西南航空 (LUV) 2013 Q3 法說會逐字稿

Welcome to the Southwest Airlines third-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, and welcome to today's call to discuss our third-quarter results.

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

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

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

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 excluding special items, please reference this morning's press release and 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 will turn the call over to Gary for opening remarks.

Thank you, Marcy, and thanks, everyone, for joining us this morning for our third-quarter financial results.

I will just give a quick overview and then turn it over to Tammy Romo to cover the financial results.

A very strong performance, especially from a revenue perspective.

That was reflecting a robust travel demand environment, but also significant achievements by our people in optimizing route networks and integrating AirTran.

Costs also moderated during the period, and it was a reflection of lower fuel prices versus a year ago, and also reduced fuel consumption per unit versus a year ago.

You will note the increase in productivity with respect to our people versus a year ago, and that is despite the increase in capacity.

I want to take this opportunity to thank all of our Southwest and AirTran employees for a great quarter.

They are working exceptionally hard.

The results show it, and I really appreciate it.

We made great progress during the quarter on our strategic initiatives, in particular the AirTran integration, the fleet modernization, and the international reservation system technology project.

We broke ground on the Houston Hobby International terminal project which is slated for 2015, and we started the countdown to the 2014 repeal of the Wright Amendment here at Dallas Love Field.

There is a billboard outside Dallas Love Field that says 51 Weeks to Nonstop Love.

Despite these solid results, we have a lot of work to do, and also, I would add, a lot of upside.

We still have about 15% of our capacity deployed as the AirTran brand, and it is not optimized.

Because of the fleet conversions underway, we are under-scheduling our aircraft for revenue service.

That is compared to where we will be post-integration, and even though we are on track for our planned 2013 AirTran synergies, we have a higher percentage of our system in development.

And all of these create earnings drags which should dissipate post-integration.

Considering all that, it was an exceptionally satisfying quarter.

Our fourth-quarter outlook is encouraging as well, in particular the holiday bookings.

And as you would expect we, like everybody else, saw an impact from the government shutdown, but hopefully that drag will be short-lived.

Then finally, our fourth-quarter outlook for fuel prices is stable, at least for right now.

We're finalizing our plans for 2014.

They will most certainly have a bottom line that achieves our 15% return on invested capital mandate.

We have no capacity growth planned for next year.

In addition to running the business, our goals are to bring up the international service at Southwest and finish the AirTran integration.

We will be very focused on doing everything we can to make our 2014 plans a reality, with the normal caveats, of course, for the economy and fuel prices.

Tammy with that very quick overview, let me turn the call over to you.

All right.

Thank you, Gary.

Hi, everyone, and thanks for joining us today.

We reported great results this morning, setting several records.

Net income excluding special items was a record $241 million, which was nearly a 150% increase year over year, and EPS was a record $0.34, which was in line with consensus and represents 162% year-over-year increase.

Our operating income was also a third-quarter record at $439 million, which produced an operating margin of 9.7%.

Our pretax ROIC for the 12 months ended September 30 was 11%.

We are making great progress there.

Our revenues for quarter were also a third-quarter record, increasing significantly year over year to $4.5 billion.

On a unit basis, total operating revenues increased in the 4% to 5% range compared to third quarter last year on a 1% increase in ASM.

Passenger unit revenues increased a little over 5% compared to third quarter last year, with strong unit revenue improvement each month of the quarter.

July and August were up about 4% to 5%, and September was up 7% to 8% year over year, which is much improved from our first-half performance.

July benefited from solid holiday traffic and healthy demand drove strong yields throughout the quarter.

Our business traffic also showed signs of strength.

Our outstanding unit revenue performance was particularly notable, considering the 4% increase in seats per trip and nearly 2% increase in stage length, which resulted in a drag on PRASM of about two points.

But please keep in mind the impact to unit revenue is more than offset by the significant unit cost benefit that is driving the EBIT improvement from our fleet modernization efforts.

The large number of developing markets that Gary mentioned was also a drag on our PRASM results, year over year, close to probably about a point.

And again roughly 15% of our network was deployed in new markets or in conversion markets as part of the AirTran integration and our ongoing networking optimization efforts.

These markets are progressing nicely, and developing faster than traditional new Southwest markets.

Our people are doing a fabulous job delivering our strategic and revenue initiatives, which contributed significantly to our record third-quarter revenue performance.

We realized approximately $120 million in net synergies during third quarter from the AirTran acquisition, with approximately two-thirds of that coming from net revenue synergies.

In fact about $45 million came from incremental codeshare revenues.

Our Business Select revenues were approximately $27 million, and we recognized approximately $13 million in incremental revenues from our Rapid Rewards program.

Our no-show policy was implemented in September, and contributed $5 million in incremental revenues in third quarter.

And 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 the year.

Our Wright Amendment revenues were also strong, producing $85 million in third quarter.

Looking ahead, we expect unit revenue trends to be choppy through the remainder of the quarter.

Thus far in October we were impacted by the government shutdown.

We are currently estimating about a $20 million impact from a reduction in government-related travel, and our best guess at this point is that October PRASM will be up about a percentage point.

Holiday bookings for the remainder of the quarter are strong.

We currently are expecting healthy year-over-year unit growth for the November/December combined period.

But keep in mind the late Thanksgiving holiday will create difficult year-over-year comparisons in November, but that would have a corresponding benefit, of course, to December.

Shifting to freight revenues and other revenues, our freight revenues were a strong $41 million, benefiting from an expanded cargo network with the introduction of Southwest cargo on AirTran flights during third quarter.

