西南航空 (LUV) 2017 Q2 法說會逐字稿

Welcome to the Southwest Airlines Second Quarter 2017 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.

Joining the call today, we have Gary Kelly, Chairman of the Board and Chief Executive Officer; Tammy Romo, Executive Vice President and Chief Financial Officer; Tom Nealon, President; Mike Van de Ven, Chief Operating Officer; and other management -- I'm sorry, other members of senior management.

Please note today's call will include forward-looking statements and because these statements are based on the company's current intent, expectation and projections, they are not guarantees of future performance and a variety of factors could cause actual results to differ materially.

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

This call will begin with prepared remarks from management, after which the lines will be open for questions.

(Operator Instructions)

At this time, I'd like to go ahead and turn the call over to Mr. Kelly for opening remarks.

Please go ahead, sir.

Thank you, Tom, and good morning, everyone, and thanks for joining us for our second quarter 2017 conference call.

I am very pleased to report another very strong quarter and record EPS, and that is despite higher labor contract costs since 2016 and also somewhat higher fuel prices.

We had strong cash flow.

We completed our 2016 share repurchase authorization.

I was also pleased to see growth in average fares for the first time in about 2 years.

And despite some drag from our reservation system conversion, we had a solid unit revenue performance of increase of 1.5%, which was right in line with our expectations.

Without the res system conversion, it would have been closer to a 2.5% growth on 5.1% capacity growth, a very solid revenue performance, with corrective actions planned before year-end on some of our res system issues.

Our third quarter outlook is in line with second quarter.

The year-ago comps, taking those into consideration.

The new reservation system penalty is a little bit more in the third quarter.

The 4th of July holiday timing softens the third quarter performance and the sequential comp to second quarter is harder with the full Easter benefit showing up in the second quarter.

Net all that out and up 1% year-over-year is what we would expect, what you all should expect, relative to the trends from the second quarter.

Our cost forecast for the year is higher than we last reported.

I'm not real happy about that.

We're certainly not satisfied with that.

We'll be working hard during the second half of this year to rein it back into our original 2017 plan.

I was very pleased with the second quarter cost performance and can at least confirm that, trend wise, we'll see our unit cost pressure year-over-year begin to ease here in the third quarter and then again in the fourth quarter.

Tammy will explain further, but I did want to offer some commentary on our capacity forecast.

It's being updated today for the full year 2017.

We have a large number of airplane deliveries scheduled for this year.

If you will note in the press release, it's 71.

18 of those are preowned airplanes.

They go through an extensive conversion process to match the Southwest livery and convert to our maintenance configuration.

So we conservatively planned for the completion of that prior to committing those airplanes into revenue service.

And our tech ops folks are doing a fantastic job.

And what we're finding here in 2017 is the aircraft are being delivered earlier than we had planned.

We have put those early deliveries into revenue service this year, in essence, as a spare, and that's driven our cancellations down and, therefore, our ASM production higher, all compared to our forecast -- and that's all as compared to a 3.5% annual forecast.

So knowing that, for the second half of the year, we've updated our forecast and we've also decided to implement some scheduled flying with some of this available aircraft soon, and that will be flying beginning in the fourth quarter.

We expect the incremental capacity to be profit-accretive, of course, or we wouldn't do it.

The fourth quarter will still result in very modest year-over-year capacity growth somewhere in the 1% to 2% range.

And as of now, we aren't expecting any change to the rough 2018 estimates that we provided last quarter and then updated today.

The highlight for this year and for this quarter was our new reservation system.

I am very proud of our people, the job that they did in designing and building and testing and deploying this new technology.

It was literally a flawless deployment.

We've discovered some design issues, if you will, and as I said, I expect those to be remedied quickly.

Next, I'm very proud of all of the frontline employees along with all of our training folks.

They worked exceptionally hard to learn and use a totally new system.

It has been very hard work, but they have made it look easy to our customers.

So again, my hat is off to them.

So aside from what I would describe as normal break-in issues that one would expect from a system effort that's this massive, it is all we expected it to be.

We'll work hard to hit our $200 million run rate of incremental annual revenues by the end of next year and that does not include fixing the problems that we discussed that affect the second and third quarter.

We achieved another important second quarter milestone with the completion of the new international concourse at Fort Lauderdale and then the launch of new international flights from Fort Lauderdale, and that included the new destinations on our route network, which was Grand Cayman.

We opened Cincinnati in the quarter to a very warm welcome from the community.

We're off to a great start there.

And we are in the final lap this quarter preparing for the launch of the 737 MAX 8 on October 1 along with the retirement of our Classic fleets -- or fleet rather in late September.

So I do want to thank all our people again for a very strong performance, congratulate them on a superb quarter that earned them profit sharing of $202 million.

And with that very quick overview, I'd like to turn it over to our Chief Financial Officer, Tammy Romo, to take us through the quarterly financials.

Thanks, Gary, and welcome, everyone.

Our employees did a great job again this quarter providing their legendary customer service, and I'd like to thank them for that and congratulate them on a great quarter.

Our second quarter profits were a strong $746 million and, excluding special items, $748 million and our earnings per share, excluding special items, was a record performance.

Margins were very healthy and our operating margin exceeded 21%.

Our balance sheet, cash flows and liquidity remained strong and I am delighted with our recent upgrade to A3 by Moody's.

We are committed to our investment-grade rating and, as always, the prudent management of our capital structure.

