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Good day, everyone, and welcome to the Southwest Airlines Second Quarter 2018 Conference Call. My name is Laurie and I will be moderating today's call. This call is being recorded and a replay will be available on the southwest.com Investor Relations section.
And at this time, I'd like to turn the conference over to Mr. Ryan Martinez, Managing Director of Investor Relations. Please go ahead, sir.
Thank you, Laurie, and I want to welcome everyone to our second quarter earnings call. Joining me today, we have Gary Kelly, our Chairman of the Board and CEO; Tom Nealon, our President; and Tammy Romo, our Executive Vice President and CFO. I'm sure you've seen our earnings release this morning and on today's call we'll share more insights about our second quarter performance, as well as our outlook, and then open it up for questions.
Before we get started, please note that we will make reference to forward-looking statements that are based on the company's current intent, expectations, and projections, and a variety of factors could cause our actual results to be materially different. This call will also include references to non-GAAP results. These results exclude special items, so please reference the Investor Relations section of southwest.com to find this morning's press release and our SEC filings for more information regarding both forward-looking statements and reconciliations of non-GAAP to GAAP results.
So with that, I'll turn the call over to Gary.
Thank you, Ryan, and good morning everybody and thank you for joining our second quarter earnings call. Mike Van de Ven, our Chief Operating Officer, has also joined us and you will be hearing from Tom, Mike, and Tammy, so I'm going to be very brief.
Given the challenges in the quarter, our people did an exceptional job and produced exceptional results, and I am very grateful to them, I'm very grateful for them and, just at the outset, I really want to thank them. I'm very proud of what our people produced.
We produced record earnings per share. From what I've seen, Southwest produced the strongest operating and net margins in the domestic industry, and that is despite our second quarter challenges. We benefited from federal income tax reform, but even that wasn't quite enough to offset the fuel price increases. But once again our people did a great job, as we were under-budget in virtually every other cost category.
It feels like the business effects of the April accident are behind us. Our folks did a tremendous job of regenerating booking momentum; close-in yields are strong. We're recovering strongly in third quarter relative to the second quarter, and especially if you take into account the increasing stage length and aircraft gauge.
Fourth quarter bookings are also strong, although it's still a good ways out, and the nice thing is that fourth quarter has no headwinds, aside from the usual economic or competitive issues. I want to personally thank Tom and Mike and Tammy for their stellar and steady leadership.
And at this time, I'd like to turn it over to Tom to provide an overview of the business, and Mike is going to cover operations, and Tammy is going to wrap it up with cost and financial recap. So, Tom, over to you, sir.
Thanks, Gary. Good morning, everybody. Well, as you know, and Gary has covered some of this, our second quarter got off to a very tough start. Having said that, though, our teams did work very hard and they fought through a lot of uncertainty.
We ended quarter with record operating revenues of $5.7 billion, which is up slightly year-over-year. Our second quarter RASM decreased 3% from last year, which is right in line with our guidance, and our load factor was down about 1 point from last year at 84.7%. But even with a decline in our load factor, we carried over 35 million revenue passengers in the quarter, which, by the way, did record number of customers for Southwest for any quarter.
The revenue impact of Flight 1380 was 2 points of RASM, which is roughly a $100 million reduction in passenger revenues. We re-launched our broader marketing efforts, including full digital and television, with our May 15 summer travel fare sale. And at this point, I'd say that our marketing is fully back to normal.
As you know, a fare sale for summer travel is very, very unusual for us, but the sole purpose was to get back in front of our customers, get traffic back to southwest.com, and re-stimulate bookings at attractive price points to make up for some of the lost ground, and we did that. The sale was very targeted driving travel in June through October, and it focused primarily on Tuesday and Wednesday travel, and we're very careful to preserve close-in yield opportunities with a 21-day advance purchase requirement. And the sale worked just as designed and it did help stabilize our passenger revenue trends.
Our yields for the second quarter were down 2.5%, but we saw this begin to stabilize in late May. And over the past two months, we've seen our yields strengthen considerably, and I'll talk more about that in just a moment. And, of course, our revenue management team, well, they did an incredible job and they delivered incredible results under a very, very difficult set of circumstances. I do want to thank you guys. I suspect you're listening to the call and thank you for that.
We did see very meaningful revenue benefits in the second quarter from our O&D revenue management systems, or bid pricing as it's called, and that was a key driver of our $35 million res system benefit in the second quarter. We're also using an array of other pricing techniques and tools behind the scenes. Our new res system is allowing us to manage our inventory and pricing with much greater granularity, and all these new capabilities are enabling us to better manage our low-fare offerings, in particular in competitive markets.
In terms of our ancillary revenue performance, we had a really good quarter. Our EarlyBird product had another strong performance in Q2, as did our upgraded boarding product, both of which were up strong double digits year-over-year, despite a slightly lower load factor. I'm also very pleased with the strength and growth of our Rapid Rewards Program, which is outpacing our capacity growth. And we're also very pleased with our business partner revenues. The combination of these two things were the primary drivers of the 10.4% increase of the revenues.
And our credit card portfolio also continues to perform well and growth in new card members and credit card spend were both up double digits for the quarter. And, of course, we continue to see great traction in growing our West Coast Rapid Rewards members and cardholder base, which aligns very nicely with our entry into Hawaii. And as you're probably aware, we launched a new credit card last week and that strengthens our frequent flier program even more.
On our last call, I talked about the impact that our sub-optimal schedule had on RASM due to increased shoulder flying. And as expected, this was about a 1 point drag on our Q2 RASM. You'll see this begin to recede in Q3 as our fleet builds back up to nearly pre-Classic retirement levels. So when you net out the temporary items, the 2 point RASM impact from Flight 1380 and the 1 point impact from the sub-optimal schedule, I feel very good about the underlying strength of the business and how we've rebounded since April 17.
Let's now talk about third quarter. So we expect our third quarter RASM to be in the range of flat to up or down 1% year-over-year. So let me start off with a few moving parts in Q3 that I want to talk through before reporting on our base business trends.
First and foremost, again, we are very pleased with the performance of our commercial initiatives that were enabled by our new reservation system and we remain confident in our plan to deliver $200 million in EBIT value this year on new reservation system. For Q3, we expect a $70 million to $80 million benefit, the majority of which is driven primarily by improved O&D revenue management, and this equates to a 1.5 point benefit to third quarter RASM.
