西南航空 (LUV) 2016 Q3 法說會逐字稿

Welcome to the Southwest Airlines third-quarter 2016 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 www.southwest.com in the Investor Relations section. At this time I'd like to turn the call over to Ms. Marcy Brand, Managing Director of Investor Relations. Please go ahead, ma'am.

Thank you, Tom, and good morning, everyone. Welcome to today's call to discuss our third quarter 2016 performance.

On the call today we have Gary Kelly, Chairman, President and CEO; Tammy Romo Executive Vice President and CFO; Bob Jordan Executive Vice President and Chief Commercial Officer; and Mike Van De Ven, Executive Vice President and Chief Operating Officer.

Please note today's call will include forward-looking statements and because these statements are based on the companies 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 mornings Press Release in the Investor Relations section of www.southwest.com for further information regarding forward-looking statements or reconciliations of non-GAAP results to GAAP results. Following the prepared remarks we will open the call up for questions. We ask that you please limit yourself to one question and one follow-up so that we can accommodate as many questions as possible.

At this time I'll turn the call over to Gary for opening remarks.

Thank you, Marcy. Thank you all for joining us.

We are very pleased to report strong third quarter profits today and especially considering the effects of the technology outage that we suffered in July. Earnings per share were down from year ago levels by a $0.01. We generated strong free cash flow of almost $400 million for the quarter and returned $312 million to shareholders through dividends and share repurchases.

RASM performed exactly in line with our expectations and again, that's taking into account the negative impact of a half a point that we had from the technology outage. We have consistently out performed the domestic industry for 2015 and for the first part of 2016, along with the lapse of the year-over-year gains in our 2015 Chase deal, we've got harder comparisons in the near term.

Even with the out performance though we've seen weakening sequential trends for a number of quarters now. But that feels like that's coming to an end taking into account the timing and the holidays in September, November, and December/January time period, the monthly and quarterly sequential trends look good to us. They look like they're stabilizing. I would quickly add that it's a little too early to tell if they are improving although close in bookings and yields are improved.

As compared to some of the guidance that I've heard from our competitors, there seems to be a difference between the expectations surrounding the December/January holiday time period but it's our guess at this point, consistent with what we saw calendar wise in 2011, that might be as high as a point and a half. So you take that into account and again, our trends between third quarter and fourth quarter look very comparable and maybe even better.

Couple of very encouraging signs. First of all the percent of new markets or developing markets are roughly at historic levels for us, down very significantly from where we were in 2014 and 2015. This will continue and perhaps fall further in 2017 as we slow our domestic growth to roughly 2%, and of course this bodes well for our unit revenue outlook. The domestic industry is growing seat miles well ahead of GDP growth and we've seen significant competitive capacity adds in markets that we serve and its increased competition that's diluting revenue on routes that we serve that accounts for the decline in unit revenue trends especially here in 2016.

We are planning for rising cost in 2017 and that is due to higher jet fuel prices and labor rates. Our goal is to arrest the trend of declining unit revenues in 2017 and achieve positive unit revenue comparisons for the year as compared to 2016. We'll rely primarily on basic revenue management and route design techniques to achieve that and we're leaning heavily on our fleet modernization in the near term to help mitigate our unit cost pressures.

In the meantime, and as we anticipated again for 2017, profits, cash flow internal investments, and shareholder returns are all strong and we achieved a 32.3% ROIC pretax for the 12 months ended September 30 and will be close to 30% for the year 2016. So I anticipate another very strong showing in 2017 despite the competitive environment.

Our priorities for the balance of this year and next year are unchanged. We'll start service to Cuba next month. We'll launch Mexico service from LAX under the new US Mexico bilateral in December. We'll complete construction of a new five gate international terminal in Fort Lauderdale in mid 2017 and then launch new international flights thereafter. We'll deploy the booking feature of our new reservation system in December and begin flying those bookings in May of 2017 when we're fully deployed with our new reservation system. We'll launch the new Boeing 737 Max next year and coincident with that retire our Boeing 737 Classic fleet.

In addition to those initiatives, we'll also continue to focus on the basics which are three: running a reliable operation, offering our customers exceptional hospitality, and delivering superior profits and returns for our employees and our Shareholders. So with that very quick overview, I'd like to turn it over to Tammy Romo to take us through the quarter.

Thank you, Gary, and welcome everyone. We're delighted to report another quarter of strong results.

Our third quarter GAAP net income was $388 million and excluding special items our net income was $582 million which represented almost a 7% decline from third quarter last years record result. Aside from our normal hedge accounting adjustments, special items this quarter included $356 million in expense related to proposed union contract bonuses and an $18 million charge related to the early termination of four of our classic operating leases.

As a result of the reduction in the outstanding shares from buyback activity, our earnings per share of $0.93 was down slightly by only 1% year over year exceeding consensus by $0.05. The impact from our share repurchases is meaningful and since 2011 we've decreased our share count by 18% demonstrating our ongoing commitment to return value to our shareholders.

Our third quarter EPS included about a $0.07 impact from our July technology outage and without this impact, third quarter EPS, excluding special items, would have exceeded last years record $0.94 with net income excluding special items comparable to last years record $623 million.

Of course we're delighted with our return on invested capital which was an outstanding 32.3% ROIC for the 12 months ended September 30. Overall, a very strong performance and I'd like to commend all of our hard working employees on another stellar quarter, especially with the challenging operational environment from the technology outage.

We remain excited about the progress on our commercial and operational investment, including our new reservation system that we will begin selling reservations on in December followed by the transition to [one] reservation system planned for May of next year. And our outlook for Fourth Quarter supports another solid quarter to end a tremendous year of strong results.