Overall, I'm very pleased with the second quarter and would like to congratulate our employees on the $202 million in profit sharing.

On the revenue side, our second quarter passenger and operating revenues hit an all-time quarterly high.

Our unit revenues have turned positive and were up 1.5% year-over-year.

This performance was right in line with our guidance, even with the greater than expected impact from the new reservation system cutover.

The RASM pressure from the reservation system transition was less than 1-point year-over-year for our second quarter.

Adjusting for this unfavorable impact, our RASM performance looks to be at least on par with the industry, which is notable considering our very significant outperformance in second quarter of last year.

As noted in our earnings release, the RASM pressure from the transition to our new reservation system is temporary and these items are relatively minor considering the significance of the technology efforts.

And we expect to have the necessary technology and procedural fixes in place by the end of this year.

For our third quarter, we expect year-over-year RASM growth to be approximately 1%, which includes about 1 point of unfavorable impact from the reservation system cutover.

We do not expect a significant impact beyond third quarter.

Our third quarter revenue trends were also impacted by the timing of the July 4th holiday as well as last year's outage, which roughly offset each other on a unit basis.

Adjusting for the timing of July 4th, sequential trends look to be in line with, if not slightly ahead of, historical trends.

We had nice growth again in other revenues for second quarter, which increased 7.6% year-over-year, driven primarily by increased Rapid Rewards.

And we expect another year-over-year increase in other revenues in third quarter.

So turning to costs now.

Our second quarter cost performance was slightly better than expected.

Similar to first quarter, fuel prices were higher in the second quarter this year as compared with the same period last year.

We saw fuel efficiency gains in the quarter, with the capacity increase outpacing the increase in gallons used.

This is meaningful and is being driven by fleet modernization and other fuel savings initiatives.

Based on market prices last Friday and our current third quarter hedge position, we expect our third quarter fuel price per gallon to be in the $1.95 to $2 per gallon range, which is below a year ago.

Third quarter fuel cost estimate includes $0.35 in hedging losses, which is comparable to the amount of hedging loss we currently expect for fourth quarter.

With fuel hedge losses significantly below where they were last year and the second half of the -- of this year, we currently expect our economic fuel price per gallon in fourth quarter to also decrease year-over-year.

Excluding fuel, special items and profit sharing, unit costs came in a little better than we expected, primarily due to lower advertising spend.

We were up 5.3% for the quarter largely due to higher wage rates from labor contracts as well as technology implementation costs associated with the new reservation system and our operational initiatives.

We expect these cost pressures to ease as we go through the remainder of the year.

Based on current trends, we expect third quarter CASM, excluding fuel, special items and profit sharing, to increase in the 2% to 3% range year-over-year.

Last year's amendments to our labor agreements are driving 3.5 points of the year-over-year increase, which is being partially offset by a slowing technology spend and continued benefits from the retirements of the Classic.

And we continue to expect fourth quarter unit costs, excluding fuel, special items and profit sharing, to be comparable with year-ago levels.

Considering our modest capacity growth plan for the fourth quarter, I'm encouraged by our fourth quarter unit costs outlook, which does reflect our focus on lowering costs.

And we intend to do that as well as we move into 2018.

We ended the quarter with our industry-leading investment-grade balance sheet as strong as ever.

Our year-to-date free cash flow of $1.4 billion was solid and was driven by strong operating cash flow and manageable CapEx level.

Our expectation for CapEx in 2017 remains at roughly $2.3 billion, with $1.4 billion related to aircraft spend.

During the second quarter, our Board of Directors approved a 25% increase in our quarterly dividend as well as a new $2 billion share repurchase authorization.

For the first half of this year, we have returned $1.1 billion in buybacks and dividends to our shareholders.

$400 million of these returns were from the accelerated share repurchase program that was launched during second quarter and completed this month, which completed the previous $2 billion buyback authorization.

And in June, we paid our 163rd consecutive dividend, which totaled $76 million.

Our leverage, including off-balance sheet aircraft leases, is now just over 30%.

And as ever, preserving our strong balance sheet and cash flows remains a priority for us.

Turning now to fleet and capacity.

All said, there hasn't been really any significant changes to our fleet or capacity plans.

We ended the second quarter with 735 aircraft in our fleet.

And as a result of the Classic retirements, we expect our fleet to decline to 688 at the end of third quarter.

We'll grow our fleet to 707 aircraft by year-end 2017 and we still expect to be at 750 aircraft at year-end 2018.

With respect to our Classic fleet, we had 69 Classic aircraft in our fleet at the end of the second quarter and are down to 67 today.

We intend to retire all 67, of course, by the end of this quarter.

As we continue to manage through the retirement of these aircraft, we purchased 2 of our 300 previously under operating lease during second quarter.

And the lease termination cost associated with this was approximately $8 million, which was recorded as a special item.

At the end of second quarter, we had 21 Classics under operating leases remaining in our fleet.

And we expect to record a charge of approximately $60 million as a special item related to these aircraft, which is primarily related to the lease payments due as of the date we ceased use of the Classic.

There could be additional charges recorded in third quarter associated with certain lease return requirements that may need to be performed on the aircraft prior to their return to the lessor, but we don't expect these charges to be significant.

And just as a reminder, these charges were contemplated in the estimated $200 million even improvement from accelerating the Classics from 2021 to 2017.

Turning to our order book.

We made just some tweaks to the order book and, in short, we added 4 preowned 700s.