Second, as you might expect, the summer travel fare sale had an overall dilutive impact to yield, overall (8:43) booking curve and we estimate that it will negatively impact third quarter revenue by $30 million, or a little more than 0.5 point of third quarter RASM. The good news here is that we don't see any material revenue impact from 1380 beyond Q3. We're continuing to see very positive signs of our recovery and a continued strength of the Southwest brand.
Third, our flight schedule in Q3 is still somewhat suboptimal, but the headwinds begin to subside in August as the percentage of shoulder flying begins to decrease as we overcome our fleet deficit. The schedule impact in Q3 improved sequentially from Q2, but is still about 0.5 point drag on Q3 RASM, and this penalty should subside wholly by Q4.
Finally, in our March 8-K filing, we called out that we needed to recast some prior period items to reflect several accounting changes, one of which was specifically related to our Rapid Rewards Program. The primary changes that we now account for are loyalty points at fair market value rather than incremental cost, and the net effect of this was an increase to our third quarter 2017 RASM and this creates a 1 point year-over-year RASM headwind to our third quarter for this year. This is purely for accounting purposes and the impact is largely isolated to Q3.
So we have several moving parts here in Q3, but when you adjust for the onetime items, the summer fare sale, the sub-optimal schedule, and the accounting adjustment, we feel very good about the strength of our base business. We are, in fact, seeing sequential yield improvements in the third quarter and we're seeing very good momentum with close-in yields, in particular in June and July.
Although the higher yields will put some pressure on our load factor, we're seeing solid demand across the booking curve and we're seeing particular strength in close-in demand. And as we announced in June, we've taken action on the capacity side as well and we've reduced our fourth quarter capacity plan by 2 points. We're also continuing to take aircraft deliveries and we'll be out of our fleet deficit position by the end of the third quarter. And finally, we continued to prepare for our launch of Hawaii service and our ETOPS work continues to be on track, and we're ready to serve Hawaii once we receive the necessary approvals.
And lastly, I'd like to share just a few thoughts on the fourth quarter as well. And you all know this, but we've been working through a lot of headwinds, onetime headwinds, over the past two quarters, second and third quarters, and Flight 1380 and suboptimal schedule and fleet deficits, it's been difficult and it's been challenging, but we have produced very, very solid results.
Looking forward to the fourth quarter, I'm really excited about the fourth quarter, because it will be a clean comparison. Our fleet deficit issues go away. The sub-optimized schedule goes away. The effect of 1380 will be largely behind us, and the momentum that we are feeling is real and it's tangible and it's building.
I feel very good about what we're seeing in terms of the business trends. We're seeing solid demand. We're seeing strength in yields and the quality of our schedule continues to improve. So having said that, our focus, of course, is to ensure that we bring in a very strong third and fourth quarter.
And with that, I'd like to hand it over to Mike.
Thanks, Tom. Well, as you all know, the operation really picks up steam in the second quarter as summer travel gets into full swing. And we operate over 4,000 weekday flights during the quarter and we carry almost 400,000 customers a day over the period, so that's all Southwest Airlines. We don't spread any of that over partners or regional providers, and I don't believe any other carrier alone comes close to that kind of volume. So I am very proud of our team, our people, our frontline. They are warriors out there. They care about our customers. They care about each other. And there were certainly strong headwinds that they had to lean into to deliver a very solid operating performance in the second quarter.
Of course, Tom's already mentioned that the primary headwind was the acceleration of our fan blade inspection program. So we accelerated our program prior to issuance of any mandatory inspection protocols, and we completed inspections on about 17,000 fan blades in 30 days. We also in May had 17 aircraft out of service for about a week as a result of a really freak hailstorm over a small section of our gate area in Denver.
So both of those items reduced the amount of aircraft we had available to fly for scheduled service. And that, plus really the normal summer of thunderstorms, put us in operational recovery mode for really a large part of the second quarter. And despite all those headwinds, our on-time performance improved about 0.5 point from last year. So we had about 77% of our flights arrive within 15 minutes of scheduled arrival, and that's a little lower than what I would like, but it's closer to about 81% within 20 minutes. So even with all of those unexpected challenges, we didn't really suffer from lengthy delays.
The bag handling for the second quarter was the best in our history, and roughly 99.7% of our bags were flying on the flights that they were tagged to be on. And by the way, that's a complementary free of charge service from Southwest Airlines. We also had the lowest ratio of customer complaints from the DOT this year as compared to the same timeframe in 2017. And just as a reminder, we were the best in the industry in 2017, so again improvements in that area.
So my point is that despite very challenging operational headwinds, our people delivered a solid travel experience for our customers, and they did that with a very respectable cost performance for the quarter. Our ETOPS certifications, as Tom mentioned, are progressing. We have our application filed with the FAA and it's under review. We are flying domestic simulation flights using our proposed processes, and we're working with the FAA to amend and adjust those processes as are necessary.
And once our procedures are approved, we can begin our training programs, work toward validation flights, and all of those things require a tremendous amount of work and coordination between Southwest Airlines and the FAA, and both of our engagement teams are working hard together every day. So we've previously announced our U.S. gateway cities of San Diego, Oakland, San Jose, and Sacramento, and Hawaii destinations of Lihue and Maui and Honolulu and Kona, and we just remain focused on that effort.
So with that, I will turn it over to Tammy.
Right. Thank you, Mike, and thanks to everyone for joining us today. Moving right into cost, I am pleased with our second quarter unit cost performance. Our CASM ex-special items was up only 1.5% year-over-year, with the biggest driver, of course, being higher fuel. Our economic fuel price per gallon increased 11% year-over-year to $2.21, which was in-line with our guidance. This included about $0.02 net benefit from hedging gains of $0.08, offset by $0.06 of fuel hedge premium costs.
For third quarter, based on market prices last Friday and given our hedging positions, we expect our fuel price per gallon to be approximately $2.25. Similar to second quarter, this includes an estimated $0.07 hedging gain and $0.06 of fuel hedge premium costs. While we're never happy about higher fuel prices, the successful implementation of our strategic initiatives over the past few years has us well prepared for the 40% year-over-year increase in market prices.