With that overview, I'll turn to revenues which were a strong $5.1 billion. This was just $7 million shy of beating third quarter last year's record excluding the special revenue adjustment and third quarter last year. And if you exclude the $55 million unexpected reduction in our revenues from the technology outage, our third quarter of passenger and operating revenues would have reached record levels. The 4.1% year-over-year decline in operating unit revenues was driven by record third-quarter traffic at lower yields.

We did see improvement in close entrance during the quarter, however the fare environment remained challenging. Stable but soft is how I would characterize the yield environment in third quarter with average fares down over $7. Our freight revenues were impacted by softer demand environment but our other revenue improved year over year driven by strong record rewards and other ancillary performance especially Early-Bird and upgraded Boarding products. Overall, given the industry fare environment we are pleased with our relative operating revenue performance.

Turning to our Fourth Quarter revenue outlook. While close end trends have been encouraging the industry yield environment remains competitive and in addition, as other airlines have noted on their calls, fourth quarter comparisons will be challenged by the calendar placement of the holidays particularly Christmas and New Years. We estimate the calendar placement and compressed holiday travel the week prior to Christmas attributes an estimated point and a half of RASM penalty. As a result, we expect our fourth-quarter RASM to decline in the 4% to 5% range with October currently running down about 5% including the impact of Hurricane Matthew. October is trending in line with what we saw in July and August suggesting trends have stabilized. Based on the holiday shift, December is expected to have the most difficult year-over-year comparison.

With respect to sequential third to fourth-quarter trends, we're about two points off normal averages which we attribute largely to the calendar placement of the holidays as well as the impact of the outage and to a lesser extent Hurricane Matthew.

Looking past all the noise around the holiday shift, we are very pleased with early January bookings and wouldn't rule out starting the year with flat to possibly positive year-over-year unit revenue comparisons. We currently expect fourth-quarter freight and other revenues to increase from fourth quarter last year as well.

Moving now to our cost. Our operating unit cost excluding special items decreased 2.4% year over year, largely from lower profit-sharing and jet fuel prices. Our profit-sharing for the third quarter was $101 million compared to $177 million in third quarter last year. The lower profit-sharing expense is due to the year-over-year increase in proposed union contract bonuses.

Our economic jet fuel price per gallon declined a little over 8% year over year to $2.02 for third quarter which was driven by lower crude and heating oil prices. We expect fuel prices to be higher here in the fourth quarter and based on market prices last Thursday, and our current fourth-quarter hedge position, we expect our fourth-quarter fuel price per gallon to be close to $2.10.

Excluding fuel, special items, and profit-sharing, our unit costs came in of 2.6% which is better than we expected. When you consider that almost a point and a half of this year-over-year increase is from accelerated depreciation associated with our classic fleet retirement and close to another point of the increase was driven by cost associated with the July technology outage, this was a very solid performance.

Based on current trends, we expect fourth quarter 2016 CASM excluding fuel, special items and profit-sharing to increase in the 4% to 5% range year over year. About 3.5 points of this increase relates to the impact of the recent tentative agreements in our ongoing labor negotiations and another point relates to the accelerated depreciation of the classics.

For full year 2016 we expect a 2% to 3% increase in our unit cost excluding fuel, special items, and profit-sharing with the impact of the recent labor negotiations driving just over a point of the increase. The remaining 1% increase is right in line with our guidance at the beginning of the year driven by the acceleration of the classic fleet retirement and as always, we remain focused on controlling spend to protect our low cost structure and low fare brand which is even more essential with the increased labor cost pressure and a challenging revenue environment. We're making important investments in operational planning and recoverability tools for our employees to improve the customer experience as well as our efficiency.

I have just a few comments on our liquidity and capital deployment. We ended third quarter with cash and short-term investments of $3.4 billion. We also have a fully available unsecured revolving credit line of $1 billion which was recently replaced and extended through August 2021 at a favorable term.

Our estimated CapEx for this year remains unchanged at approximately $2 billion with $1.3 billion of that for aircraft spend and approximately $700 million in non-aircraft capital spend. Our free cash flow of $392 million during third quarter enabled us to return $312 million to a shareholders through buybacks and dividends. We completed the $250 million accelerated share repurchase executed in July and year-to-date we have returned $1.7 billion to shareholders through the repurchase of $1.5 billion of common stock and the payment of $222 million in dividends. Our leverage including off balance sheet aircraft leases is in the low to mid 30% range.

I'll turn to the fleet and quickly walk you through that. We ended the quarter with 714 aircraft in our fleet and our plan is to end the year with 723 aircraft and that remains unchanged from what we last reported to you. We reached a meaningful milestone in our fleet during third quarter with the retirement of our last Dash 500 aircraft. We have 95 classic 737-300s remaining in our fleet that will be retired by the end of September next year.

During third quarter, we purchased four of our Dash 300s off operating lease. The lease termination cost was recorded as an $18 million special item and essentially represents the cash payment for the equity buyout. We assumed ownership of the aircraft thus adding the fair value of the aircraft as well as the associated remaining obligations to the balance sheet of said. We will continue to pay the underlying debt payments but we now avoid the lease return condition cost exposure. And our estimated EBIT improvement of our accelerated classic retirement remains in excess of $200 million as the prepayment of the rents were already contemplated in our original assumptions.

As the economics of the equity buyout were clearly favorable, we will continue to evaluate the opportunity to do similar transactions with the remaining 31 classics under operating lease that have terms that extend beyond September 30 of next year. Our year-over-year capacity growth for this year remains unchanged in the 5% to 6% range and as we announced last month, in light of the current revenue environment, we are slowing our capacity growth next year to less than a 4% likely 3.5%. Our domestic growth is estimated to account for approximately two points of that growth with the remaining allocated to international.

