Southwest Airlines Co. (NYSE:LUV) Q3 2023 Earnings Call Transcript

Southwest Airlines Co. (NYSE:LUV) Q3 2023 Earnings Call Transcript October 26, 2023

Southwest Airlines Co. misses on earnings expectations. Reported EPS is $0.38 EPS, expectations were $0.52.

Operator: Hello everyone, and welcome to the Southwest Airlines Third Quarter 2023 Conference Call. My name is Jamie and I will be moderating today’s conference. 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 floor over to Mrs. Julia Landrum, Vice President of Investor Relations. Ma’am, please go ahead.

Julia Landrum: Thank you so much. And welcome everyone to our third 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. We also reference our non-GAAP results, which exclude special items that are called out and reconciled to GAAP results in our press release. 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: Well, thanks Julia and good morning everyone. Before we jump into the financials, I wanted to acknowledge that there have been heart wrenching challenges around the world the past several months. And we’ve had natural disasters in the communities that we serve. Earlier this quarter, I visited our team in Maui and witnessed firsthand the impact from the catastrophic wildfires on the island. Our hearts go out to all those who are suffering, and we’re really proud of the support we are providing including the volunteer efforts of our employees. Now moving to the results, operating revenues for the third quarter were just over $6.5 billion, up nearly 5% from the same period last year and a third quarter record. Despite the recent uptick in fuel prices and other inflationary pressures, we are again profitable with net income of $240 million excluding special items.

Revenue strength was driven by solid leisure demand throughout the quarter and by managed business continuing to come in largely as expected, and Ryan will share more details with you, but overall, demand remains healthy. As we close out this quarter and look ahead to the end of the year, we are very pleased with our accomplishments. We are running a great operation, reaching significant milestones, completing important initiatives, and delivering great customer experience enhancements. We’re making great progress on labor agreements including yesterday’s announcement of a tentative agreement with our incredible flight attendants. The team will walk you through many of these accomplishments, but for now, I want to talk to you about immediate actions we are taking to adapt to the current demand environment and solidify our path to operational and financial excellence.

Perhaps the biggest milestone is completion of our network restoration plan in the fourth quarter of this year. Reaching this milestone has obviously been a year’s long effort and has taken heroic coordination across the entire organization. It’s just incredibly challenging and I am so appreciative of every single employee. It truly was a whole company accomplishment. With this behind us, however, we are set up really well to focus on optimizing our business. That starts with reflowing the fleet order book to support orderly growth, and to that end, we just announced a new order book with our partner, Boeing, yet another milestone. This sets us up for orderly and measured growth and gives us flexibility to adapt in a dynamic environment and we have a lot of options as we move forward and we will plan in a way that allows us both the flexibility to move up or down, and this order book combined with opportunities to retire -700s and modernize our fleet supports that really well.

Finally, as we move into 2024, we are carefully evaluating the current macro environment and post-pandemic travel behaviors to create the best possible plan for the Company. We are now planning for a sequential quarter-over-quarter decline in nominal ASMs in the first quarter 2024. This will result in capacity growth on a year-over-year basis of approximately 10% to 12%, all of which is carryover from growth this year. Note that this is a reduction from what we shared in July which was an expectation to grow approximately 14% to 16% on a year-over-year basis. In the back half of 2024, we expect a nominal decline in seats relative to the same period in 2023. Therefore, for the full year, our network plan will focus on absorbing current capacity, maturing development markets, and designing schedules for current travel patterns.

This plan offers us the ability to redirect the teams that have worked so effectively to get us staffed and restored to now focus on better optimizing the operation. We will be relentless in our focus to wring out inefficiencies, drive productivity, increase reliability, and our goal to return margins to historic levels. We are still hard at work on both our 2024 and long-term plans, but we are building them with a priority and a focus on generating value, value for our employees, value for our customers, and of course, value for our shareholders. And with that, I will turn the call over to Tammy.

