Southwest Airlines Co. (NYSE:LUV) Q2 2023 Earnings Call Transcript

Southwest Airlines Co. (NYSE:LUV) Q2 2023 Earnings Call Transcript July 27, 2023

Southwest Airlines Co. beats earnings expectations. Reported EPS is $1.3, expectations were $1.1.

Operator: Good morning, and welcome to the Southwest Airlines Second Quarter 2023 Conference Call. My name is Anthony, 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. After today’s prepared remarks, there will be an opportunity to ask questions. [Operator Instructions] At this time, I’d like to turn the call over to Julia Landrum, Vice President of Investor Relations. Please go ahead, Ma’am.

Julia Landrum: Thank you, operator, and welcome, everyone, to our second quarter 2023 conference call. In just a moment, we will share our prepared remarks and then jump into Q&A. On the call with me today, we have our President and CEO, Bob Jordan; Executive Vice President and CFO, Tammy Romo; Executive Vice President and Chief Commercial Officer, Ryan Green; and Chief Operating Officer, Andrew Watterson. A quick reminder that we will make forward-looking statements, which are based on our current expectation of future performance, and our actual results could differ materially from expectations. Also, we will reference our non-GAAP results, which exclude special items that are called out and reconciled to GAAP results in our press release. So, please refer to the disclosures in our press release from this morning and visit our Investor Relations website for more information. With that, Bob, I’ll turn it over to you.

Bob Jordan: Thanks Julia, and good morning, everyone. I appreciate you joining us for our second quarter 2023 earnings call. I am very pleased to report a solid quarter with net income of $693 million, excluding special items, and all-time record quarterly revenue of just over $7 billion. The demand environment, especially for leisure travel, continues to be resilient as we have seen solid bookings throughout the busy summer travel season. Further, we continue to expect $1 billion to $1.5 billion of pre-tax profit contribution in full year 2023 for our strategic initiatives that we outlined at our Investor Day last December. Based on our current outlook, we continue to expect record operating revenue and solid profits in third quarter 2023 and year-over-year margin expansion for full year 2023.

I especially want to thank our people for doing such a fantastic job. They helped us get a record number of customers and a record number of bags on a record number of flights successfully to their destinations, as we experienced the lowest second quarter flight cancellation rate in the past 10 years. It wasn’t without trials. We had a lot going on in the operation related to weather, and weather has continued to be a challenge here in July. Despite that, our employees have continued to deliver a very solid performance. From our network ops control center to the front line, our people have worked together extremely well to minimize cancellations and produce a very reliable operation, and I’m just so proud of them for getting our customers where they need to go, despite a challenging operational environment.

While our cost outlook has increased for the year, the change is primarily driven by updates to our market wage rate accruals for open collective bargaining agreements. And while fluid, we’re making progress. It’s obviously very hard work and I’m just very appreciative of the dedication of everybody involved in the negotiation process. Now, thinking about where we are with the business, since 2018, we have seen very significant swings due to the grounding of the MAX, demand fall off, of course, from COVID, then the stress from the resurgence of demand, disruptions from post-pandemic supply chain issues, challenges with employee staffing, and most recently, uncertainty with our Boeing aircraft deliveries. The challenges we have faced since 2018 have made planning difficult, so smoothing out fluctuations is a must, and the best way to do that is with smooth and predictable capacity growth.

We told you back in April that we were reflowing our order book to allow for orderly and measured growth, and we’re still finalizing the details of that with Boeing, but we remain confident that we will get the 70 deliveries in 2023 that are assumed for our published schedules, and we are working to build a 2024 plan that should be much more stable. We currently are planning to be flying the MAX 7 at some point next year, but if not, we’ll take MAX 8 instead just as we are doing now. Where that leaves us for full year 2023 capacity is unchanged for this year at up 14% to 15% year-over-year. As we shared this morning in our release, we are revamping our 2024 flight schedules. While our network is largely restored at this point, it is not optimized, especially for post-pandemic shifts in business travel.