We'll begin the year with approximately 4% growth in first quarter 2017, bending down to flat to slightly up in fourth quarter 2017 due to the retirement of the classic fleet by the end of the third quarter next year.

In closing, we're pleased with our strong performance thus far this year and based on our fourth quarter outlook we're thrilled with the prospect of ending the year with an ROIC near 30%.

And with that overview, we are ready to take questions.

Thank you.

(Operator Instructions)

We'll take our first question from Jack Atkins with Stephens.

Good morning, good afternoon, everybody and thanks for the time.

Hi, Jack.

Just to clarify --for my first question just to clarify Tammy's comments there in her prepared remarks with the comments around unit revenue, positive unit revenues in early 2017. Was that specifically for January or was that a 1Q comment? And then also can you quantify the impact from Hurricane Matthew to your fourth quarter RASM expectations?

Sure, be happy to do that. Yes, the comment regarding getting back to flat and possibly a positive unit revenue was for early next year. I wouldn't rule that out for January but again, it's early to know. As you know, the majority of our bookings come in the month of travels so we get about 50% of our bookings in the month of travel but just based on what we're seeing in our booking trends so far for January, it looks really good.

Okay, great thank you for that, Tammy. When we think about the impact in 2017 from the recently announced labor agreements, is there any way to help us frame out the impact you are expecting on a full year next year?

We shared that for the fourth quarter. It's about 3.5 points, so that's at least a reference point for you for next year. I don't think we'll be too far off for that range on a year-over-year basis next year but we will certainly firm up all of that guidance for you on our next conference call.

Okay great, thanks again for the time.

And you had a question sorry about that of Hurricane Matthew. Let me give that to you really quick. For October it was probably close to a point for the year-over-year October performance and be a little less than that for the quarter in terms of RASM.

Okay thank you, Tammy.

We'll take our next question from Jamie Baker with JPMorgan.

Hi good afternoon everybody. So Gary, based on the trajectory that you're on it seems probable, not definite, but probable that Southwest will pay more than any airline for fuel next year, have significant ex-fuel cost pressures but you're certainly not alone and potentially see the sharpest margin decline of any airline in the states, and that's actually not the issue. I mean that's just kind of where the math is taking me. The question is when you ponder how the competition treats you and I'm not suggesting that you become is some 90-pound weakling, but is isn't there some risk that if the industry perceives you as being in a weakened position other airlines might start to turn on you?

Oh, I think that if airlines perceive weakness, they clearly will act upon that and the report today is certainly not of weakness, it's of strength. We're looking forward to a really solid 2017 and as you well know, we have consistently out performed the industry on the revenue front, not just in the last 24 months but over a longer period of time, going back well into five or six years ago, so we have a lot of tail winds that we're looking forward to.

We have a much smaller percentage of our route system under development and that's after a very aggressive 2013, 2014 and 2015 which have resulted in stellar profits, so that should provide wonderful strength for us. It is appropriate for us to slow our growth and be measured in the expansion that we undertake here in the near term until our unit revenue turns positive. We are off of our revenue plan here in 2016 and it's largely a second half issue. As you'll recall we had our analyst discussion back in June and then weeks later, we're seeing that the fare environment had changed for us pretty significantly.

We have a lot of strengths. We have costs that are significantly below the vast majority of our competitors, certainly if you look at the number of seats that are out there and we will continue to be strong and we will continue to operate strong.

A lot of the revenue declines year-over-year that we've seen after June 30, virtually all of them are in markets where we've seen competitive additions to those markets. We'll be mindful of that competitive growth, but you know that we're going to use our balance sheet, we're going to use our cost structure, we're going to use our employees with the service that we offer and we'll fight hard to maintain every single customer that we've fought hard to win.

Okay, thanks Gary, I'll just leave it at one question this time. Thanks.

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

Hi thanks. I wondered if you'd expand on that a little bit. Thinking about your relative cost structure versus other large airlines in a period where there was a lot of restructuring around you that you didn't do and a lot of furloughing around you that you didn't do. How do you feel about your relative cost position today looking out over the next five years versus the period that you have been in where large competitors restructured around you.

Well, I would say that if you look at recent history say the last five years, maybe last three to four years compared to where I think we are, Duane over the next five years, I think our competitive position is no worse and arguably at least relative to some competitors I think it will be better. We've got work to do on our part and we've got opportunities to boost our efficiencies, our productivity, we'll need to continue to work with our labor leadership to find ways to improve our efficiencies and eliminate waste, but I think we're positioned very well there.

The fleet modernization is the blunt tool that we'll use here in the near term and then as we deploy more and more new technologies over the next five years we'll have better tools and techniques to drive efficiencies further. I think we're very well positioned and that will continue to be the guiding principle for Southwest going forward which is to maintain our low cost position in the industry and improve upon it and we're going to continue to work hard to achieve that.

Thanks for that Gary, and then did you provide 2017 CASM ex? I may have missed it.

No, Duane, we did not provide that. We intend to provide that on our next call. We're still working through our plan. We're in the process of finalizing that, so we'll certainly give you a full report the next time we talk.

Just a follow-up there. Can you say how much of the accelerated depreciation is flowing through that fourth quarter guidance and when that would be expected to go away? Thanks for taking the questions.

In the fourth quarter guidance, that would be about 1% of our CASM. The change in our CASM ex.

And do you know when that dissipates? Thanks for taking the questions.

Yes, of course we'll have our classic fleet fully retired by September 30 of next year.

Thank you.

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

Hi, thank you. Gary or maybe even Bob, we often don't get a ton of data granularity from Southwest on RASM on these earnings calls but can you give us some color around the nature of what's been driving the yield weakness? Obviously you mentioned competitive capacity percentage in new markets, but what are the other things that we hear about like the impact of advantage fares or ULCCs or maybe your own mix of connecting in local traffic. Can you point out anything that's been specific or under appreciated to Southwest that you've identified at a RASM headwind that might be changing a little bit in the Q4 RASM forecast? Thank you.