Other revenues decreased 7% year over year, largely due to AirTran's fees continuing to decline with the transition of the AirTran network over to Southwest.

EarlyBird revenues increased close to 20% year over year to approximately $50 million.

And we recognized $62 million in other fees, including $4 million from the A1 to A15 premium boarding at the gate.

We currently expect fourth-quarter 2013 freight and other revenues to decrease from fourth-quarter 2012, primarily due to the continued decline in AirTran fees as continue to replace 717 flights and convert 737s to the Southwest fleet.

Turning to fuel, our third-quarter 2013 economic fuel price per gallon was $3.06, which was in line with expectations.

The 3.2% decline from last year was driven primarily by favorable jet differentials and just lower prices and a penny in hedging gains.

Fuel and oil expense also benefited from better fuel efficiency from our fleet modernization efforts.

Our third-quarter fuel burn improved by between 3% to 4%, reducing our third-quarter fuel cost by approximately $45 million.

Our third-quarter hedging premiums were at $22 million, which was what we had expected for the quarter.

For fourth quarter we currently have up to 48% of our estimated fuel consumption hedged, but about only 12% of that protection is at Brent prices, and that would kick at $135.

And another 36% is at Gulf Coast jet prices at $3.10 market prices, and that was as of October 21.

Based on this hedge position and current market prices, we expect our fourth quarter fuel price per gallon to be in the $3.05 to $3.10 range, and that reflects a $0.02 locked-in gain.

Of course over just the last day or so, jet fuel has dropped again, and we are fully participating in the market declines with reduced prices as our floors are a modest 11%, and are more than 20% below the current market.

Our fourth-quarter fuel hedging premiums are estimated to be comparable to third quarter's $22 million.

Our unit costs excluding fuel, special items, and profit-sharing increased 1% year over year, which was right in line with expectations.

The modest year-over-year increase was primarily driven by increases in salaries, wages, and benefits, airport and revenue-related costs, and those were partially offset by lower maintenance.

We expect another good performance in fourth quarter.

Based on current cost trends, we expect our fourth-quarter unit cost, excluding fuel, special items and profit sharing to be relatively flat with fourth quarter 2012's $0.0815.

This tracks right in line with our 2013 non-fuel CASM plan we communicated to you all last December that assumed a modest 1% year-over-year increase in our non-fuel unit cost excluding special items and profit sharing.

Our anticipated unit cost performance in the second half of this year clearly reflects the benefits of our fleet modernization and other cost control efforts, and we just are very pleased with our performance.

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

Turning to the balance sheet and cash flow now.

We had another quarter of strong cash flow generation, ending with $3.3 billion in cash and short-term investments.

Through the first nine months of 2013 we generated $1.2 billion of free cash flow and returned $572 million to shareholders through -- a little over $500 million, and that was $0.5 billion in share repurchases and $71 million in dividends.

Since May 2011, we have returned over $1.2 billion to shareholders through share repurchases and dividends.

During third quarter we executed a $150 million accelerated share repurchase program that reduced our third-quarter basic share count by approximately 11.5 million shares.

We have $375 million remaining under our $1.5 billion share repurchase authorization.

We have made approximately $267 million of debt and capital lease payments through the first nine months of 2013, including approximately $50 million during the third quarter, and we have approximately $46 million more scheduled for the fourth quarter of this year.

Based on 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.

Overall, our invested capital balance is down $1.2 billion, or 9% since last year, which is meaningful and in line with our 2013 plan.

Just a quick recap of our fleet and capacity plans, which are relatively unchanged.

Thus far we have taken delivery of 12 of the 18 planned -800 firm orders, and two leased -700 aircraft.

On the retirement side, we transitioned our first 717 to Delta in September, and work is ongoing to transfer 15 more this year.

Combined with our classic retirement schedule, we continue to manage to a relatively flat fleet.

We transitioned 2 more AirTran -700s during the third quarter, and 1 more, bringing our total -700s converted to Southwest livery to 15.

We plan to transition 4 more AirTran -700s this year, which will leave 33 next year once the Southwest international reservation system is in place.

Our 2013 ASM capacity will increase about 2% year over year.

For 2014 our plans remain to keep capacity in line with this year.

Our published flight schedule out through June 6 reflects our continued focus on optimizing the combined network, including five more AirTran markets converted to Southwest following Grand Rapids during the third quarter and five new overlap markets.

We also recently made the decision to no longer operate AirTran's Baltimore-to-Bermuda service, and while we haven't ruled out a decision to return in the future, a service to Bermuda on AirTran currently does not meet our performance targets.

Next month's flight schedule begins the evolution of AirTran's Atlanta service into a Southwest point-to-point operation.

And overall, as I mentioned previously, we have a high volume of developing markets as we complete the integration of AirTran.

These markets, while a temporary drag on unit revenues, are expected to ramp up quickly to be positive contributors.

In closing, our strong third-quarter results were very encouraging, with our strategic and revenue initiatives largely on track.

Our cost control efforts are working as planned, and we will continue to focus on maintaining our strong competitive position.

Our financial position remains strong as ever, allowing us to deliver on our plan to aggressively manage our invested capital and return significant value to our shareholders.

Our 15% pre-tax ROIC goal remains a priority, and we are on pace to significantly close the gap this year.

With that, I think we are ready to open it up for questions.

(Operator Instructions) We'll take our first question from Michael Linenberg with Deutsche Bank.

Hey, I guess a couple questions here.