And with the acquisition of these aircraft, we deferred our 4 remaining -800 options and converted them to 4 MAX 8 options, 2 in 2021 and 2 in 2022.

And we're gearing up for the MAX 8 and we're looking forward to that and expect even more fuel efficiency gains from that aircraft.

We'll get our first MAX delivery in August and we will have 10 by the end of third quarter.

The MAX will enter service on October 1 immediately following our Classic fleet retirement.

With this fleet plan, capacity growth in third quarter 2017 is expected to be approximately 4% to 5% and fourth quarter growth in the 1% to 2% range year-over-year.

And our expectations for 2018 year-over-year capacity growth continue to be less than 4% for the first half of the year and less than 2016's 5.7% for the full year.

Our domestic network remains strong and our international flying is maturing nicely.

And we continue to grow our network prudently and profitably.

So to close, I'll congratulate our employees again on a great quarter.

Our reservation system is up and running and our employees are doing an outstanding job navigating the new system.

Service began in June to Grand Cayman and Cincinnati and we are excited about our upcoming service to Turks and Caicos in November.

The international terminal at Fort Lauderdale opened earlier this month, which supports our current international flying as well as future growth opportunity.

The MAX 8 is almost here and we will be retiring the remaining Classics by the end of this quarter, which is, by far, the most aircraft we've ever retired in a single quarter in our history.

These are very significant accomplishments and our people, once again, demonstrated their warrior spirit and that they are the best in the industry with their unmatched hospitality.

And with that, Tom, we're ready to take questions.

(Operator Instructions) We'll take our first question from Helane Becker with Cowen and Company.

This actually Conor in for Helane.

So we appreciate the color on the 2018 capacity growth, but could you just help us break it down a little bit further?

I know that the schedules aren't final, but how much of your growth should we expect to be in the domestic market versus international overall?

Tammy, I believe that the split is roughly with what is published right now.

With the updated forecast for the improved completion factor, I believe it's roughly 3.1 points coming from domestic and the balance coming from...

For this year.

For 2017.

For this year.

That's right.

Yes, for the full year, and the balance coming from international.

So the domestic mix is still near 3%.

Yes.

It's still near 3%.

That's right.

That doesn't include the additional flights that I mentioned that we are planning to publish soon.

And those are domestic flights as well so that might boost that by a 1/10 or 2, but it will be -- obviously, it will be very modest since it's just one quarter.

Just to be clear, that's for 2018 or 2017?

I beg your pardon.

So that was 2017.

Yes, that's 2017.

Was your question '18?

Yes, sorry.

Well, we haven't shared that yet.

And quite frankly, we haven't made our final choices yet.

So you'll have to stay tuned on that one.

We opened the schedules today at least through April.

Okay.

Fair enough.

In terms of the reservation system and the cost tailwind that we should associate for that for 2018, so what was the -- was there any cost associated with the reservation system in the second quarter of this year?

And what was it again for the third quarter?

On the reservation system cost, I'll give you kind of a breakdown.

As we kind of move through the year here, we -- third quarter -- as we get into the third quarter, we do expect that to ease.

And we've got -- just from the technology for the full year, it's going to net to something relatively small, but for the -- I'm pulling here for the second quarter alone.

If you'll just bear with me one second, we'll pull that for you.

If you'll bear with me, we'll get back to you with the number for the second quarter.

And we'll take our next question from Brandon Oglenski with Barclays.

So look, forgive me because I'm just an equity analyst, but can we talk a little bit more about precisely what's happening with the rollout of the reservation system?

Why that's negatively impacting RASM and why you think that's only going to be contained in the third quarter?

I'd be appreciative.

We have a handful of items.

I would just identify, in my mind, 3 that are very isolated.

And the new system for these 3 items does not work like the old system.

So for -- and Southwest is unique.

So one of the items that's pretty easy to visualize is we have a product called Business Select that we sell that allows customers to have the first 15 boarding positions and their choice of seats once they get on the airplane.

There is a corollary product that we call Upgraded Boarding.

For any seats that have not been sold yet as Business Select, our customer service agents can sell those seats for a price at the gate.

So this is when you're there for departure.

And that particular product is not working as we would intend it to work and we are not getting the Upgraded Boarding revenue.

It's not a huge amount of money, but it's an example that we're describing.

So you think about just the vast majority of our customers, they are -- the new system is working very, very well with no real change in our -- in the new system versus the old system.

There are a couple of items like that.

The more material one is a little harder to explain and it's with our groups.

So we do have a product for 10 or more people that are traveling.

And a lot of that in the back office is manual so the new system is a little bit harder and more cumbersome, I think, is probably the easiest way for -- as a lay person to describe it.

And the issue -- it will go down in the weeds, but the issue is when we have groups that cancel, it is harder for our people to identify those cancellations, go in and reopen that seat inventory and then resell those seats, and that's where we're seeing a revenue penalty, if you will, from the group.

So there's a couple -- and that's the biggest one.

So there's a couple of items like that.

There's -- fixes are already designed.

The construction is underway.

And then now, it's just a matter of when will they be done and, obviously, Tammy and I are hopeful that they'll be done yesterday.

But those -- and we intend -- we expected that we would have some things like that, but those were a couple that we just didn't anticipate.

In fairness, we have some things that are positives too that went into effect with the new system, but these negatives are offsetting the positives right now.

So it has nothing to do with the elegance of the system, whether it meets our needs, whether it will be able to realize our benefits.