Well yes, thanks, Hunter, and I do agree with you that we talk less about competitors and competitors fares than our competitors do so that's not going to change here today but yes, the fare environment is very competitive and we have seen an increase in competitor seats in our markets that is fairly significant year-over-year. So that obviously has an impact on us.

In terms of how we -- of course the past four quarters through the second quarter of last year we benefited from a very significant improvement with our Chase credit card deal so that lapses. And that puts us in a position where I think until we find another way for us to differentiate our revenue production, we're going to kind of fall in with industry performance which is where I see us here in the third quarter. That's where I see us in the fourth quarter so I don't see that we are out of step at all.

As to the mix of within Southwest Airlines of connecting versus non-stop traffic I'll let Bob speak to that. We provide some insights there but it is clear that if I think I understand where you're headed with your point that the fare environment will absolutely impact the mix of traffic that we realize on our network, so that will ebb and flow. Sometimes that's a positive effect in a short-term and sometimes it's a negative effect. Nothing necessarily structural.

We do have tools in place to manage that. We're looking forward to better tools with revenue management techniques, revenue management systems, any reservation system to manage that in the future. But Bob, is there anything specific that you want to share here for the third or fourth quarter?

No I'm probably being redundant but we have seen as you would expect with some of the changes in the fare environment a shift from some connect traffic to non-stop. We anticipated that and so through our revenue management systems we changed settings and things you'd normally do to anticipate the shift in traffic there but it's not a material change in terms of what we were managing or seeing. We saw it and we're managing it.

But I think Hunter, we're a member of the industry. We're in a scenario where there are more seats being added than the GDP is growing in terms of driving just natural travel demand and we're all seeing unit revenue pressure as a consequence of that. It's not shocking with fuel prices being down where they are and our goal has been and will continue to be to, which I think is the right thing to do for Southwest, is to continue to target positive unit revenue performances in each and every period. We aren't achieving that right now. That's not acceptable to us and we're going to continue to make adjustments until we do.

So as I follow-up then, you said you wanted to hit revenue positive last year and you didn't, and you're still talking about seats above GDP but you're doing it too. If you aren't tracking towards positive unit revenue as we move through the course of the year, even if your relic is above your cost of capital, would you cut capacity further?

Well again I have to pushback a little bit. Without retelling the entire story if you go from 2013, 2014, 2015 and there's some spill over into 2016, we had strategic opportunities that we took advantage of. It's something that you know well. Especially given the aggressive growth that we had in those periods, the revenue performance was exceptional. There are a lot of things that came online that we were confident they would produce. They have produced and they've been sustainable.

The industry growth has picked up in the last several years, so yes we'll need to contend with that. It is certainly correct to say that we are one of those that is currently growing faster than GDP and I'm mindful of that and hopefully have explained why that has been. I think prospectively we'll need to be more conservative with our growth and we're obviously committed to doing that in 2017. Tammy has already pointed out that we have an opportunity for positive unit revenue performance beginning in the first quarter. Some of the January strength we're seeing admittedly is the holiday shift, but I think the main tail wind that I'm encouraged with is the fewer number of markets under development that sort of balanced against the number of markets that are now facing more competition. On balance right now that's a negative number.

Thank you, Gary.

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

Hi good afternoon. Just follow-up on a couple of things. Just on the compressed holiday travel, is the thinking based on what you were seeing in bookings, do you recover most of that 1 to 1.5 point impact and the (inaudible) compression is not significant? And --

Yes.

Go ahead.

It's recovered in January, yes.

Savi, I'll clarify that. Yes, so basically if you look at the Christmas holiday, with that falling on a Sunday, there will be compression basically I think prior to that holiday. In other words customers will wait to take that trip in between New Years, or in between Christmas and New Years, so we do expect some of that 1.5 points to shift into first quarter but we believe some of that will be permanently lost, if you will. If you actually go back to periods where this, where the holiday timing fell at the same spot on the calendar, I think that's 2011 and 2005, our forecast lines up with what we saw back in 2005 and 2011, so we don't expect all of that shift to move into July (sic). I would expect them actually that we might lose the majority of that, but you we'll have to wait and see. It's so early to know at this point.

Got it and Tammy maybe if I could just ask on that 3.5 point pressure in fourth quarter as you do the contract. Which contracts are in that and are there any that's not? I'm just trying to think of if there's maybe a partial impact to the quarter or how should I think about that as maybe a run rate going forward?

I think you should think of it as the based on the status of all of our TAs that you're aware of. So mainly of course that would be the pilot and our flight attendants.

Okay got it great and if I might squeeze a quick enough answer in, Gary you mentioned route design techniques in addition to basic revenue management. Could you clarify that?

Well, sure. It's just all we're talking about is just what frequencies we have deployed to city pairs, what city pairs we have out there, so nothing magical about it but those are the two levers as you well know and those are the levers we will rely upon here to manage towards positive [RASM].

Great, thank you.

We'll take our next question from Andrew Didora with Bank of America.

Hi good afternoon, everyone and thank you for taking the questions. Tammy just had a question with regards to fuel. You remain 63% hedged for 2017 and this is pretty much well ahead of where you have been at this time of the year for each of the past two years from a hedge perspective. Can you give us a sense of the range of prices that you may have locked in for fuel next year or just based on the current curve and current hedge book what your 2017 hedge losses would be relative to 2016?

Sure be happy to provide that. As you noted we're 63% hedged and we have gains that would kick in if I remember correctly just above 75 Brent and the liability associated with our hedge book for 2015 is $525 million.