When we think about maybe the opportunity at Love Field, and this is to Gary, I think you do about 120 departures, and I think you'll have 16 gates there.

I sort of think about Southwest doing 10 turns a gate or so.

Although I think Gary, we have joked about in the past, I think there's that one gate in LA where you do like 13 flights a day, or 13 departures.

When we think about the potential size that that airport could become, is it 10, maybe 10 flights a gate per day, or is there the opportunity to hardstand flights out there as well?

Any color on that would be great.

Good morning, Mike.

With respect to your last question, all the departures there will be via a jet bridge.

So that means 16 gates.

I think 16 gates is plenty.

I think we have all we need, and it is a little bit premature to speculate on what the potential is out of this market.

But we are excited about the opportunity.

I don't see any reason why you couldn't assume 10, at least right now.

The bigger aircraft like the 737-800 is probably not a reasonable expectation that you could get 10 800 departures a day per gate.

On the other hand, I don't think we will have all 800s at Dallas Love Field.

But your guesstimate for Dallas Love in the 120 range is about right, and I also agree with you that it is a reasonable assumption that the flight activity will go up.

But it is a great airport, it is right on track in terms of the construction.

12 gates are open, 8 more will open next year, and it will be ready and we will be ready.

So we are very excited about the opportunity.

Hey, Gary, just one other on that.

With schedule changes, and typically I think you go out like 220 days or so.

Like what schedule change should we look for when we should maybe see some changes to the Love schedule?

What would be the potential timing on that?

We typically publish schedules every two months, and roughly your 220 is a decent guess.

They could be as little as six months, maybe seven months.

That would give you some idea of what to look for early next year.

Okay.

Good.

Then just my second question, when I look at your performance this last quarter, when I sort of think about Southwest and how you have priced in the past, a lot of times it would look like that you were more likely to go out with a fuller airplane at the expense of yield.

And yet it seems like this last quarter there were periods where we would see loads down and healthy yields.

I think it was just a function of a good strong pricing environment.

But how much of that may be some of the new tools that you have been implementing?

I know you've talked about that on the last call, the new O&D revenue management system, maybe some of your techniques on inventory, and allocation among the different fare classes.

Is that started to kick in?

Are you getting any sort of pick-up on that?

Anything incremental?

Mike, I think that's really more evolutionary as opposed to a market change this year versus last year with respect to revenue management tools, but it is the right conclusion to draw that every year we are adding to our tool chest there.

I think more than anything, and again, we had an 80.8% load factor for the quarter, which as you know us, historically that is really high.

It was off 1 point from a year ago.

This year we were purposefully using less sale activity.

A reflection probably of a couple of things.

One is just the conversion of AirTran markets into Southwest Airlines, and also a reflection of what we believed was a healthier economy this year.

So philosophically we still want to be the low fare carrier.

We like to be aggressive with fare sales, and we'll continue to use that technique.

The other thing that is nice this year is that we have less markets that are, quote, new to Southwest, and where we don't have to depend as much on price to generate trial on our flights, or on an AirTran flight, either way.

But yes, it is just a better economic environment overall.

Much stronger travel demand in the third quarter than what we were seeing in the second quarter and as compared to a year ago.

Finally, what is a reality in 2013 is the networks are connected and they were not a year ago.

The schedule in the third quarter was getting more and more optimized for that, for those connected schedules.

So they were completely independent a year ago and not nearly as efficient.

And I am sure we were using price to fill up airplanes as a consequence.

Okay, very good.

Thank you.

We will take our next question from David Fintzen with Barclays.

Hey, good morning everyone.

A question in thinking through the growth in seats per departure out into 2014.

That's running sort of up for now, and presumably that starts to come down, but is it still up 2-ish% for 2014?

Hi, David.

We'll still see -- we will start seeing that tapering off, as you suggest.

So I don't know if it would be up quite 2%, but your -- probably in the 1% to 2% range is a reasonable guess at this juncture.

Okay.

The reason I ask is if we're looking at your -- just thinking, obviously there's still a lot of pieces moving around.

If we're thinking about sort of the absolute ex-fuel cost growth of kind tapering down to the 3.5% range year over year, I mean, is the right way to start to think about 2014 from a cost perspective -- I know it's early, sort of continuing that level of absolute cost inflation and then mitigating it with some of that upguaging?

Does that kind of get us ballpark how we should be starting to think about 2014 in terms of CASM?

Yeah, I think that is fair, and then as Gary mentioned, we are working through our 2014 plan now.

We will give you better guidance on that at our next conference call.

Excellent.

Then just a quick one, on the 800s, as you are bringing more 800s in, presumably you're going to hit the sort of least dilutive markets first, and then kind of work down the system.

Should we be thinking of sort of a lower marginal revenue generation on the 800s as you get more 800s into the system, or is it kind of holding up as you get more and more of the new planes?

So far it has been holding up, and I think what we are looking at right now for 800 deliveries next year, at least my expectation would be that it would hold up in 2014.

Okay.

Excellent.

Thank you.

We will take our next question from Hunter Keay with Wolfe Research.

Hi, good morning, everybody.

Good morning, Hunter.

If I look at the percent of revenue passengers versus emplaned passengers, it looks like it's gradually declining.

If you apply just sort of back of the envelope an average fare to that mix shift, it looks like last the year's third quarter, for example, it looks like you're sacrificing about $63 million of revenue, and that's about 150 basis points of would-be PRASM growth.

We talked on the last call about the incremental cost method versus the deferred method of accounting, but you are not really recognizing the revenue and the cash, given the incremental method of recognizing this.

Does it seem like it is still appropriate?