With hedging losses well behind us and a strong hedge in place for this year, as well as next, we are well-positioned to manage through fuel price headwinds. At current levels, we are recognizing modest net hedging gains and, as a reminder, our fuel hedge kicks in more significantly at Brent crude prices $80 per barrel and above.
So, I feel very good about our fuel hedge portfolio. We have meaningful protection as prices move up and will move down with the market as crude prices decline. I'm also pleased with our continued fuel efficiency gains from fleet modernization, including the retirement of our Classics. Our second quarter available seat mile per gallon, our key fuel efficiency metric improved by 1.7% year-over-year. Through the first half of the year, our fuel efficiency improvement is slightly trailing our 2018 goal of 2% to 3%, primarily due to our utilization of the 700s to cover our fleet deficit and sub-optimal flight schedule. I expect to see momentum in our fuel efficiency as our schedule becomes more optimized in fourth quarter and beyond, coupled with the increasing mix of MAX aircraft in our fleet.
Excluding fuel, our second quarter cost performance was better than expected, primarily due to timing. Our unit cost, excluding fuel, special items, and profitsharing, was up only 0.4% year-over-year versus our guidance of 1% to 2%. This was largely due to costs shifting into the second half of this year and in total, about $30 million shifted from first half into second half, primarily in the areas of advertising and technology.
We also have had some second half cost inflation that is driven by the timing of events and spend. And for third quarter, our unit cost inflation includes a heavy concentration of advertising. Part of it was planned, as we discussed, related to Flight 1380 and in addition, year-over-year trends will be impacted by lower advertising last year third quarter, resulting from the pullback in advertising following the hurricanes and natural disasters.
Maintenance expense is also expected to be higher year-over-year due to timing of heavy maintenance events. And we continue to see a higher mix of operating expense versus capitalization with our technology spend. With all that in mind, we currently expect our third quarter unit costs, excluding fuel, special items, and profitsharing, to increase in the 2% to 3% range year-over-year.
Looking ahead to fourth quarter, we also have some inflationary year-over-year pressures relative to first half 2018 trends, particularly in depreciation as we lap the Classic retirements and continue investing in the fleet. Also, as you think ahead to fourth quarter, keep in mind, we'll have some incremental unit cost pressure from our recent reduction in fourth quarter year-over-year ASM growth, as it is difficult to shed a similar level of fixed costs overnight.
As such, our full year 2018 CASM, excluding fuel, special items, and profitsharing, is now expected to be flat to up 1% year-over-year. This is more inflation than I would like and we will certainly strive to drive efficiency and productivity. And as a quick reminder again, this guidance does include our tentative agreement with AMFA.
Before I move along to the balance sheet and cash flow, I also want to thank our people for their continued efforts and diligence to efficiently and effectively control our costs, especially in a rising fuel price environment.
As we have communicated to you all many times, maintaining an investment-grade and very strong balance sheet is among our top priorities, and we continue to have a balanced approach to managing our capital. Our liquidity remains very strong. Second quarter operating cash flow was $1.6 billion, with free cash flow at $1.1 billion. There was no change to our full year CapEx guidance, which remains in the $2 billion to $2.1 billion range this year, with $1.2 billion of that for aircraft.
During the first half of the year, we executed $1 billion in share repurchases. This includes the $500 million accelerated share repurchase we launched at the end of April, which will be completed no later than the end of this month. And this leaves $350 million remaining under our $2 billion authorization. And as you will probably recall, in May our board of directors approved a new $2 billion share repurchase authorization, and our board substantially increased our quarterly dividend 28% to $0.16 per share, or $0.64 annually.
This builds up on the significant value we've returned to shareholders, which over the past five years we've returned nearly all of our free cash flow through share repurchases and dividends. And we intend to maintain our balanced approach to capital deployment with the continued focus on profitably growing our business and strong returns above our cost of capital.
I will close out with a quick recap of our fleet and capacity. We took delivery of 12 Boeing 737-800 aircraft and two MAX 8s in the quarter, bringing our total fleet count to 730. And we expect to end the year at 751 aircraft. And we continue to plan for our 2018 capacity to increase in the low 4% range, with third quarter up in the 4.5% to 5% range and fourth quarter up in the 6.5% to 7% range year-over-year. And as Tom mentioned, we are on track with our ETOPS work to hopefully begin selling Hawaii service this year.
Lastly, we currently have 30 firm aircraft deliveries in 2019 and our current plan is to earmark some of our 737-700 aircraft for retirement next year, as we continue to invest in fleet modernization. We continue to have tremendous flexibility in our order book and fleet, which will serve us well in any environment.
In summary, we had a solid second quarter, record second quarter earnings per share, and we generated what we expect to be industry-leading margins and high returns on invested capital, despite higher fuel costs and our second quarter challenges. Our employees performed magnificently and I am proud of what we accomplished together. The recent strength in yields is encouraging and we are focused on reliable, efficient operations as we work diligently to control our costs. And I'm pleased with the returns we are seeing from these significant investments we've made on fleet modernization, our new reservation system, and our Rapid Rewards Program, as well as overall strength of our network.
We have ample liquidity and we continue to return significant value to our shareholders, while continuing to invest in our people and our business. To reiterate, we are focused on revenue generation and prudent cost control to deliver healthy margins and shareholder returns.
With that, Laurie, we are ready to take questions.
Thank you. [Music] (00:24:55-00:25:16) And we will take our first question today from Jack Atkins at Stephens. Please go ahead, sir.
Hey. Good morning. Good afternoon, guys. How are you all doing?
We're doing fantastic. Thank you.
Great. Well, thanks for taking my questions. So, I guess, first off for either Gary or Tom or maybe both if you'd like to expand on it, just the tone of your prepared comments was very constructive with regard to the momentum that you're seeing in your business. I would just be curious to know, is this macro related? Is this due to the flexibility in the tools that you're seeing sort of playing out from the new reservation system? I would just like for you to expand on that for a moment, because it certainly sounds like the business, as you look out into the fourth quarter, could be heading toward inflection and profitability.
Well, I'll start and Tom will clean it up. But I do think that we are in an environment, here in 2018, where the economy is very strong. It's growing and travel demand reflects that. We have improved our revenue-producing capability significantly over the past – oh, call it – seven years and are in the midst now, of course, of taking, I hope, a leg up again. We had some, obviously, well-covered disruptions here in the second quarter.