$525, thank you. And your hedge losses for 2016 were turning at [$1 billion]?

So our hedge losses for next year will be, based on the market, will be significantly less next year. You are correct.

Great thank you and then second question just for Gary. I guess based on what you're seeing in the RASM environment, is there anything that makes you question or have you seen any sort of structural change in the health the general health of the leisure traveler at all?

Oh, no not at all. I think this is all pretty predictable to if the scenario is lower input cost and capacity is then secondly stepped up is a consequence because profits are strong, there are more seats fighting for the same number of passengers essentially and prices are going to soften and that's exactly what's happening here. So couple things need to happen. Either demand needs to improve or supply needs to come in better alignment.

But in the meantime I'll just remind everybody that the profits are if they are not record levels they are near record levels, so I think what we'll want to do at Southwest is to continue to manage in a way that does not assume that these good times are extrapolated into infinity. I think that would be an enormous mistake, so the best discipline for us is to make sure that we keep revenues at a very healthy level and then therefore for us that means we want to continue to hang on to their unit revenue gains that we worked hard to achieve. That's pretty much it in a nutshell. That's what every other airline is seeing and what they will do to manage is obviously their business, but that's what we are going to do at Southwest.

Thank you.

We'll take our next question from Rajeev Lalwani with Morgan Stanley.

Hi thanks for the time. Just on your comment of getting to positive RASM next year, do you think your capacity guide, that 3.5%-4% level is enough to get you there based on just demand trends today and competitive dynamics today or do you think you need a little bit of help from the latter things I just mentioned?

No, I think that is a good plan for 2017. Our plan is to have flat to slightly up unit revenue performance for the year. There are always things that are unpredictable in any given year but that is the plan and that's based on our capacity set for next year. The one strategic thing that clearly we have under way that we'll want to follow through with is we're building this international terminal at Fort Lauderdale and that's strategic and it's committed and we will absolutely add to that.

Back to Savi's earlier question, with our current performance we're going to look very hard at our route network and make some decisions about what routes we might want to cut, what routes we might want to increase. Just a normal part of our process that we go through, for every schedule for that matter, but it will be with an increased intensity here because we aren't hitting our target. That's what you would expect us to do and that's what we expect ourselves. But yes, I'm comfortable with the 3.5% to 4% growth for next year and we'll continue to be thinking about what we do in 2018 based on how things progress in 2017.

Sorry, but Gary you are assuming the current demand environment, the current competitive dynamics continue into next year, or are you thinking that's the help to get you there?

It is based on our forecast of what competition is doing in 2017. So all of us have a sense of what capacity is expected for 2017, so yes we're factoring all that in.

And then follow-up. What is the reservation system upgrade come into play as far as being able to help you get there, or is that part of what you were just describing earlier in terms of router network adjustments?

No I'm not counting on anything from our new reservation system for 2017 in terms of moving the needle on improving our RASM performance. We're just going to rely on doing things the old fashioned way for now, which again I'm very proud of what our people have done over the course of time to get us to this point knowing full well we don't have all the tools and techniques we would like to have or that we will have. But those aren't going to magically appear in 2017. It will come on line and my expectation is they will come on line gradually and beginning in late 2017 early 2018. If we do better than that would all be fantastic but I'm not counting on that.

Helpful as always, thank you, Gary.

You bet.

We'll take our next question from Julie Yates with Credit Suisse.

Good afternoon, thanks for taking my questions. I wanted to go back to your comments on flat to positive RASM potentially in the first quarter. What are the other factors that give you confidence on that trajectory given your low level of visibility with just a fraction of the bookings so far your own capacity growth still above GDP, there's not a ton of relief on competitive capacity, the holiday shift might not fully be recaptured, and Easter shifts back into Q2. So I'm just trying to understand what you guys are seeing at this stage that gives you the confidence to say that.

Julie that's based on the bookings that we have for January relative to where we were last year, so as you pointed out, that's certainly not a forecast for all the reasons you just noted but the early signs for January are encouraging.

And then can you just remind us on Easter shifting back into April, I think last year you called it out as a $15 million swing between the two quarters, is it similar this year?

At this point I wouldn't think it would be materially different from that.

What percentage of January do you have booked at this point?

I don't know off the top of my head but it's not much. It's enough for us to get a read on the headline trends that we're describing to you but we've got a long way to go. We generally will start a month with about half the bookings in place. I'd mention one other thing on the first quarter which is our seat growth is less than 3% in the first quarter so our growth is absolutely beginning to slow.

When will you guys give us an indication on the pace of growth in the second quarter? I noticed recently on the website you guys are going to release two more weeks November 1, I think typically you released more like four to six weeks of seat inventory. Is that because you're rethinking the pace of growth in the second quarter given the revenue environment?

Julie, I can help. As it lines up to our full year guidance anyway, the less than four, just kind of mathematically the way that would fall out quarter to quarter is that second to third quarter would be in the 4% to 5% range and then we've been down in the fourth quarter and so that would be closer to flat when we get to the fourth quarter. So that's kind of mathematically how all of that would fall out. Now of course domestic growth would be less than what I just provided. Might call it a point or so.

The schedule all we're doing now is preparing for the launch of the new reservation system and that's the only thing that has a bearing on what you see published.

Okay, understood.

We don't have a specific date to tell you yet but other than we said it's going to be in May, but just to be clear the published schedule has nothing to do with any concern about the revenue.

Got it. Okay thanks so much.

You bet.

We'll take our next question from Darryl Genovesi with UBS.

Hi guys thanks for the time. Tammy you called out 100 basis point to 150 basis point hit to RASM in the fourth quarter from the calendar, but I was wondering does that also include the discount travel vouchers that you had issued during the service disruption, the redemption of those that likely takes place in the fourth quarter?