And how are you guys, I know you just made a change to the frequent flyer program recently, bit how are you guys going to sort of ensure that the liability doesn't run away from you because of the generosity of the program, or at the very least how you recognize it from an accounting perspective?

I think, well there's two -- I mean the accounting is ultimately tied to the economics of the program.

So obviously we are monitoring all of that, and we recently increased the, I guess the redemption coefficient, which is obviously a tool that we have to manage that liability.

So we will continue to monitor that, but you are correct, we do account for that on the incremental cost method.

Okay.

All right.

That's fine.

Thank you for that, Tammy.

In terms of sort of, Gary, how you think about the brand and managing customer perception and customer confusion.

If you guys are to do things like, say, like restrict certain discounted fares, things like that, maybe a little more than just around the edges, is it fair to assume that maybe AirTran has to be retired, whether it's the website being shutdown or the planes being completely painted?

The brand of AirTran has to pretty much go away before we think about you guys maybe tinkering with maybe a little more substantive revenue initiatives?

I don't think so.

In other words, to me what we want to do is manage the amount of change that is underway at any given point in time.

More than being concerned about the brand confusion.

Right now, as you well know, there is a very different product at Southwest versus AirTran.

So we are already dealing with that.

That challenge will continue to grow smaller every single month.

So AirTran will begin to shrink pretty rapidly now that 717s are moving out of the fleet.

And so that's going to diminish over time.

I think more importantly is the focus that I mentioned.

So for 2014 we have a lot of work remaining to finish the international technology work.

Make sure that that is up and running so that we can finish the AirTran integration into Southwest.

That is a tremendous amount of work with those two things.

The remaining AirTran integration includes a conversion of 33 737s into the Southwest livery, and I guess around 62 more 717s into Delta's livery.

So as you can imagine, there is a lot of work involved with that fleet conversion.

In addition to that, we will be replacing, on an airplane-by-airplane basis, all of the AirTran 717s that are going out of the fleet.

So we have to ingest all of those airplanes.

So that is the perspective, in other words to your question.

With respect to our brand, I think that we will want to continue to protect the brand.

We will want to continue to focus on the friendly aspect of the brand, the low-fare, low-cost nature of our brand, and look for opportunities where we can improve the customer experience and drive more revenues.

But specifically with respect to tinkering with our brand, that is something that we will be involved with here, thinking about 2014, and then we will do the same thing again in 2015.

Nothing to report to you specifically yet, but stay tuned.

Thank you very much.

We'll take our next question from Helane Becker with Cowen and Company.

Thank you very much, operator.

Hi, everybody.

Thanks for the time.

So your average fare was up 11% in the quarter from $143 to $159.

Can you say what percent of that -- can you divine that by mix, business versus leisure?

Or maybe a different way to ask it, can we expect that level of fare, that $159, $160 to continue going forward?

Hi Helane, how are you?

We actually saw an improvement in our mix, really across the board for the quarter.

So we saw nice healthy fares, which of course was fueled by the demand environment, and just overall an improvement in the mix.

Okay, and then for my follow-up question.

Gary, if there are slots or other things available as a result of maybe a settlement with American and the Justice Department, are you guys interested in expanding out in Washington?

Absolutely.

For opportunities?

And I wouldn't restrict it just to Reagan.

We would be interested in more slots at LaGuardia as well.

I am reasonably confident that there will be slots that become available, and then I am assuming that there will be an opportunity to bid.

If there is that opportunity, we will certainly take advantage of the bidding.

Last time the slots came up for bidding, we were outbid.

So there's no guarantee that even if they are divested that we will get any.

But certainly that is something that we are interested in, yes.

Great.

Thank you.

Have a nice day.

We will take our next question from John Godyn with Morgan Stanley.

Hey, thank you for taking my question.

Gary, just on the last thing that you just mentioned there.

That you thought you were pretty comfortable or confident, I don't remember what word you used, that slots were going to become available.

Is that sort of your view on whether we're going to see a settlement or not?

Is that the implication there?

Well, yes.

I am not trying to be presumptuous here.

That's just under the assumption that the merger goes through in one form or fashion, it is my belief that slots will become available.

Obviously, if it doesn't go through, then I'm not assuming that any slots come on the market.

Got it, okay, thank you.

I cannot imagine that the merger goes forward without requiring divestiture.

That's been our position from the very beginning.

Obviously the Justice Department seems to agree with that.

Fair enough.

I just wanted to clarify.

The 0% capacity growth rate for 2014, you guys went out with that number now a bit ago, and it certainly seems as we are looking at trends in the fourth quarter that things are going quite well.

Is there anything that can happen in the next kind of six months that would cause you to revisit that number?

Or should we think of that 0% as truly a firm number that won't be revisited until even farther?

Well, no, I wouldn't lock it down that way.

But it will be plus or minus zero, based on everything that we know today.

So you bring up the slot question in the same breath, and who knows?

We maybe get slots that require that we fly, so we might need to increase capacity to take advantage of an opportunity like that.

Again, this is just pure conjecture on my part to answer why would we vary from that.

Things could obviously change next year for the worse in the economy, and we might want to schedule less flights.

So we will definitely want to maintain that flexibility.

But back to Hunter's question, we have a lot of work to do between now and the end of 2014.

I would rather not introduce a lot of growth, or even modest growth, into that environment.

I think we will be very well prepared to contemplate growth opportunities after all the integration is complete, and I think we will have a number of very exciting opportunities to think about.

Really, now and next year is not the time to be thinking about that.

Okay.