These are just a couple of one-off items that we found that we'll fix and we'll get it behind us.

Okay.

I appreciate going a little bit more in depth there.

And then, I wanted to talk to your comments as well as you're getting the aircraft in the fleet a little bit faster this year.

It sounds like you're still talking about 4% capacity growth in the front half of '18.

Does that mean you're finding incremental opportunities for capacity next year, given that, that growth was most likely slated for earlier in the year in '18?

If I understand your question, I think what we are about to publish in terms of additional flights, they are flights that we have already planned for next year and we're simply accelerating them to 2018, if that's the answer to your question.

Yes.

So it's a complicated way to ask it.

So in other words, if you fast forward to the end of 2018, we don't -- we're not doing anything right now that would end up with more trips, in theory at least, than what we were contemplating before.

That's just with a caveat that we're only published through April and we are still working on what we want to do for the balance of 2018, but I think, conceptually, all we're doing with the additional fourth quarter flying is we're accelerating already planned adds into the fourth quarter.

The other color commentary I would offer up there is it's a little painful for us here in the fourth quarter to ground the Classics.

And in order to continue with funding some of the additional flying that's already committed for end 2017, we're having to make cuts in areas that we don't like.

So this is an opportunity for us to restore some of those more painful cuts.

And as I mentioned before, these are kind of no-brainer opportunities for us where we're very confident that there'll be profit additive to the quarter.

They were planned additions in the first place.

We just found the airplane time available and have been able to accelerate it.

And if I could jump in here, Gary, just to add a little color on the first question.

The technology year-over-year impact in the second quarter was in the $10 million to $15 million range.

And for the first half of the year, we had pretty heavy spending as well in the first quarter and that was probably another, call it, $35 million.

So for the first half of the year, we've -- the impact is about $50 million and -- which will be a headwind as we -- or rather a tailwind as we move into the second half.

As we move into the second half of the year, we'll see the -- basically, the year-over-year comparison essentially go away.

So we'll be back in line for the most part in third quarter and fourth quarter with respect to our technology spend.

There's kind of a punch list along those lines.

The technology spend may be a little bit more complicated to think about the future, but we have ramped up our training.

There's overtime hours associated with that so that's a cost bubble, if you will, during this second quarter for our operations team.

We've staffed up significantly in our call centers to handle the cutover and we have committed plans for that, through attrition, for that headcount to trend back down.

So that will be somewhat of a cost bubble not just to the second quarter so that will ease back over time.

And then, there's some amount -- there's tens of millions, call it, 10-ish million that is related to simply having payment for 2 reservation systems simultaneously.

It's a smaller number, but that will cease as well.

So there's a fair number of things there.

The hard part about the technology is we have a lot of work to do in our technology group and the question then becomes, well, do we replace that technology spend that was for the new reservation system and put that money to something else?

So that's not what we want to do and we haven't set our budget yet for 2018 for that, but there's clearly a handful of items here that will result in some material improvement, I think, going forward.

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

Since we're on the topic -- on the cost side, it looks like you're kind of exiting the year at a flat year-over-year rate.

Any reason we should believe that cost could be down year-over-year next year on the...

We -- yes, you're exactly right, Savi.

As we get to the fourth quarter, we'll be trending towards flat year-over-year due to a number of tailwinds.

And as we look forward to 2018, I do think we have opportunities to improve our cost.

We're working through our 2018 plan now and that certainly would be the goal.

That would be the objective, yes.

But I'd like to come back and give guidance later this year, but that's certainly what our desire is, is to bring unit cost down year-over-year in 2018, excluding fuel, special items and profit sharing.

And by the way, Savi, just looking at the market as we get past our fuel hedge losses, we'll have -- relative to the market this year, we'll have nice comparisons on the fuel side as well.

So as we end the year here and move into next year, I'm feeling pretty good about our cost position.

I am, too.

I think these are all qualitative thoughts.

In fairness to both of us, we just haven't put a pencil to it yet.

We haven't worked through all of our wants and needs for 2018, but the Classics are gone.

Some of these res transition costs won't be repeated -- and just the benefits of having the MAX in the fleet and just overall fleet modernization.

And we'll grow a little more next year than we're growing this year and that's beneficial on the cost side, too.

So I think those are all reasonable assumptions at this point.

And just give us another quarter or so to finalize our plans and we can give you better guidance for next year.

That's helpful.

And just somewhat tied to that, we're hearing on several -- a couple of different calls that there are kind of these certain areas, aggressive pricing going on, even in the walk upstairs, in certain hubs.

And I'm just kind of curious if you're seeing that.

And 2, if you are going to see costs lower next year, is there as much pressure to kind of push through pricing increase?

I think that was an impression this year just because of the level of cost increases.

But how do you think about kind of pricing out there?

Well, again, I would kind of go back to my earlier comments, which I feel like the second quarter was a very strong revenue performance.

I think that the third quarter outlook is more of the same.

It is very competitive.

It's competitive now.

It's been competitive for years, as we all know.

So there's a lot of action.

There's adds, there's subtracts and, despite all of that, we had a really strong second quarter.

And I think, again, we'll have a strong third quarter.

So implicit in that is stable is my report.

Now, are we seeing fare activity along the lines that you described?

Absolutely.

But one statistic, I think, that you all would enjoy that I did jot down for this quarter as an example is for the first time in a while, the majority of our markets are showing unit revenue gains year-over-year.