Those adjustments to the network will be largely complete by the March 2024 flight schedules, and we expect those efforts and the continued maturation of development markets to generate an incremental $500 million in pre-tax profit in 2024. The changes will also reduce the percentage of system capacity and development by more than half, returning to normal pre-pandemic levels by the end of next year. We already have our schedule published through March 6, 2024, and currently expect first quarter 2024 capacity to be up in the range of 14% to 16% on a year-over-year basis. Now, keep in mind that nearly 90% of that year-over-year growth is carryover from 2023. For the remainder of 2024, we are planning for a sequential deceleration in year-over-year growth in each quarter next year as we work our way back to our long-term goal of mid-single-digit growth year-over-year.

We’ve made a lot of progress in the first half of 2023, completing several major milestones. We quickly developed and are on track for our winter operations plan. We have the staffing plan in place to fully utilize our fleet by the end of the third quarter and have the network restored by the end of the year. Again, to be clear, it’s restored but not yet optimized, and Ryan will share more on how we’re going to adjust the network based on post-pandemic travel patterns. But we have a lot of exciting things in the works that we believe are going to contribute to our 2024 financial results and help us deliver another year of margin expansion next year. In closing, our accomplishments in 2023 lay a foundation for us to shift our focus to restoring our industry-leading financial and operational performance, boost our operational resilience, and make advances in our industry-leading customer service through a focus on digital hospitality.

I just can’t say this enough, I’m just so proud of our people. They are the heart of Southwest Airlines, and they deliver day in and day out for each other and for our customers. And with that, I will turn it over to Tammy.

Tammy Romo: Thank you, Bob, and hello, everyone. First, I’d like to extend another thanks to our employees for their commendable efforts this quarter, resulting in solid operational and financial performance, a hard earned improvement from where we began the year. Overall, we had a really solid quarter. Operationally, we had a great completion factor, despite many weather challenges. Financially, bottom line profits were in line with our expectations, despite pressure from market-driven labor accruals. We produced an all-time quarterly operating revenue record. We also generated double-digit operating margins each month during the quarter. All of this was made possible by the drive and hard work of our incredible employees.

I just can’t thank them enough. Ryan and Andrew will speak to our revenue trends and operational performance. So, I will jump right to cost, fleet and then balance sheet. Beginning with fuel, our second quarter jet fuel price was $2.60 per gallon, slightly above our previous guidance. Throughout second quarter, crude oil prices stayed within a reasonable range, hovering for the most part around $80 per barrel. We are 49% hedged for third quarter and estimate our third quarter fuel price to be similar to our second quarter fuel price. And that includes an estimated $0.08 of hedging gains. We now estimate our full year 2023 fuel price to be in the $2.70 to $2.80 per gallon range, including $0.09 of hedging gains. This is up a dime from our previous guidance due to higher refining margins.

Of course, market oil prices and heating cracks can be volatile, which is why we hedge. We are currently 54% hedged in 2024, and over the last few months, we’ve added meaningfully to our 2025 portfolio and began building our 2026 portfolio. The total fair market value of our fuel hedge portfolio for third quarter through 2026 is $373 million. We will continue to see seek cost effective opportunities to expand our hedging portfolio with a continued goal to get to roughly 50% hedging protection each year. Moving to non-fuel cost, our second quarter year-over-year CASM-X increase of 7.5% was towards the unfavorable end of our guidance range due to incremental adjustments to market wage rate accruals for our open labor agreements. We have said this from the beginning, but our labor accruals are based on market, and in this environment market has obviously been dynamic.

We are planning and eager to award our work groups with well-deserved compensation increases. Looking ahead, our nominal third quarter cost trends remain fairly consistent with second quarter. We currently estimate our third quarter CASM-X to increase in the 3.5% to 6.5% range year-over-year. This increase is again largely driven by higher labor costs. We are also continuing to incur additional maintenance expense relative to 2022 for our -800 fleet as more engines come due for heavy maintenance, adding further pressure to our second half cost inflation. For our full year 2023, we now estimate CASM-X to decrease in the range of 1% to 2% year-over-year compared with our previous guidance of down 2% to 4%. The estimated 0.5 increase is due primarily to higher labor cost pressures as I’ve already covered.