Fair enough.

Tammy, if I could just follow up on what you said recently on business mix improving.

Is there anything you can tell us about sort of the last few quarters, or just something to put it in perspective, that puts how much it's been improving today versus some point in the past?

I'm just trying to get a better sense of the trajectory there.

Sure.

Just on our business mix, it did improve from the second quarter.

I think we reported that we were at about 30% in the second quarter of this year, and that is up to about 35% here in this quarter.

So we have seen, when I was referring to signs of strength, that was one of the reference points.

Corporate sales also increased year over year, actually rather dramatically, and so just a lot of encouraging signs across the board.

Thanks.

Really appreciate the time.

We will take our next question from Duane Pfennigwerth with Evercore.

Thanks, good morning.

Just following up on John's question.

When you are in a position to play offense again and start to grow, what are the relative attributes that you consider when deciding where to point your aircraft?

Is it only a relative cost decision?

And how has your experience in Atlanta changed your thinking in that regard?

Let me take a shot at answering your question, and you can tell me whether I'm on target with your relative cost point.

We will be looking for opportunities where it can play to our strengths, and where we can stimulate traffic, looking for nonstop opportunities where we think there is sufficient traffic that is perhaps underserved.

As we think about the future, I don't think that there is anything that is fundamentally different about how we would contemplate growing.

I think in this environment with higher fuel prices and having more of a challenge in stimulating traffic, we will just be a lot more measured in pursuing those opportunities.

Dallas Love Field is an obvious opportunity.

I am sure we will face vigorous competition from DFW.

So we are not willing to commit yet exactly what we want to do and when, for competitive reasons.

But right now we are just focused on bringing up our international capabilities and finishing the AirTran integration, and not focused on growing the airline.

Thanks for that, Gary.

Then broadly can you talk about the cost buckets that will help or hurt CASM next year?

And can you provide any update on your pilot negotiation?

Thank you.

Tammy, you want to talk about the cost outlook and then I will try to chime in on the negotiations.

Yes.

Our most significant cost reduction initiative, as you probably are aware, is our fleet modernization efforts.

Where you will see those savings would be in our maintenance, materials, and repairs, and in our fuel and oil expense, and you are already starting to see some of the benefits in fuel efficiencies.

So those are going to be the primary two buckets where you will see a reduction in costs, and of course we will continue our efforts, as always, just to control costs overall.

And just a quick point on this year.

If you recall last year we went into the year with a goal to reduce our overhead by about $100 million, and we are right on track with that goal.

So, and again, working through the 2014 plan, but as always, we're going to be very diligent in our cost control efforts.

Duane, you specifically asked about pilot negotiations.

So I will answer that and just comment on the rest.

I think the negotiations are going fine.

In terms of what is being discussed at the bargaining table, as you know that's going to be confidential.

But there is nothing really that I can report at this point, other than we are continuing to have meaningful discussions.

Our pilots are very devoted to Southwest Airlines and certainly want to make sure that their Company succeeds, and I am very grateful for all of the hard work that our pilots do for us every single day.

But I would be remiss if I didn't also share that we are in negotiations with many other work groups.

In fact, most of our -- the vast majority of our union contract employees, their contracts are amendable at this point.

We have a number of negotiations underway, and they are all proceeding and all, I feel like we are having a very good dialogue.

But otherwise, just really not at liberty to provide any other insight there.

Okay.

Thanks for the time.

We will take our next question from Thomas Kim with Goldman Sachs.

Good afternoon.

Thank you very much.

We are certainly pleased to see the improvement in the ROIC.

And I wanted to ask, to what extent do you think you are somewhat handicapped to achieve the 15% target without necessarily growing the ASMs more meaningfully beyond, let's say, in 2014, let's say?

Why don't I take a shot of that, and then I would love for Tammy to be able to comment, as well.

I don't think we are handicapped.

I don't think achieving our return mandate is a function of growing ASMs.

I think it is a direct function of us optimizing our route network, and as a follow-on, managing the revenue production.

The other material input, of course is fuel prices.

And it is so nice to have stability in fuel prices.

It is somewhat humorous to us that for two quarters in a row we had the exact fuel price per gallon of $3.06 after all of our hedging for a second and third quarter, and as I mentioned in my comments, the outlook for the fourth quarter is in that range.

So that is extremely helpful.

We want to maintain our low-fare brand and not continually be forced to chase operating cost higher and higher and higher and higher.

That is what creates so much instability in our customer set.

So we think we have very good revenue momentum.

Both I and Tammy have gone through the whole list of things with you that are not optimal yet.

Again, just as a headline, I would say we are in the midst of a major merger integration, and despite all of the noise that comes along with that, are producing record earnings here in the second and third quarter.

So oftentimes you see the opposite result, in other words, where people are really distracted and not performing.

So I feel really good about where we are, and Tammy and I and all of our leaders know darn well that we've got a number of opportunities that we can pursue, and that will be our focus.

As I said, our 2014 plan will have a result that achieves a 15% return on invested capital.

I am not guaranteeing that we can achieve it, but I am guaranteeing that we will have a plan that provides that result.

Tammy, anything you want to answer or add?

Really not much to add to that, Gary.

Just again, we're going to continue to be diligent on the cost side, and of course, as we have demonstrated this year, we are very focused on managing our invested capital as well.

You certainly do have a very strong balance sheet, which affords you a lot of flexibility.

I wondered to what extent would you consider increasing your capital return to potentially juice up the ROIC?