No that did not include the travel vouchers. We would expect some impact from the travel vouchers but we don't expect that to be [there].

Okay thanks for that and then I guess on--

And just if you're looking for a dollar figure there, it's going to be, say, under $10 million.

Right. Thank you and then with respect to 2017 unit costs, I think Duane asked you about accelerated depreciation, you said it carries through but it doesn't actually grow next year right? The accelerated depreciation is pretty constant from here?

It's pretty constant, that's exactly right. As we move into next year.

And hiring units along the way so that will actually come down as will the fuel burn penalty that you get with the older airplanes and the extra maintenance burden, so it all sort of tapers off.

Okay and then are there any other big cost items that you'd highlight for 2017 that we haven't talked about already today?

We will have some costs associated with the implementation of our reservation system as we ramp up for that. That will also taper off, but as Gary alluded to earlier I think we're very well positioned next year. Yes, we do have cost pressures from our labor agreements but we have opportunities throughout the Company to really fine tune and improve efficiencies and that's exactly what we are going to be focused on and we are looking forward to giving you more of an update on our next conference call. But other than that I wouldn't really call anything out.

As we look into 2017 and 2018 too, our hope would be on the technology side as well. We could at least start bending that down in addition. So no, we are very focused on this and I am confident we'll be able to control our cost over the long run.

Thanks very much.

I think this is probably somewhat related to Jamie's earlier question about cost, but there is a significant amount of spending this year and next year related to technology investments and they are not necessarily all capitalized. A lot of that's just running straight through expenses. So they are all being done because we believe that there will be significant value that flows from them. And I agree with Tammy, I would hope that we can reign in some of our technology spending in the future because it's -- for us, it's quite high right now but all very important things that we want to get accomplished.

Great, thanks again.

We'll go next to Joseph DeNardi with Stifel Nicolaus.

Gary, if getting to positive RASM next year is a goal of yours and the Company, should it be a component of your short-term compensation? As far as I can tell about 17% of your short-term comp is driven by total revenues. Would you like to commit to replace that with a RASM metric?

Well I wish it was up to me and I would do it differently. That's a joke. I don't know I'll talk to the Board about that. I've heard that feedback from Investor Relations that some of our investors are interested that. We try to have a balanced approach. We don't want to incent the wrong behavior and although the officers that I work with and our Directors are all focused on just doing what's best for Southwest Airlines, period. But yes, that's something that we'll look at, but no I'm not going to commit because I'm not in charge. I'm not the Chairman of the comp committee and that will be up to the Compensation Committee.

Okay fair enough. And then just at Lauderdale could you just, I mean are you guys prepared at this point to maybe share with us what your plans are? I think you have exclusive access to four of the five gates. What sort of utilization do you guys expect to have there initially?

We'll be releasing that in January. So stay tuned.

Okay, thank you.

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

Thanks, Operator. Hi guys, thanks for the time. Just one question here. I know the flight attendant results are due back on Monday. When is the pilot results due back?

I think Mike it's later next week?

It's November.

November 7.

November 7, perfect. Then on the CASM guidance, the 4% to 5% that you gave us, is that inclusive of the salary increases that you also talked about or is that excluding those salaries?

That would be including them.

Yes that assumes those deals are in effect, yes.

Okay, and then just one last follow-up. You talked about the tech outage earlier in the third quarter. So as you think about that IT spend, does that also include some amount of money to prevent an occurrence again or if something goes -- you can't obviously always prevent things but if something goes wrong again can you -- can like your pilots wirelessly check in or can you go to a wireless system or somehow still manage to keep the airline running while in the background you fix the issues?

Actually, you're very insightful. We have a long list of opportunities to improve our tools and techniques and of course we just didn't start this year. This has been a process, I've been with Southwest 30 years and we've been continually investing in technology and evolving the tools. Hardening or fortifying our technology is absolutely a component of our spending.

Right now, we are in the midst of establishing a new data center which, in effect, has a complete redundant data center at the same place in addition to a back up facility, as just one example. All those things are under way and with the belief that just like a product, we want our airline to be better every year than it was the year before and we want our technology tools and capabilities also to fit that kind of a definition.

I think I've mentioned to you all many times before, we've got two basic stacks of technology we're working on. We've got the commercial side of things with the new reservation system as the marquee item, but there is a long list of sub projects under that we have shared with you all that are on the docket over the next several years. Likewise, Mike Van de Ven on the Ops side of things has a similar agenda and better automation and techniques, rather tools and techniques and communication techniques are very much in the queue for work over the next several years with respect to our flight crews.

So the outage was really odd. I think I would readily admit to everybody that it is impossible to have a fail-safe back over for every conceivable scenario that could happen but it is -- we're in really good shape and have a lot of experience in preventing outages like that. So hopefully that addresses your question but absolutely we'll want to continue to invest to fortify our technology.

Yes, thank you very much. Thank you.

We have time for one more question. We'll take our last question from Michael Linenberg with Deutsche Bank.

Hi thanks, good afternoon everyone. Two quick ones here. Gary you talk about the increased competition in your markets. Can you give us a sense about maybe as a percent of ASMs what you've seen coming over the last year and just looking at the schedules, it does seem to be much more driven by ultra low cost carriers rather than majors, is that right?

Oh, sure. In other words all things that you know that most of the high growth airlines are the smaller low cost airlines, although some of the legacy carriers are obviously growing in the grand scheme of things pretty aggressively, but most of it is coming there. And then number two, Southwest is a big city, big traffic airline. That's where the passengers are so we are clearly -- there's one exception with one airline who has a different strategy but in an environment like this we at Southwest should fully expect more competition. We have expected it. We predicted it internally and in fact its happening, so we need to compete and we need to compete by striving to have the best service at the lowest price and that's what our strategy is oriented around. We aren't surprised that is the case, Mike, but that's what you're asking is exactly what's happening.