But I think, Jack, most of the things that we're reporting to you are micro, not macro. And no doubt, our competitors benefited from some of our issues in the second quarter and I expect that we will claw that back, and that's happening here. But aside from the – I don't know how you think about it, whether it's micro or macro, when you get down to the industry level, it's still a very competitive industry and the industry collectively is growing, and that means we're facing more competitive capacity as time goes by.
But I think most of what Tom is reporting today is mostly unique to Southwest and our execution, working through some challenges. And again, I know we've said it repeatedly, but I think everyone here has done a marvelous job of responding to an unexpected challenge and getting through that. And now I think we've got a lot to look forward to, in addition to planned activities that we're rolling out in 2018.
So the nice thing is, we're seeing the results we hoped for and we have more to come. And I'll just put in a little teaser that we have the benefits flowing from our new reservation system, which are well-known and well-covered, and now we need to deliver. And again, Tom's report was we're pretty much on track with that and now we're beginning to work on a portfolio of new ideas that will flow in the future. It's not going to be fourth quarter. It may not even be in 2019, but we need to keep this pipeline full and I'm very confident that our folks will continue to do that.
I guess, the only thing I'd add, Jack, is just to kind of jump out of that, I think the execution, both the operational execution that Mike talked about and the frontline execution is outstanding. I think that one thing I didn't hit on in my comments that I think is important – and I think this is kind of a macro thing – our marketing kicked back in in a very, very big way. It was really highly effective in driving demand back to our website and even bookings.
I think that as we drive more demand to the site and the new capabilities that Andrew and the commercial side of the house have around yield management, pricing management techniques and tools, we're starting to really monetize those things. And I think it's really valuable and it's really important, and it gives us a level of granularity we've just never had before. We're seeing it come to fruition, so I think that contributes a lot to it.
Okay. That's a very helpful answer. Thank you. And then just as a follow-up to that, Tom, kind of going back to your comments on the reservation system benefits that you realized in the second quarter that you anticipate realizing in the third quarter. Am I right with that math to assume that leaves about $90 million or so that's left to be realized in the fourth quarter? And if I'm not right, could you kind of give us a correct number on that? And then, is all that expected to flow through on the revenue side, or will that come in other places on the P&L?
Yeah, you're probably very close. I'm not sure exactly if it's $90 but you're not out of the ballpark. I'm sorry. What was the other part of your question, Jack? Is all going to flow through...
Well, $90 million or so roughly, is that going to be on the revenue side, or is that going to flow through other places on the P&L?
Yeah, it'll be predominantly on the revenue side.
Okay. Thank you for the time.
We'll go next to Hunter Keay at Wolfe Research.
Hi, everybody. Thank you so much. I was hoping you might talk at the very least qualitatively about how you're thinking about your capacity growth, given that I think you've loaded your schedule for the first, whatever it is, nine weeks of 2019. It's showing sub 3% growth. I'm pretty sure you haven't loaded Hawaii in there, so that's probably going to be incremental. But when we think about the year as a whole and some of the wonky stuff that we're going to be lapping in the back half of 2019, how are you guys thinking about maybe like a core growth rate for the year on a system ASM basis?
Well, I'll start here. We're at a pace to grow in the low 4% range this year. That's down from what I had planned for us for the year. I don't think that we'll grow over 5% next year. That, again, is what we had planned initially for 2018, so it would be something less than that. But we haven't fully baked the year and, yeah, you should – but, Hunter, the point you're making is a good one, which is you should not assume based on what you've seen there for the first part of 2019 that that is our growth rate for the year. I certainly agree with that.
Right. Okay. And then when you guys have said in the past that you won't fly a route that isn't profitable, how are you defining that term?
Revenues minus expenses.
Okay. So is it operating expenses or is it the marginal cost of operating that extra flight, or is it all-in expenses including aircraft ownership?
Fully allocated.
Always fully allocated?
Of course.
Okay.
So now markets take time to mature and we have a set of very mature markets that are well into the profitability range. And we have start-up markets that sometimes will take several years before they reach the kind of maturity that we're satisfied with. But I'll tell you this. Once we decide to put Southwest in a market, we are loathe to pull out. So we have the overall cost structure and operating margins and balance sheet to be patient, and there are a thousand city pair examples over the years that would support that patience.
A lot of our competitors, of course, will go in, they pull out, and we're just not going to do that. But wherever we decide to go, it is with, obviously, an eye towards success, which means absolutely fully allocated profitability, of course. We can't achieve the kind of results that we have unless we have a philosophy like that, so I'm not sure I understand the question.
Okay. I'll leave it there. Thank you, Gary.
And hi, sir. Please check your mute button.
Who?
Jamie Baker.
Ah, well, there you go.
Yay.
Hey, Gary, at the industry level, the competition is finally beginning to emphasize the goal of achieving higher margins next year. And that's a welcome change since the industry margins have been down for, I guess, three years now. But by the looks of consensus and certainly my own model, it seems that – I mean, it's basically a layup that Southwest has higher margins next year. I'm not asking you to endorse this. Rather, can you identify anything, any sort of headwind, that would be specific to Southwest that might interfere with the process of expanding margins? I guess I'm asking you to kind of play your own devil's advocate here.
Well, while I appreciate the complement there and we're very confident and I think our folks have the track record to demonstrate, I did have to chuckle at your report this morning. You know you left the H out of Southwest there.
We've already taken heat for that. Oh, man.
I just mainly want you to know that I read your stuff. But the other thing that I...
Well, it was a test. You passed.
Well, the other thing that I noted is that you referred to one of our competitor's historic statement of this is not a hobby. Back to the previous question, it has never been a hobby at Southwest and we have a very long track record of producing. So as we think about the risk associated with next year in light of your question, I wish I could agree with you that thinking about a year is a layup, because it's just a tough business. Things happen. And they just have to be managed and we need to plan and manage the company in such a way that we could absorb the unexpected.
And that's why it's important, far from this being a hobby, you have to have a strong balance sheet, you have to have strong profit margin, so you can absorb the kind of unexpected blows that no doubt will come up. It could be higher fuel prices next year. It could be a recession. It could be undesired, back to Tammy's comment, complaint about our – even the modest cost pressures that we're seeing here in the second half, it could be unexpected cost pressures. So all of that has to be managed and there's just tremendous operating leverage in an airline, because of all the high fixed costs. So all that just needs to be balanced accordingly.