Tammy Romo: Thank you, Bob and hello everyone. First, I would like to extend another thanks to our wonderful employees for their continued hard work this year, especially in challenging environment. Ryan and Andrew will speak to our revenue trends and operational performance, so I will jump right to cost. Beginning with fuel, our third quarter jet fuel price was $2.78 per gallon, towards the higher end of our guidance as crude oil prices consistently rose throughout the quarter, peaking to nearly $100 per barrel in late September, and rising refinery margins added further pressure to our third quarter fuel price. Moving into fourth quarter, we currently estimate our fuel price to be in the $2.90 to $3 per gallon range, which includes an estimated $0.19 of hedging gains.

We now estimate our full year 2023 fuel price to be in the $2.85 to $2.95 per gallon range including $0.14 of hedging gains. The total fair market value of our fuel hedge portfolio for fourth quarter through 2026 is $538 million. We added modestly to our fuel hedge position for 2026 during third quarter. We continue to be roughly 50% hedged in 2023 and are currently 55% hedged in 2024, in line with our goal to be roughly 50% hedged in each calendar year. While we are not immune to rising oil prices, I am grateful that our hedging positions relieve some of the additional pressure. We continue to look for prudent opportunities to build out our hedge position for future years. Moving to nonfuel cost, our third quarter year-over-year CASM-X increase of 4.4% was right in line with our previous guidance range, driven primarily by higher labor rates for all employee work groups and the timing of planned maintenance expenses.

Looking ahead to fourth quarter, we currently estimate our CASM-X to decrease significantly year-over-year. There is a lot of noise in the year-over-year comparisons and the magnitude of the decrease is primarily due to impacts from elevated operating expenses and lower capacity levels in fourth quarter 2022 as a result of last year’s operational disruption. Our guidance range is inclusive of wage rate increases associated with the recently announced tentative agreement with our flight attendants. You can find additional details in this morning’s press release. Given inflationary pressures, particularly labor rates, combined with moderated capacity growth, we are expecting increased headwinds to our 2024 year-over-year cost. While we hit major milestones this year, our margins are not where they need to be and we intend to be relentless until we deliver.

We therefore plan to adapt our network and capacity plans to support both a reliable operation and improved returns on investments. Given our company’s commitment and history towards maintaining a competitive cost advantage, our goal will always be to manage costs accordingly. Now turning to our fleet, during third quarter, we received a total of 18 -8 deliveries and retired 4 -700s, ending the quarter with a fleet of 817 total aircraft. And we just finalized a new order book with Boeing which funds our long-term mid single digit growth plan and provides us the ability to phase out the -700 fleet over time, that really it gives us just a lot of flexibility. We provided full details on the new order book in this morning’s release. We now expect to receive 85 -8s this year and plan to retire 41 -700s.

This leaves our net expected increase of 44 aircraft unchanged from our previous guidance. Taking all this into consideration, our 2023 CapEx outlook remains approximately $3.5 billion. Looking to 2024, reiterating what Bob shared, we are planning for capacity levels that better match the current environment. We now expect 2024 capacity to be up 6% to 8% year-over-year. With our new order book, we have the fleet flexibility we need to organize the Company around a disciplined financial plan, one that we can adjust up or down to adapt to the current environment. We continue to expect our five-year capital spending on average to be in line with our previous guidance of roughly $4 billion per year. Lastly, our balance sheet remains strong. We are the only U.S. airline with an investment grade rating by all three rating agencies.

We have $11.7 billion in cash and short-term investments, and we continue to be in a net cash position. Year-to-date, we have returned more than $400 million to our shareholders through dividend payment and made debt repayments of nearly $80 million. Closing out the year we expect to pay a modest $7 million in scheduled debt repayments and continue to expect our 2023 interest income to more than offset 2023 interest expense. Let me close by saying, I am tremendously proud of our people and their hard work. As we look ahead, it is imperative we remain focused on building our 2024 plans and beyond to provide a resolute path to prosperity for our company, our employees and our shareholders. We have a history that proves we do not rest on our laurels and I’m confident we have all the elements needed to bring about the success you should expect from Southwest Airlines.

And with that, I will turn it over to Ryan.