I won't speak to our future plans, but I think you can just look at what we have done here in 2013, and I think that is just evidence that we're committed to manage that as aggressively as we can.

Yes, we are very mindful of that, and we have -- last year in fact, we were very explicit that we were going to aggressively manage our invested capital, and Tammy pointed out that it is down, I believe 9% year-over-year.

So, no, we'll want to continue to do that.

We've got very strong operating cash flow.

I don't know anything right now, about 2014 that would suggest that we won't have strong cash flow next year.

There is always the things that are hard to predict, but like I said, we will have a plan that will have a 15% return, and that will result in a very strong operating cash flow plan for next year.

That is very helpful.

Thank you.

We will take our next question from Jim Parker with Raymond James.

Good afternoon, Gary and Tammy.

Hi Jim.

Following up on the questions about Atlanta.

When you all originally acquired AirTran, did you anticipate cutting back the number of flights to the extent that you have?

Or have you come up with better opportunities elsewhere that has caused you to cut back further?

And then what are the -- what are your game plans for rebuilding service in Atlanta?

Well, I will speak to all those, and Tammy you chime in.

When we struck the deal with AirTran, crude oil was $80 a barrel.

So we did not contemplate at that point, we did not predict that oil would be at $110 dollars a barrel.

So I would say that.

That has had a significant impact on not just Atlanta, our entire domestic route system.

So we have been trimming flights across the country.

In fact, it is a rarity to find cities that are having increased flight activity.

The opportunity for many of our cities is to continue to add new destinations.

But the short-haul markets, Jim, in particular as you know, have really been hit hard over the last decade, and have not recovered since 2007, 2008 and 2009.

So that would be my answer to your question, is no, we didn't plan on $100-plus crude oil.

I believe we will have a substantial operation in Atlanta.

We will keep tuning it until we are satisfied that it's right.

There is absolutely no mandate, whether it is Dallas Love Field or whether it's Atlanta, that the flight activity has to be at a certain level.

The other thing I would mention about the number of flights, it's very misleading considering that the gauge is changing so dramatically.

So you will be seeing 717s replaced by 737 and the trips, in other words the trip count won't equate to the seat count, and I will just ask you to stay tuned on that.

Atlanta is very important to us.

We have had a wonderful reception there.

Atlanta was a challenge for AirTran, and we are seeing very meaningful improvements in the local market in particular.

We have a big step coming up next month to convert to the point-to-point route system.

It is a -- if radical is the right word, it is a radical change for the operation, and the bookings so far look very solid.

So I don't see a misstep there, and I am anxious to see if we can't build the business from here.

At the same time, we are really hampered by the fact that it is not all one brand.

The majority of the flights are still AirTran and I think we are all looking forward to the day where it is all Southwest.

That will really put us in the position where we can best answer your question, and that won't be until the end of next year.

So we've got a ways to go.

We are very committed to the market.

Regardless of the number of departures that we have, we're going to have a very large presence in Atlanta.

Tammy, anything you want to add?

The only thing I would add is exactly what you said.

We in April 2014 will have 160 flights, which as you know, Jim, compared to many of our other focus cities, that is right in line with what we would traditionally do.

So again, I think still a very strong presence there in April.

I think, Bob, did you have anything that you want to add?

Gary really covered everything.

I would just tag in on the November schedule change.

It's a big deal.

We are moving from a hub-and-spoke structure there that AirTran had to a traditional, a little more smooth throughout the day flight structure that Southwest would have.

It provides a lot better local timings.

We're just a couple of weeks away from that.

We were already gaining local share as compared to AirTran.

The bookings, while it's early, the bookings performance for that November schedule look really promising.

We're seeing gains locally and we seeing that we are holding onto the flow traffic and connect traffic as well.

So not only would that be a better schedule for our local Atlanta customers, it will be a better schedule, I'm very hopeful in terms of financial performance.

Typically with a big schedule change like that, it takes the market a while to adapt to the change in flight timings, and we are not seeing any dip at all.

Can I just, Jim, add one quick color commentary to Tammy's point?

Atlanta is one of the biggest cities that we operate in, period.

It is bigger than Dallas, bigger than Houston, two original cities.

Bigger than LA, Bigger than Oakland, the list goes on and on and on.

So it is a very large operation for Southwest Airlines.

Okay.

Thanks.

We'll take our next question from Glenn Engel with Bank of America Merrill Lynch.

Can you talk about international, how that is proceeding and when you hope to start flying that?

Yes.

International is proceeding right on pace.

We are probably nearing the point where we can publicly release some milestones.

I am not ready to do that yet.

But 2014 is still the plan and it is going to happen.

There are, after the Bermuda closing, there are seven international destinations that will be the candidates for conversion from AirTran in 2014 over to Southwest.

They'll take place, those conversions will take place throughout the year.

So to bring up international, Glenn, we've got to finish the technology, be ready to take (inaudible).

Then we have to convert the AirTran international airplanes, and there's 33 737s.

Mike Van De Ven and his team will add some Southwest 737s to that international fleet, but all of those things will have to take place to get international up and running.

I don't believe there is anything that we need to do with route authorities, but our regulatory folks are all over that.

I'm not aware of any issues on that front.

So it's again, primarily just getting the airplanes converted and getting the technology up and running.

The technology milestones are in view, and what we have reported consistently to you all, and especially on the second-quarter earnings call, is that that project is right on target, right on schedule.

So my confidence in the deliverable for next year just goes up with every passing day, because we keep hitting every milestone that we have given them.

The Company is very focused on it, which is again why I have answered several questions the way we have today.