Now, understanding we're in the business to take a risk as we assess the outlook for 2019, I agree with you. I think that the economy looks pretty good. I'm not overly concerned about fuel price increases from here. Tammy's pointed out, I think, very well how well our hedge is positioned. We have very modest levels of debt. We don't have any significant debt financing requirements. And we have new equipment coming in next year, which is 100% MAX.
This year, obviously, we're getting a blend of some NGs, as well as MAX. So it's a pretty good setup for next year. We'll need to manage our expansion and it will be Hawaii. And then secondly, we need to manage the execution of various initiatives we have under way and our spending there, and then just our overall cost. So, as I've put in the press release in my comment, I want more of a focus of our company on the operating cost as a priority than what it has been over the last 5 to 10 years, simply because we had higher priorities.
We needed to transform Southwest, which our folks have done. So I would just – hopefully that's responsive to your question.
Yeah.
We never ever approach a year as if it is a layup. That's, quite frankly, when you get into trouble. But even in a year like this one, we're having a few unexpected challenges, our folks are doing extraordinarily well. So I think we'll be very well-positioned and I think, once again, I believe we'll have a really good 2019.
Excellent. And as a follow-up to that, Gary, you did mention in passing, I think it was new ideas that will flow in the future as it relates back to some of your newfound capabilities. Can you opine on that at all? Are you talking about possible product initiatives that you're considering, something that might alter the in-flight experience? Is it something that might impact boarding? Is it something about distribution? I'm sure it's accretive in your model. I'm just wondering what part of the either booking process or flight process it might impact. Not looking for specifics, just where might this manifest.
Well, I don't think we need to change the essence of what Southwest Airlines is to still find opportunities to drive revenues. And I think the way you – it's not ready for primetime, although we are looking at the prioritization of our initiatives over the next three years to see how we might want to fit some new ideas in. The main reason I wanted to bring it up today is, we've had a good flow of initiatives over the last 5 to 10 years, and they have served us well. And we have not mentioned what's next and what is beyond our new reservation system, and we're in the midst of executing that.
And I think that there's – fortunately, I think that there are a lot more opportunities and when they're ready for primetime, we'll share them. So it is mainly just to let our investors know that we're not sitting idly by and counting on the initiatives that you know of, that now it is time for us to get busy on the next stream, and I would expect that in the not too distant future that Tammy and Ryan would be in a position to begin unveiling those.
That's excellent, Gary. I can assure you we'll fine-tune our spellchecker as well. Take care.
All right, sir.
And we'll go next to Rajeev Lalwani at Morgan Stanley. Please go ahead.
Good afternoon.
Hi.
Tom, you made some fairly constructive comments about 3Q and what it's implying about 4Q based on forward bookings, et cetera, and it seems like you've got a nice acceleration coming as you move ahead. But what am I missing in that thinking? Are there any headwinds that we should be aware of as we start looking at the next quarter? Because, obviously, it seems to be a bit of an anomaly this quarter with all the various things you pointed out.
Yeah. I think there are anomalies in the third quarter that we already talked about. But, again, just kind of back to the base trends we're seeing, strengthening since late May, early June, into July in terms of shopping, pricing, close-in strong, further-out strong. So we're feeling pretty good about where we are. We're only published through February of the fourth quarter, obviously. So where we are in the curve is very, very early, but we do feel pretty bullish about where we are in the third quarter.
I think that we are saying flat to plus or minus 1%, and I think we have a real shot on the revenue side, right? But we have a lot of work to do. And where that goes in the fourth quarter, there's nothing that myself or the team is looking at that says, boy, there's something very foreboding in front of us. We aren't seeing that. I think as trends, if they're going to carry on as they are, I think you'll have a very nice third, fourth quarter, so we have a lot of work to do. Just as Gary said, there's no such thing as a layup here at all. So we have a lot of work to do, but that's probably how I would answer that, Rajeev.
Okay. And, Gary, in terms of just how you're approaching capacity here, in particular the implication of higher fuel, I mean, how is that impacting the way you're thinking about capacity? I know you've trimmed a little bit to stabilize sort of the RASM environment, but I guess the specific question is, how is higher oil impacting your thinking of the business, in particular capacity as you look forward?
Well, obviously, it can't be ignored. And I think the one thing that I've not talked about that I do want to just make the point in terms of how we're thinking about capacity is, we have invested a great deal in Southwest Airlines, and especially in recent years. And by definition, the investment means for the future, for future growth. We've just opened up a new training facility across the street from our headquarters. We've just acquired new flight training simulators. We're investing in airports across the country, and all of that creates overhead. And to not add capacity and absorb that would sub-optimize the investment that has been made in the company, which has been very, very necessary. So I would just ask you to also factor that in. A lot of operating leverage, a very heavy amount of fixed costs in our business, and you just leave a lot on the table if you don't fully take advantage of those investments.
Now, the concern that you have about higher fuel prices, that's why we hedge. That's why we think it is important to hedge. And I think that it's served us extremely well over the past generation in something that – as I think about the next generation in Southwest, I hope they always employ that kind of a risk management technique. But at the margin, higher fuel prices have to make us a little more circumspect about our expansion, and it probably causes us to take less risk with the additional flights that we add.
I think finally, if we do decide that we need to reduce capacity, we have more flexibility built into Southwest today than ever. Again, from a growth plan, it's not literally reducing the fleet, but we have more flexibility today than ever. And it just comes with a penalty, a unit cost penalty, because there'll be a lot of unabsorbed overhead, if you will. So all of that just needs to be balanced and right now my view for 2019 is that it is a year that looks very solid in terms of us thinking about expanding not more than 5%, as I mentioned to Hunter, but certainly it's a year that we feel like the risk/reward is such that it argues in favor of continuing our expansion.
Thank you, Tom. Thank you, Gary.
Sure.
We'll go next to Savi Syth at Raymond James.
Hey. Good afternoon. Just a quick question on the fuel side. Tammy, you mentioned that hedging really kicks in about $80. Is that for 2019, too? And also connected to that, what's the portion of the $345 million that's related to 2019?
