if it is a new city pair.

In other words, just because we're switching flights from AirTran to Southwest does not mean it is the same flight.

It could be a brand-new city pair, and we could be discontinuing a city pair that AirTran had.

It may take a dip, and we see that as a new developing market.

But our expectation is that they are going to develop very quickly, and that's what we were referring to in the press release.

Understood, thanks very much.

David Fintzen with Barclays.

Good afternoon everyone.

Good afternoon.

Coming back to RASM, and fully appreciate the economic base lines are pretty volatile.

Coming at -- if I think about the second half, you've got the upgauging drag that you referred to, which I would think of largely in the run rate.

You also have then the coach air benefits and some of the positives from the initiatives.

As we look at say 3% July, and who knows where exactly domestic ATA or A4A will shake up, but is that relative performance how we should think about the balance of the second half for -- does the bad guy of upgauging offset the good guys in the optics in RASM?

Help us think through the relative to the industry, because obviously the baseline is changing in terms of the economy and it will probably change if not again, multiple times by the end of the year.

We probably ought to let you just work with IR on that as time goes by here too because I think there are a couple of moving parts.

But the seats are the big thing that is different, and I don't think it's immaterial here.

It's 1 point or 2 effect on RASM.

And I'm talking about within Southwest RASM.

It is comparing, for example, second quarter '13 versus second quarter '12.

But it also distorts somewhat the comparison between our RASM change compared to the industry.

There are a couple of thoughts there.

Now, I think what Investor Relations could help you with is how does that ongoing year-over-year seat density, to use that term, how does that play out over the next couple of years?

And we can certainly do that.

You're going to continue to see an increasing mix of 800s.

You've pretty much got the full-up effect of converting to the EVOLVE seats.

But remember now, we are just now going to start retiring 717s and replace those with 20 more seats in terms of 737.

So, this is going to play out over a while.

Having said all of that, what we are seeing so far in July is 3% unit revenue gains and feel pretty good about that.

The other thing to take into account, and Tammy made this point, is that yes, there is a RASM effect; but just because the arithmetic shows that doesn't mean it's a bad thing because there is also a chasm benefit.

And we're very confident we are seeing margin expansion because of the upgauging.

And that is the important thing to note.

Just need to make sure you've got them both work in tandem in the way you model, and the good news is we are seeing really strong RASM, especially considering that kind of a drag.

Another way to come at it, the initiatives that are obviously very -- should be margin accretive in the second half, are they -- are the positives of revenue in terms of -- things like co-chair, obviously talked about the O&D revenue management, but are those really, think of that in the run rate by July?

Or is there also a positive phasing that is yet to come as we move through the year to balance the negative arithmetic of --

I think it is both.

I think there are -- you will see an increasing mix of more seats per departure, which should continue to enhance the margin as time marches on, between now and the end of 2015.

And again, between now and then, the major contributor is probably -- I'm just thinking out loud, it's probably going to be the 717 retirement in favor of replacing it was 737s.

That is point number one.

Point number two is that you have yet to see the real benefits of the network optimization and also the maturing of the transitioned AirTran markets into Southwest.

So, we have put a lot of chips on that initiative, if you will, and we're just now getting started with that in the second quarter.

So, we are looking for and expecting an uplift from that from second to third and then more again from third to fourth.

We have been talking a little bit this afternoon about Atlanta as an example, so Atlanta is a visual out there that happens in November.

And again, I think what I was alerting you to was that initially there might be a little hit there from Atlanta, but it's all being done with the thought that you are going to have a much better revenue producing route system in Atlanta once we make that change.

Those are just examples of things that we will continue to roll out.

Tammy, do have some other color you want to add there?

Yes, the only thing I would add on the run rate for RASM is, as Gary mentioned, the impact of the increase and seats per trip probably had about a 1 to 2 point RASM impact here in the second quarter, probably closer to 2. And in the second half I think that would soften in a bit, simply because we had some upgauging in the second half of last year.

So, it should ease a bit as we go into the second half, but there'll be still some impact.

I can tell you understand all this very well, but just to make sure we are not confusing anybody else.

As to the question from a business perspective of whether upgauging the fleet is working and oh yes, we've got more than ample evidence that that is a fact.

As I mentioned, the 800s,, we are filling those extra seats and we are filling the 800s at a higher rate than our normal system average.

So, we can tell you exactly what revenue was generated on the 800s.

And then the same is true for the 700 EVOLVE aircraft.

My recollection is, Tammy -- you know, David, that we have added 6 seats per aircraft, and I believe that we filled 3.6 seats out of those 6. And it's virtually -- the incremental cost of that is virtually nil.