And for a while, it was a minority of the markets over the past year or so to my recollection.

So the -- you can see the granular strength market by market.

There's some markets that are under pressure, but overall net-net, we're seeing more strength than we are weakness.

And the other thing that is encouraging is we purposefully slowed our growth for 2017.

We purposely reduced the mix of markets under development in the system in 2017.

So we're now down to what is a more normal level of about 3% to 4%.

And just looking at the "developing markets" as an entity, they show very nice same-store year-over-year gains in the second quarter, which, again, is very encouraging.

So we want to be as aggressive as we dare with our capacity, but overall, we want to be cautious and we want to make sure that we're hitting our revenue and our profit targets.

As to next year and the way to think about it, we'll start the year, I'm sure, with the goal to have positive unit revenue performance in 2018, but I know our leadership team would agree that the overall goal is to sustain or grow our margins.

So I think we've got an opportunity to do that.

We've already talked about the all other than fuel cost outlook for 2018, which right now we're all kind of excited about that.

But in addition to that, we're going to have a fuel price decline next year.

So it's set up very well.

We're not intending to grow aggressively at all next year, although the percentage increase will be higher than 2017, but we want to manage it in such a way that we drive unit revenue gains and strong margins.

We'll take our next question from Joseph DeNardi with Stifel.

Tammy, just given some of the tweaks to the fleet, can you just update us on where you think CapEx in '18?

I think at the Investor Day, the charts that you had showed, aircraft CapEx down about $600 million or $700 million.

Is that still what you guys are expecting?

Yes, there -- even with the tweaks, we're still expecting our total CapEx to be -- we're hoping to bend it down from the $2.3 billion level.

But I would say at or below the $2.3 billion is our goal for next year.

So I think, at least with the fleet changes that we have, we'll be within that guidance.

Okay.

I mean I guess that's a lot different than what the message was from Investor Day.

Have there been changes on the aircraft side?

Changes from the aircraft side?

No, other than the -- so the goal is to bend down from the $2.3 billion, which is in line -- that's total CapEx.

Okay.

Yes, maybe I can just follow up off-line because aircraft and nonaircraft should be down pretty substantially next year.

Is that -- I guess, is that not what you're saying?

I mean instead of bending down, it should be down quite a bit.

Well, we -- as I said earlier, we are working through our plan next year for CapEx.

Taking it down in 2019 for sure off the top line there.

It's down -- yes.

So we'll be down next year, but we're finalizing all of the nonaircraft spend.

So technology, of course, is a piece of that.

So we're finalizing what that is going to be for next year.

And with this year, just to give you the magnitude of that, that's $250 million.

And facilities, that's running about $300 million this year.

So we're working through all those details for our plan next year, with our goal to bring the total CapEx spend down.

But I just don't have a number to give you today, Joe.

Okay.

And then, Gary, I think back on the fourth quarter call, you kind of talked about loyalty program disclosures and how you guys wanted to communicate the value that you get from selling miles with Chase.

Could you just provide us with an update as to what you think a proper set of disclosures would look like or a better way to kind of communicate to the market how good of a business that is for you?

Tammy, do you want to answer that?

I'd be happy to.

Well, I can answer your question.

That is a really good business for us.

Our Rapid Rewards revenue, other revenue, was up significantly in the quarter, double digits year-over-year.

So it continues to be a strong contributor.

In terms of the disclosure, understand your desire there for more disclosures.

And we are looking at that, and we're working to provide additional disclosures.

But we need to determine what information would be most useful to all of our investors while protecting our competitive strategy as well as honoring our contractual commitments.

So we're working to strike the right balance there.

And in terms of when you might expect us to potentially expand our disclosures, we're looking to do that in the first quarter of next year with the new year.

And keep in mind, too, we'll be -- we'll -- we've got a new revenue standard coming out.

So we're looking at all of that together.

And that's kind of the time line we're looking at in terms of providing the disclosures along the lines that I know you're looking for.

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

So it's probably safe to assume you guys are looking like a high single-digit capacity growth rate in 2018.

But looking beyond that, you guys are only growing your fleet count by about 2.5% in 2019, even if you exercise the options you have on the fleet plan now.

Now I know we're a long way away and things are going to change but, Gary, I was kind of hoping maybe you'd kind of put your thumb in the air a little bit and talk about that at a high level.

Should we think about maybe 2018 as sort of a transition year, a little bit of catch-up growth from the artificially depressed growth this year and that you'd get back to like a GDP-ish-like number in 2019 on capacity with the caveat that things can change?

Yes.

No thumbs in the air, sorry.

So I think we'll first focus on our 2018.

We're not seriously contemplating any changes to our fleet plan for 2019.

And we'll see how things develop for this year and next year, and then we'll set our plans for 2019 accordingly.

Okay.

I think that's fair.

I appreciate that.

And then could we talk about Hawaii for a second?

You're going to announce that -- if and when you announce it, I'm not asking you to talk about that at all, but would it be fair to assume that you have to solve for some complicated, maybe product-related things that make the decision a little more difficult like, say, catering or seat assignments or overwater IFE or something like that, before you consider competing there?

And -- or do you think that just like brands and low fares alone are simply enough to sort of have a Southwest Effect in the traditional sense in that market?

Well, we've got operational challenges that would certainly be unique for us with Hawaii, and I think that's the bigger issue for us.