Yes, hey, Savi. Yeah, it's similar. It's a similar story for 2019. We are 64% hedged for next year, so we're in good shape as well. So kind of a similar story. And as we get to $80 per barrel, we would see those hedges kick in more significantly.
Are you able to give the breakout of the fair market value that's kind of related to 2019 itself?
Sure. Yeah, let me pull that number for you here. If you'll give me one second, I'll give you the breakdown.
Sure. And maybe, Tammy, while you're looking that, if I can ask a follow-up on kind of the unit revenue trend here. I was just wondering what the hurricane – is the hurricane a benefit to 3Q RASM look? What I'm really trying to get at is, as these overhangs come out, it sounds like you're comfortable with kind of getting back to that positive RASM trajectory, but I just wanted to clarify if I'm hearing that correctly.
Yeah, Savi, this is Tom. I think the way we look at that is probably about 0.5 point of upside for us.
Okay.
But that's all factored into Tom's...
That's already in.
...flat plus or minus range, so we've got – as usual, there's just a lot of stuff in the stew. So there's pluses, there's minuses, and that is one. That is assuming, of course, we don't have a similar impact again this year, but that's what's implicit in there.
That is one of the tailwinds that gets us to our current guidance.
And, Tom, do you – go ahead, Tammy.
Oh, go ahead. Finish your thought there, Savi.
I was just kind of curious, so, Tom, are you feeling comfortable that we can get to the positive RASM trajectories? Is that kind of the implication of some of the comments, or am I taking it too far?
Well, I wouldn't – I'm not sure I'm ready to say that we're ready to commit to that. I do feel like the trends and what we're seeing are really, really solid. We feel good about that. And I think if we were to see things continue as – hey, listen. I think things are looking solid for us and they feel very good. I'm not ready to commit to positive RASM. But, boy, I'll tell you what, if you're wondering is that what we're shooting for, that's absolutely what we're shooting for is the execution towards positive RASM, and we're going after it hard. We're going after it in terms of pricing, in terms of the capacity, in terms of the schedule, in terms of several things, in terms of the marketing. So we're going after it. Things are blazing, but that's what we're shooting for. That's what we're working towards.
And, Savi, the only way I would try to answer your question, it's not different than what Tom is saying at all, but we know where we are today and we know where we've come from, and we're really happy about that. We have good line of sight to most of the third quarter and we're very happy with that. You know, like we do, that trying to forecast 60 days, much less 90 or 120 days out, it's just not accurate.
Clearly, one can logically put together a set of expectations that say second quarter turned out pretty good, all things considered. Third quarter, as of July 26, has shown notable improvement, which I would have expected, but you still have to go do it. And then the third quarter is hampered by a few things and those kind of burdens clear in the fourth quarter. So one would expect, I think, that fourth quarter is better yet again than the third quarter.
And, obviously, if we're talking flat to up or slightly up or down, logically then you would say, yeah, that means that fourth quarter is positive. So I think all those things ring true. It's just we're not ready to forecast that. We don't have enough information to do that, but we're very encouraged with the trends and I agree with the way Tom described it, which is we have palpable momentum and with a little bit of luck here, the momentum will continue to build.
And I'll just chime in.
Appreciate it.
Savi, I'll just chime in, too, before I answer your fuel question. Just in terms of the trends from quarter-to-quarter, Tom walked you through all the noise with all the headwinds and tailwinds for third quarter, but I do think it's – we're excited again just to get to the fourth quarter where we have clean comparisons, and so that's a plus.
We're seeing great benefits from our new reservation system and what we're seeing in the business trends, again, just repeating what we said earlier, demand is very solid. And what's particularly encouraging is the strength that we're seeing in yields and particularly the close-in yields. So all that to say, we're excited to get these headwinds behind us and looking forward to the fourth quarter.
On your question on the breakdown, I believe it was on the fair market value of our hedge, so the roughly $185 million of that was 2019 and $112 million of that is 2020, and then the rest is split between 2021 and 2022.
All right. Helpful. Thanks.
And we'll go next to Helane Becker at Cowen and Company.
Thanks, operator. Hi, everybody. Thank you for the time. When you guys were thinking about Hawaii and ETOPS certification, I know the FAA – I think this is a question for Mike – I know the FAA takes its time to do and it could take up to a year. But can you just say if where you are in the process of gaining approval is where you thought you would be six or nine months ago?
Yeah, Helane, we had set out a timeframe or a timeline, and what I would tell you is we're along that timeline. So what's important for us right now, so the FAA does have our manual procedures that we have defined. And what we're trying to do at this point in time is enough exercises to make sure that we have thought through all the different things that possibly could go wrong on a flight. It could be a mechanical issue; it could be customer illness on the flight; it could be headwinds; it could be a problem at the airport that you're landing in. And just making sure that the procedure that we have defined would anticipate and address those things, and that we're practiced at doing that . So that's the process that we're in right now.
And as we go through that, we'll have some comfort that, yeah, these procedures are well. So I would expect in the next 30 to 60 days, we will understand that these procedures are ready to go, and then we'll begin training and, hopefully, move onto a validation flight after that.
Okay. And then when we think about that training and so on, I'm sure, because that's your timeline, the costs are built into your guidance. But is that going to necessitate hiring additional head count to kind of fly the existing route network while you're going through that training process?
Yeah, and we've already accomplished all of that, so we've already understood that we're going to have a cadre for example of pilots that will go through some ETOPS training, that will pull them off of their normal flying responsibilities. And we've already adjusted our head count needs for that.
Okay, perfect. Thanks very much.
And, Helane, I did want to – you didn't specifically ask about it, but just on the business of Hawaii, we have a long track record with our network planning group of predicting the success or failure, quite frankly, of new routes, additional frequencies, and so forth. So their forecast accuracy is quite amazing and, of course, you'd have to factor in the unknown, how will competitors react and so on. But just to repeat that the gateways, say, the four gateways from California to the four island destinations that we've selected, all forecast very well.
And then in addition to that, while the inter-island was not our initial vision, if you will, for our Hawaii service, once we were asked to look at that and once we took a good look at it with the way we would flow our aircraft, it also forecasted really well, so we're very enthused about that, how fast it will ramp-up, I think, remains to be seen, of course.