So it's -- so the business side of it, the profit side of it is all there, it is just how you measure some of these metrics on a per available seat model basis can get a little distorted, which sounds like you understand perfectly.

Exactly.

And just one real quick, the 64 300s on EVOLVES, that sounds like the same number, I just couldn't remember.

I thought you said the 300s were -- some 300s going to EVOLVE.

Is that more 300s, or is that just the repeat of the numbers?

Our plans are unchanged.

I think -- I know, and I think just when we shared that with you I am not sure, but Tammy is reminding me, there are 78 300s that we consider to be eligible for the EVOLVE seating just based on the time we intend to keep them before retirement.

And we have retrofitted 14 of those with 64 to go.

Okay, great, appreciate all the color.

Jamie Baker with JPMorgan.

Hi, everybody.

Tammy and Gary, I realize synergies or somewhat in the eye of the beholder I suppose, but you did cite a $90 million figure for the second quarter as I recall.

And just for kicks, if we take that out of your operating profit, then things seem to have gotten quite a bit worse year on year.

Like down 20%.

And of course, fuel was a good guy year on year.

So, you've got other airlines out there with no synergies that still achieved improvements.

Doesn't this imply that the core operation at Southwest is rather ill?

I am sure you disagree with that characterization, but the second quarter numbers paint a very discouraging picture.

I think that is a fair question, but I think really your first statement is the most appropriate.

Which is, it is really hard to think about these pieces in a disconnected way.

The whole organism has to -- it takes everybody for it all to hold together here, and I think that's a very fair assessment.

There is definitely an impact on the revenue performance as Southwest and everybody else from the economy.

So, we are not out of line with everybody else.

Relative to thinking about these baselines, Bob Jordan and I were talking about this earlier this morning.

Nothing ever stays the same.

Whether you're comparing us to brand X or brand Y, everybody is continuing to do things plus or minus to themselves in addition to what is going with the water level.

I would agree that all of that is hard to piece apart.

We know that there are some penalties in our current route system that are being incurred because we are still sub optimized.

It's more visible to us today, in other words, than it was last October for this second quarter where we are underperforming in certain markets.

And also, we actually have a fairly large number of brand-new markets which I would put into the developing category, and we are expecting them to develop rapidly.

Those, Jamie, are some of the offsets, if you well, to all the good guys that we have been listing.

But then it all falls into the same description of we need to continue to take this combined route network and optimize it.

So, the base business, if you think about same-store sales, when we get all the noise out, our same-store performance looks quite good.

So, I would actually take it in reverse.

If we didn't have all this noise, gosh, we would have really good results.

In any event, we're very confident that these new markets that we have established -- Bob, what is an example of a new city pair?

So Jamie knows what we're talking about.

A mix of market that are new, again, as Gary mentioned before, from AirTran and then a new mix of markets that are new to Southwest Airlines.

A good example is adding -- we're adding this Houston DCA route here --

But out of Flint, Michigan, we were flying to Atlanta and now we are going to be flying to --

You're connecting to Atlanta, now you are going to Baltimore.

Now we're going to Baltimore.

So, that Flint to Baltimore is brand-new to all of us.

And that is a -- we have to treat it like a new market, and we expect it to develop very rapidly.

You'd fully expect, particularly with the connecting network we've got behind Baltimore that that Flint route will do very well because you've got so many additional places you can connect to.

But it does, again, it's a new market because folks in Flint have to learn that they can -- that that is the schedule and they have to --

Yes, but guys, airlines have new markets all the time and I just have to push back on the comment that you are in line because you are out of line.

I guess you have company with JetBlue here, Gary, but everybody else, even with your synergy figures, everyone else got better in the second quarter and you didn't.

I don't see how that is in line, but again, I guess it is subject to interpretation.

I've answered your question.

It's a fair one, we have a lot of things going on that are good and we have some things that are offsets and we also have the economic drag but that's the answer.

And in fact, we have a lot more new markets under development right now than I think any of us would like.

But we want to get this transition done obviously, and get to a point with the route network that is productive.

If they don't perform, we will simply continue to make those adjustments and eliminate the flights that don't perform in lieu of better market opportunities.

And what that also ties directly into is that we need to be very mindful of our capacity plans for 2014, and we do have a more cautious outlook for 2014 based on current results.

Okay.

Fair enough.

Thank you.

Thank you, sir.

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

Thank you, Tom.

Thank you all again for joining us today.

And if you have any additional questions, of course we will be available to take those calls this afternoon.

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

I'd like to first introduce Ms. Linda Rutherford, Vice President of Communications and Strategic Outreach.

Good afternoon, everyone.

We'll just take a moment if you have a question for the team here and queue up.

The operator will give you instructions to do that so we can take your questions.

(Operator Instructions)

Terry Maxon with the Dallas Morning News.