Turning to our fleet, during second quarter, we received a total of 21 aircraft deliveries and retired 11 -700 aircraft, ending the quarter with over 800 aircraft. We are working to reflow our order book with Boeing. However, for this year, we continue to plan for approximately 70 -8 deliveries and 26 -700 retirements, which takes the fleet to 814 aircraft at year-end. Likewise, our CapEx outlook remains unchanged at approximately $3.5 billion, which assumes approximately $2.3 billion in aircraft capital spend. Our 2023 capacity guidance also remains unchanged. We continue to expect full year 2023 capacity to be up approximately 14% to 15% year-over-year, and we have tightened our third quarter capacity guidance to be up approximately 12% year-over-year.

As Bob mentioned, we are planning for first quarter 2024 capacity to grow 14% to 16% year-over-year. Now, keep in mind, we are growing 14% to 15% in 2023, and that alone drives nearly 90% of that first quarter year-over-year growth. So, the primary driver of that first quarter year-over-year growth is annualizing the additional capacity we are adding this year. But, our long-term goal remains mid-single-digit year-over-year growth. Lastly, our balance sheet remains pristine and we remain the only U.S. airline with an investment-grade rating by all three rating agencies. We ended second quarter with cash and short-term investments of $12.2 billion, net of $67 million in debt repayments for the first half of the year. We continue to be in a net cash position and expect a modest $16 million in scheduled debt repayments for the remainder of the year.

And currently, 2023 interest income is still expected to more than offset 2023 interest expense. We declared another dividend in second quarter which was paid just a couple of weeks ago. I am proud of what we have accomplished through the first half of the year. That said, we still have work to do to return to industry-leading financial performance, which is our priority as we work on our plans for next year. This includes managing the ongoing inflationary cost pressures, reflowing our order book with Boeing to support orderly, measured and profitable growth, and rebalancing and optimizing our network. We believe these plans, combined with our existing initiatives and the maturation of our development markets will help us expand both margins and return on invested capital in 2024 as compared with this year.

Let me close by saying my confidence in our ability to achieve our financial and operational goals is anchored by my belief in the people of Southwest Airlines and their ability to create and inspire success. And with that, I will turn it over to Ryan.

Ryan Green: Thanks, Tammy. I’ll walk you through our second quarter revenue results, provide context for our third quarter outlook and update you on some of our commercial priorities. And for additional detail on our revenue performance, I’ll point you to this morning’s earnings release. Starting with second quarter, demand continues to be resilient, especially for leisure travel. Overall trends have remained steady with operating revenue for the first half of 2023, consistently well above 2019 pre-pandemic levels. Operating revenue for second quarter was an all-time quarterly record of just over $7 billion. And in fact, we had record operating revenue in every month of the quarter. Second quarter 2023 unit revenue or RASM decreased 8.3% on a year-over-year basis on a capacity increase of 14.1%.

And while it’s a year-over-year decline, it’s still our second highest second quarter RASM to date, which points to the tough comp we were up against from last year. And as a reminder, year-over-year RASM was impacted by a 5-point headwind from approximately $300 million of higher-than-normal breakage revenue that was recognized in the second quarter of 2022, resulting from flight credits issued during the pandemic that were set to expire prior to our later policy change to eliminate flight credit expiration dates. Overall, second quarter revenue came in at the favorable end of our expectations as close-in leisure held strong. Second quarter revenue from corporate travel came in largely as expected, as we realized sequential and year-over-year improvement in managed business revenue.

And while travelers from some of our largest segments have reduced their frequency of their business trips from pre-pandemic levels, we’re very pleased with the gains we continue to make in the managed business space. Small and medium businesses, government and educations are strong points for us, and we are growing the number of accounts we have under contract. All of this has allowed us to continue to grow our share of the managed business travel. We gained additional passenger market share in the second quarter and exited the quarter seeing more unique travelers flying for business than we saw pre-pandemic. Moving to the third quarter, we’re seeing leisure booking and yield strength continue throughout the summer travel season with July revenue, which is essentially booked, expected to also be a record.

Of course, much of the post Labor Day booking curve comes in closer but we’re very encouraged by the response to our June fare sale for off-peak fall travel and what that suggests for continued leisure demand. We had all-time record bookings the week of our fare sale with three booking days that were top 10 all-time records and included our record day for the most bookings ever taken. In fact, we have more passengers booked for third quarter travel at this point in the curve than we did at the same point in time for second quarter. Of course, on a revenue basis, nominal yields are typically weaker sequentially third quarter versus second quarter but the strength in passengers points to the continued demand for Southwest Airlines. We currently expect overall corporate travel to have a modest underlying trend improvement, and we expect to continue our gains in industry market share.