As we were talking earlier, nothing is ever a layup, but the work that Mike has been conducting has gone exceptionally well. And, I would say, just from my thumbnail sketch of it, we're right where we thought we would be, but there is still work remaining between now and the fall, and ultimately it's up to the FAA to decide whether they're going to give us the good housekeeping seal of approval here. But so far, that's gone really well.
And then on the business side of things, we are no less enthused. If anything, what I was trying to suggest is that as we've looked at more opportunities, we've gotten even more enthused about that. So it'll be our commercial focus here pretty soon and we're going to stick with it and we will succeed.
Great. Thanks, Gary, and team, Tom, everybody. Thank you.
Thank you.
We have time for one more question and we'll take our last question from Duane Pfennigwerth at Evercore ISI.
Hey. Thanks. I wanted to follow-up on a question that Jamie asked earlier, but maybe a little bit more specifically. Can you weigh in on potential move to assigned seating? For example, Ryanair sees half their customers pay to reserve a seat. That's value they see in sort of paying for. Nearly as many also pay up for priority boarding. In core Southwest markets, your customers know, appreciate, or at least understand your open seating. But in markets like New York, where you have less presence, it has to be costing you some share among corporates and leisure passengers. So can you give us some confirmation it's something you're actually looking at? How quickly could you be in a position to make the change? And was the res system a prerequisite to making that change? Thanks for taking the questions.
Yes, sir. Yes, sir. Great questions. Well, let me be very blunt. We are not looking at assigning seats right now. We're not talking about assigning seats now, and we're not talking about looking at it at some time in the future. Just trying to be very clear on your questions. On the points that you make – well, before I address that, the opportunities that we have to layer in some additional initiatives don't require assigned seating and they are very handsome opportunities. These are ideas. They're until – as my good friend Bob Jordan always says, it's an idea until it's a plan. And so we're in the midst of developing some plans. But it does not require assigned seating to pursue some really exciting opportunities I feel like we have.
Now, everything you said is true. There are absolutely customers who demand assigned seating. We do have examples around the world where carriers have gone to assigned seating. Assigned seating does open up an array of opportunities that we could think about. Tom, I think it probably is fair to say that the new reservation system at least puts us in a position where we can more realistically think about that. So I like being in a position where some day, if we decide to do it, we could evaluate assigned seating. And it ain't happening now and it won't happen next year. And why I would want to predict anything beyond 18 months, I don't know, so I won't.
But I think, Duane, all I wanted to allow is that – with our investors, is that look it's something that we could consider. There are pluses and minuses on balance to this point. In our Southwest life, we have concluded that we are better off with what we're doing today, and I still believe that by the way, but it doesn't mean that we can't come back and revisit that at some point in the future. But we don't need it right now.
And what I'm really excited about here in the near term are things that we don't get asked about as much or talk about as much, and it's all the things on the operations side that Mike Van de Ven has underway with a new maintenance record keeping system, a new flight following system, and just better communication capabilities for our operations employees, which should put us in a position to offer better customer service and be more efficient. Our folks are running a really great airline right now and it will only get better. And now, to be able to think about layering in some more new revenue initiatives is very exciting. And one of these days, we can cuss and discuss about assigned seating, but it's nothing that's happening right now.
And, Gary, if I could just add to that. Duane, this is Tom. And what may surprise you is we actually did look at this – when was it, Gary, 2004, 2005?
Right.
And not just looked at it. We actually flew real flights with real customers, real passengers, out of San Diego in I think it was 2005. So, I guess, the reason I bring that up is we are not so wed to things that we're not open to looking at new ideas, new ways of doing it. That actually proved to us that we could do it if we chose to. Our customers actually asked us not to. That was the interesting thing. It was actually the business travelers, interestingly enough. But that work did give results in the new boarding process.
I guess, my point is you get a derivative benefit of looking at new things. I agree with Gary completely. It is not on our punch list right now at all. We have much bigger things to get at. But I don't want you to think we are immutable in what our product is and we'll continue to make the product stronger. That's just not one of the things we're going to be working on.
Part of our current thinking is all the facts that you all know, which is if we're not the strongest brand in airlines, we are among the strongest brands, and that's with the product that we offer today, to Tom's point, about what our customers told us more than 10 years ago. And number two, doing it the way we do it, we've been the largest airline in the country for 15 years. So I don't like the saying, if it ain't broke, don't fix it, but there's certainly no evidence that it's broken.
Okay. Okay. We'll stay in suspense and thank you for the detailed response.
Ladies and gentlemen, that does conclude today's analyst portion of the call. Thank you for joining us. And we will now begin with the media portion of today's call. I'd like to first introduce Ms. Linda Rutherford, Senior Vice President, Chief Communications Officer.
Thank you, Laurie, and welcome to members of the media to our call today. Before we start taking some questions, Laurie, could you give them some instructions on how to queue up to begin our Q&A session?
Certainly. [Music] (01:06:12-01:06:55) And we'll go first to Andrew Tangel at The Wall Street Journal. Please go ahead, sir.
Hi, Southwest folks. Thanks for taking the question. A question about fuel costs and fares. How much more room do you all have to raise fares as you try to recoup these higher fuel costs? At what point do you see higher fares, higher than where they are now, scaring off customers and reducing demand? And right now we're in a time where consumers are paying a lot more for a lot of other products.
Well, thanks for the question. I would just want to get my factoids straight here, but the – first of all, we had a very solid second quarter. I think you're familiar with the challenges that we had, so despite the challenges. And during the quarter our fares were down year-over-year 4.4%. So despite the fact that fuel prices were up, we used savings from the tax reform to kind of fund that, if you will, and we didn't sock it to our customers. So we're America's low fare leader. We work hard to keep our fares low. And to the extent that fares go up at Southwest, we try to do that in, obviously, a modest and gradual way.
Obviously, if our overall costs go up, it puts pressure on us and we need to be compensated for our service and some things have to be passed along to the customer. But we're in good shape and we had a solid quarter. So we've got some – I think we'll have very good comparisons with our average fare levels this year versus last year. So I'm certainly not warning you or anybody that they need to be looking out for fare increases coming from Southwest. Doesn't mean we won't increase fares. I'm just saying that we're in good shape and right now you're not seeing overall fare increases.
Mind if I add to that...