Do you have a sense on percentage of coverage? Is that something you'd have or maybe I can get it from you offline?

You know, I don't have that readily in my mind. I'm looking at Tammy and Marcy to see if they have something they feel comfortable in sharing, Why don't you let us work on that because I think it's a very reasonable question and something that would help everyone understand better what is happening in the revenue environment but in any event we need to be very prepared for competition. We are, our employees are warriors and we're going to fight very hard to not only keep the customers we serve today but we want to win more in the future so you do that with great service and low fares, period.

And Gary, on just the in terms of seats, I do have that figure. It's roughly, probably roughly a 20% increase year-over-year for the third quarter and just the group, the ULCCs.

Oh, great.

It's big and again, I think that hopefully that will help everyone get a sense of why there is some impact on our unit revenue performance. It's a pretty big increase and actually, as I look at our individual city pair results I'm very pleased with how well we are performing. We aren't going anywhere and we aren't going to back off in these markets and obviously, we are very pro competition and pro consumer and very well prepared to compete in this environment.

And then just squeezing in one more on ancillaries per passenger. Every airline measures it differently. They throw in different items. When you guys think about that, like what's a rough number and if you don't have it you can always give it to me offline, but thanks for the questions.

Well Mike you just talking about what's the right number to be targeting for us?

What is it currently. Are you $12 a passenger, $15 a passenger, how do you think about that and just kind of get a baseline number.

We've got the number, I just don't have it at my finger tips. We don't rank high in the way I think we would categorize ancillary and I do think that we have some pretty significant opportunities to drive our ancillary business in the future. I would just quickly say that while we aren't hitting our revenue target in the bullseye right now we are doing a lot, so I don't want our Company to chase too many things simultaneously. We need to focus, we need to execute well, we have a very good strategy, we have a long history of performing exceptionally well and I'm very confident that we'll continue to execute well.

However, there are a fair number of opportunities that we ultimately will want to pursue and we'll keep those relatively close to the vest until we're ready to reveal them. But I'm not talking about charging for bags and I'm not talking about change fees or some of those basics, but we do have opportunities to invest in tools and techniques and perhaps beef up our own resources to be able to pursue some of these opportunities and I think that they would be meaningful.

But driving growth in the ancillaries per passenger is absolutely an objective that we have. I don't know that we'll be doing a lot of that in 2017. It feels to me like it's more of a follow on after we get our new reservation system in.

I agree, Gary. The only other thing I'd add to that is at least for the ancillary products that we do have like our Early-Bird and our Business Select, Early-Bird as an example we're continuing to see very significant year-over-year growth and ancillary products such as that.

Okay great thanks Tammy, thanks Gary.

Thanks.

That concludes the Analyst portion of today's call. Thank you for joining. Ladies and Gentlemen we'll now begin our media portion for today's call. I'd like to first introduce Ms. Linda Rutherford, Vice President and Chief Communications Officer.

Thank you Tom, and welcome to the members of the media who are on our call today. Before you start queuing for questions, Tom do you mind just giving them some instructions on how to do so?

Yes ma'am.

(Operator Instructions)

We'll now take our first question from Conor Shine with the Dallas Morning News.

Just wondering if you could provide a little bit more detail, geographically which markets you are seeing higher than average competition. Are there specific ones that you feel that pressure more?

Not really. Of course knowing your Dallas centric, ironic. The one I don't mind sharing is Dallas and Dallas is very strong. Of course we're at a steady state over at Love Field at this point, but Dallas is doing well and DFW, as an airport with its traffic, has grown a lot.

Just thinking about the 48 states there's a lot of competitive pressure in the West. You've got airlines adding capacity in Seattle and LA, and I guess, Bob, in the Bay Area, so but it's for the most part it's all over the country. So there are about -- the industry is growing at about a 5% clip in terms of seats and as you know, the economy is growing sub-2% so that's what's happening and it makes sense to the industry to do that because energy prices are so low and we're very leveraged to energy prices.

Thank you.

We'll go next to Susan Carey with Wall Street Journal.

Good morning. Tammy I think I missed your last comment about -- what I heard was a 20% increase in seats. This was from the discussion about what the ULCCs are doing and I just, I'm thinking that I can't have heard that right and in which period and compared with what?

That was just for the third quarter but we're seeing -- that's year-over-year for the third quarter, but we are seeing as Gary said competition really across all of our markets by the entire industry but certainly a lot of seats being added by the ULCCs, but that was a third quarter year-over-year comment.

So I don't know the statistics Susan, so I'll make sure we clarify for you what it is, so Tammy you're saying if you took the ULCC seats in our markets that they grew their seats by 20%?

That is correct.

Wow.

Yes, their seats. Now again, they are a lot smaller than we are.

Right.

So it is not 20% of our seats it's 20% of their seats.

Okay, super, thank you.

And just to give -- not to give too many numbers but just to put an exclamation point on what Gary just said, that in terms of just total seats for the industry that's probably close to probably 5%.

This is domestic seats?

That is correct.

Okay, thank you very much.

We'll take our next question from Mary Schlangenstein with Bloomberg News.

Thanks. Gary is there any way you could put any detail on the ancillary opportunities that you'll look at? Is there anyway you can describe a couple of those for us?

Well, it's just not ready for primetime and I would rather not share with our competitors where we see opportunities for a variety of reasons, so I will decline on that one but thank you for the question.

Okay, can I also ask you filed with the DOT to extend the start date on your Fort Lauderdale Havana route to December 12. Have you gotten a response from the DOT on that yet?