Overall, however, we expect corporate travel demand will remain lower than leisure for the foreseeable future, particularly compared with pre-pandemic. So with a higher leisure mix, and as the number of business trips taken per traveler remain down for our most frequent customers, it gives us an opportunity to look at our current network design. Pre-pandemic, those travelers had a skew of short-haul travel with more frequent trips and also more midweek travel, and our current network is designed assuming those travel patterns would return. Moving forward, there is a revenue opportunity to adjust the network to adapt to the new travel patterns we expect to continue to see from our mix of business and leisure customers. Ultimately, this leaves us with third quarter unit revenue expected to be down 3% to 7% year-over-year on capacity up roughly 12% again on a year-over-year basis.

The decline in year-over-year unit revenue is driven by capacity growing faster than seasonably typical as we restore the network and normalize the utilization of our fleet as well as tough prior year comparisons from the post-pandemic domestic demand surge. So, while there is still room to optimize our unit revenue efficiency, this guide implies a third quarter record for operating revenue. So again, we are in the process of adjusting our network to support our imperative of industry-leading financial performance. Starting with the January 2024 schedules, we’ve made changes to the composition of the network such that it supports the customer travel behavior changes I just mentioned. We made changes that reflect where our customers are traveling and when they’re traveling, including time of day and day of week, and this optimization will be largely complete in spring of 2024.

In addition, we have more than 10% of our markets under development, which will normalize closer to pre-pandemic levels over the next 12 to 18 months. So, as we said in the release and as Bob mentioned earlier, the go-forward revenue opportunity from the network is substantial. And of course, we also expect continued revenue contribution growth from our existing and fully implemented revenue initiatives. Finally, we have always worked hard to consistently deliver the best hospitality and customer service here at Southwest. Our customer service is, of course, legendary, and our customer policies are industry-leading. And we are on track in deploying our onboard product initiatives, including Wi-Fi upgrades, larger overhead bins and in-seat power.

We are now focused on widening our customer service advantage through prioritizations of a series of initiatives that will improve our digital hospitality and allow our customers to serve themselves in most cases. We aren’t ready to provide you all the details there, but the initiatives will help us achieve our goal to deliver the best and most efficient hospitality with next-generation tools, airport layouts and more. And now, with that, I’ll turn it to Andrew.

Andrew Watterson: Thank you, Ryan, and hello, everyone. I’m going to provide some additional details on our operational performance and a brief update on our Winter Operations Preparedness Plan. Well, I’ll just start by commending our employees for their warrior spirits and the solid operational performance they delivered in an operationally challenging quarter. As Bob mentioned, we had record flight activity, record customers and record bag counts. But we were ready. We were staffed up and we were prepared. Our completion factor in the second quarter was really pretty remarkable. We reliably achieved a flight completion factor of more than 99% in the second quarter. It was the highest second quarter performance in the past 10 years.

And that is despite the challenging environment. June, in particular, had tough operating conditions. We had issues across the entire system with pretty much continuous weather disruptions. Safety is always our first priority, so we couldn’t avoid some flight delays, but we are really excelled in getting customers to the destinations and with their bags. And when we had weather events, we managed to reset and be right back on track the next morning, which is a sign of good management through the regular operations by our people. Underneath that headline, we saw broad-based improvements in our operating metrics as on-time performance, long delays, early morning originators, turn compliance, flown as booked and trip Net Promoter Score, all showed solid year-over-year improvements.

This was against the backdrop of runway closures in Las Vegas and Denver, which are two of our largest operations. Another drag was our block time hit rate, which dropped over 4 points relative to the second quarter last year as our pilots had to take more circuitous routing because of weather. The broad-based improved performance against these headwinds is a testament to solid execution by our people. Looking forward, we’re also really pleased with our progress on the implementation of our Winter Preparedness Plan. Just a reminder, though the plan is detailed on a micro site, which is available on our website. The plan is on track to be fully implemented in fourth quarter 2023 in advance of our winter storm season. I won’t walk you through all the details today since it’s on the micro site.