Our experience so far, on the gist of your question, is we haven't run into that in other markets.

So it's pretty much the Southwest you know and love, it's very successful everywhere we fly.

And recognizing that -- we want to be humble about this, in recognizing that Hawaii may be different, we may want to evaluate that.

But we haven't made any decisions, obviously, about Hawaii at this point.

And my belief is that when we do, if -- it's not if we were going to go, it's when we go, we think it's an important strategic offering that Southwest needs to make, as an editorial point.

But when we do that, it's my belief that it will be off-the-shelf Southwest Airlines.

The IFE, we're investing in IFE to, at least our onboard Wi-Fi and television product, to improve that performance this year.

And off the top of my head, I don't recall whether that provides for overwater or not, it's obviously satellite-delivered service.

It will -- so I think, Hunter, we'll have that.

And we think that's important also.

But our snack offerings, we do tailor to the distance of the segment.

It seems to work fine.

It's not -- I get a lot of customer feedback.

I don't typically get a lot of feedback on food offerings, although we do get some.

So it's -- I would think that it will fit within the way our provisioning works today.

Whether we want to do something that is a little more unique for Hawaii, we haven't -- you can tell we haven't discussed that yet.

But it won't be anything that's dramatically different.

Our catering is pretty straightforward, and it's -- it is snack-oriented, it doesn't require refrigeration, we manage the shelf life carefully, all of those kinds of things.

And I would think that Hawaii would fit right into that just fine.

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

Just a question for you on the Classics as you look to retire those going into the fourth quarter or end of the third quarter.

So can you maybe just provide some color on the impact that has to unit revenues?

Do Classics tend to have higher RASM?

I'm just trying to make sure I'm aware of any dilutive potential as we move forward, or the opposite, if that make sense, Gary.

Yes.

I think your -- on the revenue side of things, it's not so much that it's the Classics per se, it's just the gauge.

So we're -- we'll definitely be -- back to Hunter's previous question, a lot of the growth that's anticipated in 2018 is gauge-related.

So you're swapping out a 137- or a 143-seater for a 175-seater.

I think, in most cases, we're getting some 700s.

So yes, there'll be -- you've seen that up gauging since 2013.

So that will continue.

Tammy, I don't know if you're ready to give a gauge and a gauge guidance for next year, but there'll be some gauge inflation, if you will.

Yes, I would expect so.

On the cost side -- yes, I think you know all that.

And I think, Tammy, it's also fair to say on the gauge, to the extent that there is some revenue dilution, that's all factored into your $200 million EBIT number through 2020.

That's correct.

Okay.

sorry but on the Classics, the RASM is, I guess, typically higher than on some of these other aircraft just given the smaller gauge?

Is that fair?

No.

Well, again, it's -- it is the seats.

So we have -- the 700s have the same seats as the Classics.

So that -- I probably didn't make that clear.

And the 700s are the majority of our fleet.

So for the most part, I would assume about 80% of the Classics will be replaced with a higher-gauge aircraft, tail for tail.

Yes, I think that's probably about right.

I am putting my thumb in the air on that one.

I think that's kind of a rough justice on that one.

But the -- so if the -- what Mike was just saying is that there's also a shorter-haul orientation for the Classics.

However, we'll still replace that short-haul flight with a 700.

So I don't think there's any change per se because you're replacing a Classic with a light-seated aircraft.

I think that's all the same.

But obviously, if we're trading it out for a higher gauge, well then -- yes, well, there'll be some RASM effect of that, but there ought to be a -- the way to think about it is, yes, the RASM might show lower, but the costs are being lower still, so you're going to get an operating income benefit tail by tail by trading a Classic for an 800 under the assumption that we schedule the 800 in a way that it's full.

And we've done a pretty good job of that.

My hat's off to our folks.

We had another record load factor in the second quarter.

So that's all good stuff related to the Classics.

Okay.

And then just a quick one, Tammy or Gary, you made some comments about the rating upgrade at Moody's, et cetera.

I guess you're now A rated.

Is that sort of the goal longer term?

I mean, to me, it seems like that might be maybe too strong of a position on the leverage side but just wanted to hear your thoughts.

Yes.

We're trying to strike the right balance there.

We do want to maintain our investment-grade rating but, at the same time, manage our capital structure.

In terms of our kind of leverage goals over the longer term and, historically, these have ebbed and flowed over the years.

But just sort of as a longer-term goal, maintaining a leverage somewhere in the low 30% range feels about right.

So certainly, we don't intend to drive our leverage down really below where we are today but somewhere in the low to mid-30% range feels about right.

So but we -- we've always had a strong balance sheet as one of our top priorities, so that certainly isn't going to change.

But we certainly want to continue to optimize our capital structure as well.

So I think we're balancing all of that pretty well.

You didn't necessarily ask for the philosophy, but I'll just pile on to what Tammy said.

The -- I agree with your -- the direction of your question, which is corporate finance theory would suggest there's a more optical rating, let's say, a BBB, maybe BBB+.

But we want -- we'd like to have some cushion because there will be bad times.

And our strong balance sheet has served us very well.

You know the 46-year history, and there's no airline that comes remotely close.

And the balance sheet strength is one of those shock absorbers that has really helped us in bad times.

The philosophical point to argue here is we are still going to manage the company under the assumption that there will be very difficult times again.

I've heard comments about things are different now.

Maybe, but we're going to make sure that Southwest is very well positioned to weather the storm.