We have not.

Great. Thank you.

My pleasure. I'm very informed on that topic, Mary.

Thank you.

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

Hi, well Susan actually asked my question with an assist from Gary to clarify that. But maybe Tammy, if it's a 20% increase in third quarter and seats from the legacy up from the ULCCs, do you have a comparable figure from the legacies? And then more broadly for Gary, did you not expect this or was this to a greater extent than you'd ever seen before?

Well, no. I'll just speak for me personally. Yes, I have expected that if the industry profits recover, which they have, and then we recovered more with lower fuel prices, it's just a natural extension of that is that individual companies are going to be more aggressive and especially the smaller carriers, so I think it's all very predictable. What the effect of that behavior is, is less predictable. So we had a plan for 2016. Its turned out to be more aggressive than our results and we go back and adjust.

But no I don't think it's shocking where we are at all. And we'll continue to compete very aggressively in this environment and I think we have all of the strengths that we need, mainly the people of Southwest Airlines, to compete and win customers, compete for and win customers.

Okay thanks, and then was there a legacy figure on that, Tammy?

It would be in the 5% to10% range but just keep in mind, that's very significant percentage of the seats in the industry, but if you're just looking at the network carriers, it would be in the 5% to 10% range.

Well and if I could just, hopefully this helps clarify for everybody. We're the nation's leading airline. We're in all the major cities, we're in all the major city pairs and so by definition anybody who grows in the US they will likely be growing in our market so I probably should have made that more common sense argument for the group earlier. The competition isn't adding seats to small markets. In fact if anything they're taking seats out of small markets so where they are going where the traffic is and that is our specialty because we are an airline that serves major markets with lots of traffic. So I think that it's very it should be intuitive for everyone that whether it's a legacy carrier or whether it is a ULCC that they will likely be overlapping with us when they add capacity.

Thank you.

Just as a reminder we carry one in four passengers here in the US and our network is [fast] so I don't think there's really anything surprising in the numbers that we provided.

We'll take our next question from Dawn Gilbertson with the Arizona Republic Newspaper.

Good morning, Gary. I have a couple questions. You mentioned in the beginning the new booking future of the reservation system will debut in December. What does that mean, if anything, for travelers?

I don't think it's going to really mean anything. I think customers will mostly go to www.southwest.com, that's where the super majority of our customers book Southwest and they will see the same www.southwest.com that they know and love. It is behind www.southwest.com where we will have a new reservation system engine so -- Bob, I think for the most part it's going to be invisible to our customers so they won't know that they're making a booking in a new system as far as I can recall.

That's exactly right. The ease-of-use with www.southwest.com will continue exactly like it is today and for customers booking there they really won't see any change.

Will they see change come May?

I'd have to think about that. I don't think there's anything that is customer experience-wise that they will see, so this is all back office things. Now, Bob has staffed up in our call centers significantly in anticipation of a new system that will take longer for our people to work with just because of a learning curve. We'll have all of the resources we need so that should be transparent to the customer as well. But other than that, I don't think the customer, even in that I don't think the customer is going to see anything different.

They won't.

You mean staffing up as in the approaches or right away like starting now? In the red centers?

Well he's staffed up already because they need to go through training and they need to know what it's like to talk to a customer, to make a booking and work through changes in all those things before we add the new technology, all that is in place and I think Mike is going to -- between Mike and Bob they will have trained about 20,000 employees with this new reservation system. One other thing real quick, Dawn, since you're on this topic is remember that we launched international service in mid 2014 and that is using the technology that we are now converting the rest of our reservation system to, so we already have a lot of experience with this current technology and so I'm expecting that this is going to go very well.

Okay, couple more if I may. You gave the $55 million revenue impact from the outage. I don't recall a cost figure, a hit on the cost side. Is there a figure for that?

$24 million.

Okay and last question if I may I think you alluded to this when you were talking about ancillary, but in one of the analyst reports this morning it talked about given the weak RASM and the labor cost pressures it's time for investors to turn up the volume on the need for things like bag fees. Do you have any comment on that beyond what you've already said?

Well my hearing is good and I understand. I think my answer is consistent which is if we want to improve RASM we don't want to charge back fees because that would only have a negative effect on our RASM. We have a unique and beloved position in the industry with this approach and we would be foolish to squander it, so no thought whatsoever with charging bags.

Thank you so much.

Beyond what we already do of course. Which is modest.

Right, thank you.

We have time for one more question, we'll take our last question from Richard Velotta with Las Vegas Review Journal.

Good morning, Gary. I actually have a couple as well. One, could you give an update as to where Las Vegas stands in the queue for international service to Mexico? Based off the new plans for LAX.

Well, Rich, right now there's none planned for 2017. Las Vegas is obviously as you know an extraordinarily important market for Southwest and one that we have tremendous community relationships with. We will continue to keep it very high in our consideration set, but the focus for next year we'll be following up or following through with our Houston Hobby launch, we're obviously just getting started in Cuba and LAX to Mexico and then we'll be launching Fort Lauderdale so that keeps us really busy for the near term.

Okay, and then the other would be is it my understanding that Southwest does not have any objections to the Northern most stadium -- proposed stadium site. Pilots indicated they were not in favor of the Southern one at Bali Hai Golf Course but there's a Northern one near Russell Road that I haven't heard specifically whether there's any problem with that.

Rich, let me get back to you on that one.

All right.

I want to make sure I give you an accurate answer and that has not been my focus. So I want the most up-to-date information.

Okay, thank you.

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

Thanks Tom. As always if our media folks have any follow-up questions reach us at 214-792-4847 or via our media web portal at www.swamedia.com. Thanks so much.

That concludes today's call. Thank you for joining.