But I will say that everything is going really well, and we are already accepting delivery of new equipment and infrastructure as well as completing software implementations. We are conducting summer school to trade new ramp agents on deicing and train all ramp agents on new equipment. Obviously, the other thing we have going on is labor negotiations, where we continue to work diligently, and we continue to make progress. I do want to thank all the parties of both sides who work hard to negotiate these collective bargain agreements. I’m grateful that we’ve been able to get so many ratified in the last 9 months, but we still have more to do with a couple that have been amenable for a while. We know the negotiations could be emotional as well as complicated, but we are committed to good faith negotiations to get new agreements in place as quickly as possible and to compensate our employees with market wage rates.

So, in closing, I’d like to thank all of our employees for their hard work. It’s an honor to be part of this team and to have the opportunity to support them. And with that, I’ll turn it back over to Julia.

Julia Landrum: Thank you, Andrew. We have analysts queued up for questions, so a quick reminder to please keep your questions to one and a follow-up, if needed. Operator, please go ahead and begin our analyst Q&A.

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Q&A Session

Operator: [Operator Instructions] Our first question will come from Scott Group with Wolfe Research. You may now go ahead.

Scott Group: Hey. Thanks. Good afternoon. So, wondering if you have any color on the pressure on load factors in the quarter? And then, guiding to a lot of pressure on RASM in Q3 as capacity accelerates. With Q4 capacity expected to accelerate further, do you think we should expect further RASM pressure? And given that, do you think about maybe moderating some of the capacity growth?

Ryan Green: Yes. Hey Scott, it’s Ryan. I think just stepping back and just taking a look at the second quarter overall, I think it was a really good performance, record operating revenue for the quarter, record operating revenue for each of the months in the quarter. And I think when you think about that relative to the compare period from the prior year, with the pent-up demand in second quarter plus the headwind that we were facing there on the breakage adjustment of about 5 points, which, by the way, does not persist going forward. That is — that comparison is isolated to the second quarter there. I think that the performance is really, really good. The fare environment, second quarter year-over-year, if you adjust because that breakage benefit or breakage comparison from second quarter of 2022 gets booked into passenger revenue, that gets spread out over all the revenue there in the quarter.

And if you isolate that, average fares in the second quarter are actually up year-over-year at 2%. So, we’re in an environment here where we’re managing — we’re optimizing revenue in a really strong fare environment, which does typically have a little bit of pressure on loads. And the — and I think if you look at our domestic load factor compare second quarter, it’s in line with the compares — or the load factor performance that our competitors saw in the second quarter as well. So, all of that taken into account on the second — on the second quarter, I feel really good about that. As you think about the fare environment going forward, July here is almost booked. I think the fare environment as far as we can tell, continues to persist.

Here in July, I think, we expect another record revenue in July, again, on a tough compare from prior periods with the pent-up demand last year. So, I think we’re just in an environment here where we are managing — where we’re optimizing revenue in a very strong fare environment, and that typically comes with a couple of points of load factor adjustment there.

Bob Jordan: Scott, it’s Bob. The other thing we — obviously, the new — we’ve got — we’re in this new revenue management system as well that we’re — I think will be fully taken over the network in terms of pricing this fall. And number one, I’m happy that we’ve been able to get it in. We got it in on time, but it thinks about your whole itinerary. And one of the things that happens, too, is it maximizes close-in demand. So, it wouldn’t be a surprise doing that that you might see a little bit of a lower load here, especially as we learn the new system, and again, all that was known as we did testing. Second thing is we know we’re in a suboptimal environment. We brought capacity back quickly as we restored our flying.

I’m very proud of the team here. We will get all of our aircraft in the air and be unconstrained flying everything here at the end of the third quarter, which is actually ahead of our plan, but it’s not optimized. That’s why we’re doing all the work in the first quarter of next year around the network to optimize. The last thing, just Ryan talked about this, as you associate this to average fare, we have a large percent of our network in development. It’s over 10%. We added new cities. We grew Hawaii during the pandemic. We put kind of 100 aircraft or more into those investments, and those are still in development, and that will mature across 2024. And I expect that percent of our total system in development to be normal to fall across each quarter next year and to be normal sort of pre-pandemic normal by the end of next year.