And so we're delighted to have that upgrade and still want to have adequate leverage.

But we're not trying to fine tune this -- we're not trying to hit the BBB.

We're trying to be better than that, so that we can absorb the blow if times get bad and we don't fall into junk.

And over the past 15 years, there's been risk of that at times.

And bad things happen there, and we don't want that to happen.

And ladies and gentlemen, we have time for one final question.

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

Just want to ask a couple of quick ones for Tammy.

Could you maybe comment for a moment or just expand somewhat around the higher unit cost in the back half of the year, sort of what specific buckets would be driving those when we think about your prior guidance?

Sure.

So I was having a little bit difficult time hearing you there, Jack.

But I think what your question was as we move through the year, what -- how should we expect our comparisons to -- how should the second half comparisons be relative to the first half of the year.

So we do have a number of tailwinds, and just to recap those for you.

We have -- of course, as we get to the fourth quarter, we'll lap the impact of the labor contracts.

So that's about a 1- to 2-point tailwind as we move into the second quarter.

And as I mentioned earlier, we have about, call it, $50 million in technology costs that represent about 1 point.

So we'll see some -- our cost pressures ease in that area.

And then...

Why is it higher than our previous?

Well, we had heavy spend again last year and also just some one-time costs associated with our reservation system.

So we had about a 1-point tailwind as we move into the second half.

And then our -- the benefits from just our Classic fleet is about another point.

And then, as Gary was mentioning earlier, kind of wrapped up in other is just some of the training costs and so forth that will ease as we move into the fourth quarter.

So that's how we end up.

And fourth quarter was kind of flat unit cost comparison.

So it's coming from a number of different areas.

I was able to hear his question.

I'll just repeat it, Jack, for you, you were coming in very faint.

His question was our previous guidance was one thing and now it's higher.

What was driving the increase in the guidance?

Oh, our -- I apologize, I did hear your question differently.

What's driving our guidance from where we were previously is we have -- I guess, just at a high level, kind of going back to technology, it's really related to that.

We were seeing -- our overall technology spend hasn't really changed dramatically, but we are seeing a shift of that spend to more of an operating mix than what we had anticipated in our forecast.

So the overall spend isn't really changing, but we are seeing a little more operating expense pressure than what we had planned for.

So I'm going -- and so really the flip of that is in our CapEx.

So I do think we'll come in a little bit lower than our $2.3 billion CapEx for the year and the offset there is on our operating costs.

Okay.

Sorry if I was coming through faint on my questions.

No, I apologize.

You were very faint, but it's good to hear your voice.

Likewise.

And then just for my follow-up question.

On the $103 million hedge asset that you called out in the press release for FY '18 through FY '20, how much of that hedge asset is specifically related to FY '18?

Of '18, it's about $40 million.

And that concludes the analyst portion of today's call.

Thank you for joining.

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

I'd like to first introduce Ms. Linda Rutherford, Vice President and Chief Communications Officer.

Good day, everyone, and welcome to the media representatives who are on our call today.

We'd go ahead and get started with the Q&A portion of the call for the news media.

Tom, if you will, give them some instructions to queue up for questions.

(Operator Instructions) We will now begin with our first question.

Our first question comes from Conor Shine with the Dallas Morning News.

Gary, I was just wondering on what your thoughts are from what you've seen in Washington, D.C. around the air traffic control debate.

Are you optimistic that, that is proceeding as you'd hoped and that there might be progress made on that before the end of the year?

Well, let me answer it this way, I am delighted that we have the focus from the administration.

I'm grateful for that.

I'm delighted that we have the focus from Chairman Shuster.

And we have wonderful alignment between the commercial airlines, Chairman Shuster and the administration.

There's just a lot of controversy about the change, and I'd be the first to recognize that.

There is good momentum.

Congressman Sam Graves from Missouri signed on to the legislation.

And I thought that, that was a very significant move.

And he is very concerned about private aircraft operators.

And we were -- Chairman Shuster, I should say, was able to convince him along with the industry that there were protections in the proposed bill there.

So I remain hopeful that we can get something done.

But Conor, I have to admit that there's just a lot of work to do.

And I don't know that there is a vote scheduled in the House yet, which means that they may not have all the votes that they feel like they need.

The Senate, of course, is far behind where the House is, and there's a lot of work left to be done there.

But we need to make progress in the House first to have any hope of getting something done.

My concern overall is that, if we don't accelerate the pace, that we will face a real capacity crisis in the air because it takes longer and longer to operate flight segments, so the air space is getting less and less efficient.

Our air traffic controllers do a wonderful job of keeping the airplanes safe, but they do that by slowing things down more and more and more.

And of course, for air traffic controllers to use the old technology that they're forced to use is very, very cumbersome.

And they're understaffed.

So there's just a lot of things that must change if our country is to continue to grow air travel.

And people want to fly, so I think that's -- we need to keep our eye on the ball and worry less about some of the other politicking that's going on.

And so hopefully, we will make some progress this year.

We'll take our next question from Doug Cameron with The Wall Street Journal.

Gary, I was reading about this new plane, I think it's called the 737 MAX.

You might have heard of it.

I think Tammy said you were...

I have.

Excellent.

I think Tammy said you were due to get 10 in the third quarter.

What's -- what are you expecting in the fourth quarter?

And kind of tallied to that, have you sort of picked up anything from those who have already started operating the MAX?