(01:09:32)
Andrew, this is Tom. Just a thought on that as well. I mean, we're pretty proud of the fact that we are a low fare leader. That's part of who we are, it's part of the brand. I think that as we get more sophisticated – I think you heard the rest of the call, as we get more sophisticated with some of our capabilities, we're going to have the ability to manage our pricing and our fares much more specifically.
And what I would hope for us to be able to do is to retain low fares without – just retain those low fares, but also drive our other fares up. What I mean by that is, if we could isolate low fares into certain parts of the day where you typically have lower demand, we could still make that low fare available for our customer, and then drive other demand into the meat of the day, where you'd like to try and get a little more yield. But I think it's very important, from my perspective, that we have the ability to maintain the low fare leadership, and that's going to require pricing tools, which is what's part of what we put in with our new res systems. So, low fares are important for Southwest Airlines and for our customers.
Okay. Yeah, just if you could at least address the thrust of the question, too, about how much more customers can bear at this point. Do you have room to raise fares if you needed to, to what extent, or at what point do you hit the limit of how much customers are willing to pay and you lose passenger traffic?
Well, and again, I think all I was trying to illustrate is that our fares are down and they're down every year since 2014, as I recall. So we're doing a good job of holding the line for our customers, and so I think by extension, because we have not been raising fares overall, I think one can understand that, no, we haven't, "reached the limit." But I think the other thing I would in fairness to you and your question, is we don't talk about where we're going with our fares, and so I wasn't intending to hint to you what we might be doing tomorrow or six months from now. That's not appropriate and for competitive reasons also, we wouldn't want to do that. But that's what our behavior has been and that's where we were in the second quarter, and so hopefully that answers...
Thanks. Just a quick follow-up on – it's sort of related, but also just something you were talking about earlier with additional revenue streams to diversify revenue streams. Your competitors have talked about how they're diversifying their revenue streams. You've all talked about it too. Specifically, are you looking at potentially adding bag fees, change fees, cancelation fees as you're trying to keep fares low and deal with these fuel costs?
I didn't offer anything specific. It was worse than generic. It was very obtuse and I know that. It's basically just to let folks know that we're working on it and enthused about some ideas that we have. However, to your question, the specific question you posed, we are not thinking about bag fees. We are not thinking about change fees.
All right. Thanks. Appreciate it. I'll stop asking follow-up questions.
They're all good. Thank you.
And we will go next to Mary Schlangenstein at Bloomberg News.
Hi. I have a question for Mike, please. Mike, what led to the decision for Southwest to step-up the inspections on your engine fan blades and do those more frequently?
Well, hey, Mary. How are you?
Good. Thanks.
Well, as there have been industry inspections ongoing, and I believe those industry inspections are in their final stages, but I'm aware of maybe four or five additional industry findings. And based on those results, GE is contemplating a change in their lube and inspection intervals from something other than 3,000 cycles, and they've talked to us more about something in the 1,600 to 1,800 range. So, based on that, Mary, we just decided to make a proactive change to the intervals. And today our fleet is on a 1,600-cycle reinspection program.
Okay. So can you be any more specific in terms of what the findings were?
Other than that they were just – there are cracks in fan blades out there with respect to the industry, and I think that more frequent lubrications helped mitigate potentially that and moving that cycle down would slow the propagation rates down and just mitigate some of the risk.
Right. And were any of those additional cracks found on Southwest fan blades?
What I'm talking about – I don't know on the GE. The four to five, I don't know.
You don't know whose they were found on or you don't know if they were on Southwest?
Those four to five I was talking about were not found on Southwest.
Were not. Okay. Great. Excellent. Okay. Thank you very much.
And we do have time for one additional question. We'll take the last question from Dave Koenig at The Associated Press.
Hi. Good afternoon, guys and Tammy.
Hey, David.
Hello.
Okay. You answered questions about assigned seats, bag fees, and change fees. It strikes me you're not always the lowest price carrier on a lot of routes, and I wonder if you did have a premium cabin or you had premium seats, maybe you could subsidize lower fares in the back of the plane, or any ideas like that on your list for things that might be upcoming in the next few years?
No, that's not in the basket of things that I was alluding to. Now, having said that, we can always think about the opportunity that you just described. I would kind of lump that in with assigned seating, and that's something that we could always do. But, Dave, we can't guarantee today, 20 years ago, 40 years ago, that every time you look for a fare, that we will be the lowest fare. We can't guarantee that. That's never been the case. The vast – I don't know if it's the vast majority. The majority of the time, Southwest will be the low fare and it's an easy claim to make if you include the bag fees and change fees, and that's something that we keep track of.
Obviously, we're very familiar with the revenue. What airlines try to do is to generate a certain amount of revenue per departure. And through an array of features that are offered, some customers will willingly pay more and some will willingly pay less, and that is the theory in a nutshell. So your question certainly has merit, but we're not specifically targeting that technique as a revenue initiative at this time.
Okay. Well, you mentioned, Gary, the bag fee, but you can get around that advantage by getting a branded credit card on one of the other guys, which is why I think that the lack of a change fee is so much more important as an advantage for you folks. But wouldn't there be an opportunity there to subsidize cheaper seats in the back?
Well, yeah, that's how it works. That's my point is that, yes, I think airlines understand that customers – they don't speak with one voice, so they come to us with an array of objectives. Some people want more, some people want less for a cheaper price. And so we try to strike that balance and offer them what we can professionally, expertly deliver, if you will. But, yeah, we do what you're describing today. We offer Business Select today. We offer EarlyBird today. So we do offer an array of attributes, and we try to make it a pure choice for the customer as opposed to forcing a customer to pay for a bag fee.
With respect to what our competitors do, we try to avoid the complexity, make it really easy. You don't have to jump through any hoops to have free bags on Southwest Airlines. And that works very well for us and we get tremendous brand loyalty as a consequence of that. So I think the answer to your question is, yes. And, David, we choose not to do those things. And obviously, what we've chosen to do works very well for us and makes us the most profitable airline, so I'm just glad everybody else doesn't do what we do.
Thank you very much.
And at this time I'd like to turn the conference back over to Ms. Rutherford for any additional or closing remarks.
Thank you, Laurie. As always, if you all have any other questions, please do follow-up with our communications team. They're standing by at 214-792-4847, or you can always reach out to us through our media website at swamedia.com. Thanks so much.
And once again, ladies and gentlemen, that does conclude today's call. Again I'd like to thank you all for joining us.