This is a big effort, and it does require focus, and we are really pleased with how the project is progressing.

So I certainly don't want any distractions for our team.

And does the flat capacity guidance next year include any significant -- any international?

And what percent of the system do you think it could become way down the road?

It's really small now.

Again, it's got seven destinations and 33 part-time airplanes.

They are not fully flying international routes.

They are probably, I don't know, Bob, half of it is domestic.

Is it 1%?

Maybe 1% of our capacity today is international.

It is really premature.

I am not ready to give you the big prediction yet.

I would simply say that the opportunity with 737s to North America, including Alaska, Hawaii, is 200 to 300 airplanes.

That is not a prediction that we will fulfill that, but it is a very large opportunity, and in many cases the fares are very high.

So we think we've got ample opportunities to grow there, as we do out of Dallas Love Field and other domestic opportunities, too.

We have no lack of opportunities.

We just need to make sure that we are executing on our business plan and hitting our revenue and our cost target.

Thank you.

We have time for one more question.

We will take our last question from Dan McKenzie with Buckingham Research.

Thanks, guys, for squeezing me in here.

Tammy, one quick clarification.

Did you mention the codeshare revenue from AirTran was about $45 million for the third quarter?

That's correct.

Got it.

That is net, Dan.

That's not -- In other words, there is a lot more codeshare revenue than that, but we don't think -- well, incremental is the right word.

Sorry.

Got it.

I think you just might have intercepted my next question, Gary.

That is, I think the estimate earlier this year was $1 million today.

Right.

I guess I was just wanting to reconcile those two numbers.

Yes, sir.

Yep, okay.

In fact, Tammy, I don't know if you have the gross number off the top of your head.

The total is, if I remember correctly, it is over $200 million.

I think $220 million, if I remember correctly.

It is a giant number, Dan, but we know full well that it is not all incremental.

So we have made our best effort to try to infer from the data what is incremental.

Understood.

It is a big number.

Then I guess just secondly, does that codeshare benefit accelerate once the November schedules kick in in Atlanta?

How should we think of that?

Well, I will just give a top side answer and let Bob and Tammy think about your question here for a second.

The connection bookings for Atlanta in the November schedule change look very good.

That may very well -- there may very well be some codeshare support in there.

The only thing I would mention to you though, Dan, is that as time goes by, and AirTran continues to shrink its fleet, which is happening now in an accelerated way every month between now and the end of next year, the codeshares numbers are logically going to come down as that entity shrinks.

But, yes, Atlanta is probably in a better position in November for codeshare.

I would agree absolutely, simply because the flight timings are better.

I think you are going to see at least a modest improvement in the codeshare benefit.

The other thing to think about, too, with the -- as the AirTran fleet draws down, the AirTran fleet, we have all mentioned this, but it's sub-optimized.

So that the AirTran network is sub-optimized as compared to Southwest.

As those aircraft enter the Southwest market and are optimized, you'll in essence trade that codeshare revenue for even more effective revenue because it is part of an optimized network in total.

Right, and a much better customer experience too.

Okay.

Thanks, so much, guys.

Marcy, back to you.

Thank you all for joining us today, and as always if you have any follow-up questions please free to give a call, give me a call.

Have a great day.

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 of Culture and Communications.

All right, thank you so much, Tom.

Thanks to everyone.

We know it's now time for the media to queue up their questions they might have for Gary, Tammy, Mike, and Bob.

So if you, Tom, would give those instructions, we're ready for that.

(Operator Instructions) We'll take our first question today from Terry Maxon with The Dallas Morning News.

Good afternoon.

This is a North Texas question.

I understand you're not going to give us specifics until you're ready to give us specifics, but can you kind of tantalize us about what changes we'll see in the schedule out at Love Field, both beyond the Wright Amendment area and inside the Wright Amendment area?

Well, I think beyond the Wright Amendment state area is, gosh, it feels like it's 1971 all over again.

So we've got a lot of opportunities.

We have a lot more opportunities than we have airplanes.

So we'll be doing our best to prioritize what we do first, and then just make sure we don't get the cart before the horse here.

So we're going to take this expansion opportunity like we would any other and be aggressive when we can and be cautious when that's what's called for.

But we've got opportunities, Terry, in every direction except for South.

So it's, again, an abundance of opportunities there and some really high fare markets.

With respect to the Wright Amendment cities, we're not really contemplating any radical changes there.

As I mentioned on the analyst call earlier, the short-haul markets, and you've written about this, the short-haul markets have suffered over the last decade.

We have already adjusted our supply to that reset of demand.

And the other thing that will happen, of course, is that many of the cities, especially in Texas, are -- most of their flights are to Dallas.

Well, being able now to expand Dallas will be very beneficial for those cities.

So in other words, if we fly to the East Coast now out of Dallas, we'll have Texas customers that can now fly on Southwest via Dallas to that opportunity.

That's very substantial.

So I think on balance for the most part, it should be -- there should be good new benefits for everybody, and we're doing our best to make sure that we pay close attention to all of our cities that we serve, and do the best that we can to take good of them.

The follow-up on that.

Love Field, I think you just carried just 8 million passengers in 2012.

Is 10 million a year, once you get your schedule fully optimized out of Dallas Love Field post-Wright Amendment, a reasonable target?

Well, I don't know that I would put a boundary on it yet.

We haven't even gotten started with it.

It does have a natural cap, and although we're -- because we're so efficient I don't know exactly what that is.

But I wouldn't object to that as a reasonable number, but I'm not willing to predict it at this point.

Thank you.