And given some of the issues in the engine supply chain, which do seem to be spreading to leap a little bit, do you have confidence that none of those are going to slip into 2018?

We'll have 10 on October 1 when we start service, and then we'll end the year with 14.

Mike, do you want to talk about the airplane and what you've heard from Boeing and other operators around the world?

That airplane has been, just really from the day that they designed it until the day that they've delivered it, they have been on their time line.

And it is -- appears to be a better airplane, a more efficient airplane today than what we thought we were buying years ago.

I haven't heard any issues, or Boeing has not made me aware of any issues that caused me any concern with respect to our delivery schedule or in-service dates or the operation of those airplanes.

And Mike is our Chief Operating Officer, by the way.

And we have time for one final question.

I'm sorry, we do have the next question from Nicole Raz with Las Vegas Review-Journal.

How did Las Vegas' performance stack up this quarter compared to previous quarters?

And do you have any vision for expansion plans?

Or where does Las Vegas fall in terms, I don't know, near-term future plans?

Well, you know how important Las Vegas is to Southwest.

And it just is another opportunity to thank you on representing Las Vegas for all the support we get from your communities.

We have a great relationship with the community.

We get tremendous support from the airport.

We're the largest airline in terms of customers at Las Vegas and have been for many, many years.

And it's a very stable market.

I think I would characterize it as very strong.

To your benefit in the community, there's a lot of competition there, and we welcome that.

So we certainly hold our own with the competition.

But Las Vegas will always be an important part of our plans.

And we don't have any plans to do anything significantly different here in the near term.

But again, we will always keep an eye on Las Vegas and its needs.

And Las Vegas, I believe today is about the third largest operating point that we have in our system.

And it -- oftentimes, it vies for second and sometimes first.

So right now, it's over 200 daily departures which, for us, is very, very large.

And how did Las Vegas, in terms of -- you said, third operating point, how did that compare it to first quarter?

A stable environment, so we're not adding a lot of flights, we're not subtracting a lot of flights.

It's very stable, the business is very strong.

And I think Las Vegas is enjoying another boom here, so we're happy to be a part of that.

I'm sorry, just 2 more questions.

You were talking a lot about gauge inflation and fleet changes.

I'm having a hard time following that.

Are we going to see any type of upgrade or new airplanes here in Las Vegas?

What does that actually mean?

You will.

And gauge just means -- it's an industry euphemism, it just means the number of seats on an aircraft model.

So 700 and -- before we get to the MAX, the 700 is the smaller narrow-body airplane and the 800 is the larger one.

And in our configuration, which is all coach, we put 143 seats on the 700.

So when we talk about gauge, if we trade a route for an 800 instead of a 700, we would say we're up gauging that market.

Since you asked, another industry euphemism is density.

So we put 175 seats on an 800.

Our competitors, who have less pitch in the seats, could put, I don't know, like 190 seats?

189.

So 14 more seats.

So that is the same gauge of the airplane, but they've chosen to jam more seats in there.

So we're -- we don't put the same number of seats in as many of our competitors do because we want you to have a comfortable flight experience.

But that's all that means.

And the rule of thumb in the airline business is the bigger the gauge, the lower the cost per seat.

And it puts us in a position, as long as we can fill the airplane up with customers, that we'll have a lower cost and can keep your fares lower.

So that's the importance of considering the gauge.

You just can't take that to an extreme.

You'd be flying 400-seat airplanes by that logic and, of course, only filling up 100 of them, and you'd go out of business really soon, so...

So the time line that we'll see that bigger gauge here, the 800, is that -- you said by the end of this year?

You've got them now.

So out of a fleet of, I'll just call it, 700 airplanes, we probably have, I don't know, Mike, 150 airplanes that are the larger-gauge 800s.

And we fly a lot of those 800s in and out of Las Vegas.

So you're already getting those.

What we were -- the previous question was on the next generation from Boeing.

So it's the new version of the 800.

It's called the MAX 8. So the gauge is the same, the seat density is the same as our 800.

And we'll have 14 of those by the end of this year.

It has a different engine.

It has different performance characteristics.

It's lower fuel burn.

It's 40% quieter.

So the odds of you getting one of those in Las Vegas because it's -- we'll only have 14 are rather low, but I'm sure you'll get them.

So we don't dedicate airplanes to a city.

They fly all over the country.

And so it's -- it will be a little bit random as to whether or not you see one.

But one of these days, I'm sure you will.

And I hope you get to ride on it because it's going to be a really nice ride.

And ladies and gentlemen, at this time, we have time for one final question.

That does come from Mary Schlangenstein with Bloomberg News.

Mike, I just want to ask real quick.

You talked about the MAX being more efficient now than when you ordered it.

Is that just on fuel burn?

And can you talk about how that may have changed, if that's what you were referring to?

Yes, Mary, that's what we were talking about.

When we were beginning to talk with Boeing about the airplane, it was a PowerPoint airplane, and they were talking about having this fuel burn improvement in the 10% to 11% range.

And I think it's closer to 14% now.

And has it been at that range for a while now, the 14%?

Yes, it has.

As they got further along into the design of the airplane, further along into the wing structure and the gear structure and the engines all coming together, they solidified that.

And their flight tests seem to prove all that out.

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

Thanks a lot, Tom.

If you all have any other follow-up questions, of course, the communications group is standing by, (214) 792-4847, or you can always find us at swamedia.com.

Thanks so much.

And that concludes today's call.

Thank you for joining.