Got a couple of questions about the LaGuardia incident.

I know you can't say what happened, but first of all, is there -- have you learned anything in the three-days since that is caused due to do any inspections or have any type of reaction with the rest of your fleet?

And secondly, their plane look certainly repairable.

The question simply, can that -- how soon will it take to get that airplane back into service?

Terry, great questions.

I just can't talk about any of that at this point.

We are obviously very pleased and very thankful that there were no serious injuries.

I was very proud of the response that our folks had in safely evacuating the aircraft.

The first responders in New York did a fantastic job as did the Southwest employees in New York.

I can speak about that.

But anything about the situation or the incident, I just can't talk about.

NTSB obviously is, as usual, leading this investigation.

We are in full support of that.

We should have a lot of information in data to get all the facts and make good judgements about whatever we need to do.

If anything, to make changes going forward.

The second part of that question, any question about whether or not that hull can be put back in service?

I would put that in the same category, I think it's a bit premature for me to make that assessment.

But obviously, by the NTSB's report that they're going to investigate -- do a full investigation, there is damage to the airplane and we're going to need to be thoughtful about that.

Mike, is there anything you want to add?

We used to have access to the airplane maybe over the last day or so.

We will have a group of people from Boeing come, then will look at the airplane, give us some alternatives, and then we will decide where to go from there.

Thank you.

David Koenig with the Associated Press.

Hi, Gary.

[Generally] folks, your line item still was down, saved money there, labor was up almost as much.

Maintenance was another line that was down, and I'm wondering how you will able to cut $10 million out of maintenance, is that from outsourcing?

And also, are labor costs part of maintenance, or is this hardware that is in that line item?

That is what is referred to as maintenance materials and repairs.

So, the Southwest employees are in the salaries, wages benefits line.

The repairs would include outsourced labor, if you will.

So, if we -- as we have done traditionally, we outsource our engine maintenance, so any labor cost that is embedded in that will be in that line item.

Maintenance inherently will fluctuate.

One activity that was completing during the second quarter is our EVOLVE seating retrofit.

Some of the costs are capitalized, some of them run through the expense line, but I would expect that spending to ease as we go forward.

Last year was pretty high in terms of our maintenance spending because we were ramping up that activity.

But in particular, Tammy, do you want to speak to some of the other maintenance cost changes besides that in the second quarter?

Yes, and part of it is, of course, we are retiring our classic fleet as part of our fleet modernization efforts and as a result of that, we are seeing fewer engine repair costs.

Those are accounted on, as Gary said, a time and materials basis.

A lot of that is just timing, when the engines fall in the quarter, so we had a little bit lighter spending this year versus last year.

But I think those were the primary drivers.

And one of your rivals mentioned yesterday one thing they were trying to do is cut cost was trying to reduce the number of spare engines because of the ease and the access to repairs and the quicker turnaround and that kind of thing.

Are you doing anything like that, or are you able to go a little lighter on spare engines because of the turnaround?

This is Mike.

We -- all of our engines in our fleet are GE engines, and we have agreements with GE on spare levels that are required, and those spare levels do take into account the engine turns, availability and access.

So, we are very, very comfortable with the spare levels that we had to support our fleet, and I believe they are some of the most efficient in the industry.

Thanks very much.

Kelly Yamanouchi with Atlanta Journal-Constitution.

I am interested in finding out how the transition of the route network in Atlanta is affecting your efforts to attract new customers in more business through the acquisition of the Atlanta market.

Are you still going full steam ahead?

Are there challenges in attracting more business for Atlanta?

Kelly, I think it is premature.

I think what has happened since we have acquired AirTran in '11 until now is we have seen a significant increase in nonstop traffic and we have been very pleased with that.

The change that you are referring to though is more material and the schedule does not start flying until November.

I see, okay.

Any changes in the view the potential, the long-term potential for the Atlanta market since the AirTran deal was announced, whether due to macro factors or otherwise?

Absent macro factors, no.

Actually I've been very pleased with the Atlanta response up to this point.

I think it has been terrific.

And we've just got to work our way through the transition to a different style of flight schedule.

And obviously, we put forth a meaningful marketing effort locally, and I would want that to continue.

I think we have a great opportunity there.

I think we've been very warmly embraced by the community, and just looking forward to the day where it is all fully integrated into Southwest Airlines.

That will -- we are right on track with that.

It is going to take us until the end of next year, but very much looking forward to that.

I have very high hopes for the Atlanta market or go

Great, thank you her go

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

Thank you so much.

As usual, if you all have any follow-up questions you can reach our communication department, (214)792-4847 or via swamedia.com.

Thanks so much.

This concludes today's call.

Thank you for joining.