We'll take our next question from David Koenig with The Associated Press.

Hey, thanks so much.

Hi, Gary.

Just following up on the slots question that came up during the analyst portion.

Have you talked to anyone at American or Airways, or even DOJ about that?

Could you be part of some sort of prepackaged deal?

Personally I have not had serious conversations with anybody about anything with respect to that merger.

Okay.

If somebody wanted to talk to us about a deal, well absolutely we would talk to them.

There's nothing wrong with that.

But generally, David, we don't comment on what kinds of things that we might be doing.

But just, with this situation, yes, I'm going to give you a straightforward answer, which is no, I've not been involved in any serious way with anybody.

Okay, and the reason I ask, of course, is -- so your comments earlier were just -- you were surmising, based on your long experience in the industry?

It wasn't any particular inside information you had from any of the participants?

I have no inside information.

Okay.

All right.

And I -- no, I think, at least I tried to make clear that I was -- I think what I said is I was reasonably confident that there would be a divestiture required.

And yes, that's based on our knowledge of the law and our knowledge of the slots that are hoarded at Reagan, in particular, and the fact that the Justice Department has sued to prevent the merger.

So those are the inputs that I was using to voice that opinion.

Got you.

Thank you.

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

Hi there.

You mentioned that bookings looked good in the shift to point-to-point for Atlanta.

And I was wondering how the shift for the November schedule has been affecting unit revenues and load factors for Atlanta.

And also how it has been affecting the mix of Atlanta O&D passenger share so far.

We don't (multiple speakers) again, all I can tell you is repeat what we said before, which is that the bookings look very good at this point in time compared to a year ago for Atlanta.

It is a very different operation.

Bob is looking at these bookings in total, and what was interesting to us is that we did see a little bit more strength in the connecting bookings out of Atlanta.

But it's way too early to give you any insight along the lines that you are asking us.

We'll probably need -- and one day or one week doesn't make for a trend, either.

So we'll need some time to evaluate how good a schedule we have.

I'm sure it won't be perfect, and I'm sure there'll be follow-on tunings that we'll want to do.

Bob, I'm pretty sure we don't have every destination in place that we would like, much less all the frequencies.

So we've got a lot of work to do in Atlanta.

Again, Kelly, the main thing to remember is this is still dominated by AirTran brand and service.

It's not close to being finished.

I'd say we're probably a good 18 months away before we've got something that we're totally satisfied with.

But this is a big step, and based on the step that we've taken, we're very pleased with the results that we've seen so far.

But all that's very premature.

All right.

Thank you very much.

We have time for one more question from Jack Nicas with The Wall Street Journal.

Nice quarter.

One thing obviously I think jumps out is the 11.3% hike in the average paid fare.

Now, obviously you folks are coming from a low base fare and you're allowing bags to fly free.

So still can be a deal there, but do you think that that sort of increase significantly affected your strong revenue performance this quarter?

And do you think that this could lead to a trend of rising fares that will continue at Southwest as a result?

Well, just a little quick background, and then make sure I answer your question.

The 11% is a little misleading.

If you'll look at the average passenger distance that they flew, that's called the average length of haul, that was up 4.3%.

So in other words, one would expect to pay a higher fare to fly farther.

So you have that effect going on.

4.3% is quite a change in a year-over-year comparison there.

So that's part of the 11.3%.

If you also look in the statistics, you'll find that the yields went up, what Tammy, 6.2%, 6.3%, something?

That's probably a better indicator for how much fares went up year over year.

Those are -- we're a low-fare carrier.

Those increases are a function of cost pressures.

The primary cost pressure that we are managing is fuel.

It is true that fuel moderated year over year, but again, we're dealing with catching up to fuel increases that have been taking place over the last decade, and finally we're getting caught up.

If fuel prices are flat next year, I would hope that we wouldn't have to have fare increases.

But that's just an opinion.

I can't give you any insight legally as to what we're thinking about with fares going forward, other than the obvious which is we want to be a low-fare carrier.

That's who we are.

So we're going to work very hard to keep our costs low so that we can pass those savings along to our customers.

Okay.

Thanks very much.

And one quick follow-up.

Obviously you folks have bucked the trend of charging for baggage.

Will you be able to stick with that and continue to allow two bags to fly free and simultaneously keep those fares low?

Or is there an opportunity there to maybe, along with everyone else, charge for at least a bag or two?

And then, therefore, drop your fares maybe a little bit?

I believe we will.

I would temper that with the following.

Right now it's our belief that we get more customers and more revenue by not charging for bags.

In fact, there was a study that was released to the media this week ranking Southwest as one of the most transparent, friendliest brands to work with, with the airline industry being ranked as a whole at the bottom.

So we think that that kind of a brand image brings us a lot of business that we would not get if we started charging for bags like everybody else.

So there's a real value to being different than the herd, and especially when you're different in a way that most everybody thinks is really good.

However, if over time if customers prefer the unbundling approach, sort of an a la carte approach, and they understand it and they favor that, well we'd be crazy not to provide our customers with what they want.

But as I mentioned earlier, our focus right now, to finish out this year and for 2014, is going to be implement international service at Southwest Airlines, which is a very big effort, and finish the AirTran integration.

A change in the fee structure would be, I think, a significant distraction.

So there are no plans to make any significant changes in 2014.

Understood, thanks very much.

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

Well, thank you all for being on the call today.

As you know, we stand by if you think of further questions as you're compiling your stories.

That number to call is 214-792-4847.

I thank everyone for being on the call.

And this does conclude today's conference.

We appreciate your participation.