Ryan Green: Thank you, Tammy. I’m going to walk through a review of our third quarter revenue results, provide context for our fourth quarter outlook and share some exciting commercial updates with you today. For additional detail on our revenue performance, please see this morning’s earnings release. Starting with third quarter, demand continues to be healthy. Operating revenue was a third quarter record of just over $6.5 billion and on a year-over-year basis operating revenue was up nearly 5%. And that’s on a tough compare period given pent-up domestic travel was still underway last year. When you compare revenue performance versus third quarter of 2019, operating revenue is up nearly 16% on 12% capacity growth. Also average fares were up 2.6% year-over-year and are up over 7% over third quarter 2019.

So, while we have work to do to cover our unit cost challenges, I am pleased we are moving in the right direction. The nearly 5% operating revenue growth year-over-year on a capacity increase of 12.5% had unit revenue or RASM declining 6.8% for the third quarter of 2023. July 4th and Labor Day travel came right in line with our expectations. However, bookings for non-peak August and September, while stable, came in at the lower end of our expectations. This performance aligns with fall start dates for primary and secondary schools continuing to shift earlier in much of the country. For example, in our markets, a third of schools were back in session by the second week of August, which is nearly double what it was pre-pandemic and nearly 95% of schools were back before the Labor Day weekend.

We are planning for these back to school trends to continue as we work on our August 2024 capacity plans. In addition, we had multiple records set from our ancillary products and our loyalty program. We had an all-time best quarter for ancillary revenue with 24% year-over-year growth and Rapid Rewards set a third quarter record for revenue generated from the program. New Rapid Rewards member acquisitions were a quarterly record and the number of engaged members grew 10% on a year-over-year basis. Rapid Rewards point redemptions were up 16% compared to the same period last year and retail spend on our co-brand Chase Credit Card was also a third quarter record. Our customers love the benefits they get from the card as evidenced by our low cardholder attrition which continues to be below pre-pandemic levels.

Overall, we see a resilient consumer and high engagement with the Southwest Airlines brand. Consumer spending trends still favor services, particularly travel experiences, and we expect that will continue. Moving to the fourth quarter, we are seeing a continuation of healthy leisure booking demand and stable business travel patterns. As a result, we expect a nominal sequential increase in operating revenue, resulting in record fourth quarter revenue and passengers which would bring us to three consecutive quarters of record operating revenue. October performance has been strong to date and bookings for the holidays as a whole are also strong. RASM however continues to be impacted by higher than seasonally normal capacity, driven by our network restoration plan, a larger than normal investment in development markets, and business travel that while improving is still below historical levels.

We also expect the close-in leisure trends we saw in non-peak August and September will persist into the non-holiday periods of the fourth quarter, and our guidance range does contemplate potential challenges from this year’s holiday placement including the expectation that a portion of return travel will spill into January. I am encouraged however that we have higher booked load factors for the December holiday period this year than we had at the same point last year, which indicates to me we’re not experiencing significant book away as a result of last year’s operational disruption. All-in, we expect RASM in the fourth quarter to finish down 9% to 11% on a year-over-year basis on capacity up approximately 21%. Again, we are steadfastly committed to addressing RASM performance to ensure a revenue plan that is appropriate.

For the current near-term, we are continuing to execute a strategy of fare sale campaigns to address low demand flights with meaningful advanced purchase requirements. This helps build load factor in suboptimal capacity without impacting higher demand flights or diluting close-in yield strength. Looking to 2024, as Bob mentioned, we will address RASM by moderating capacity to better match demand and optimizing our schedules to accommodate current travel behaviors. Our current set of strategic initiatives including GDS participation and the new revenue management system will also contribute incremental pre-tax profits to 2024 as they mature and hit their full run rates. Finally, we’re tireless in working to make customer experience on Southwest Airlines even better and drive even more loyalty from our customers.

Earlier this month we announced several exciting updates and the first involves several enhancements to our award winning Rapid Rewards program. We will add the ability for customers to combine Rapid Reward points with cash next spring which increases the ubiquity of our loyalty currency and makes it easier to book additional flights on Southwest Airlines. We also made it easier to reach our A-List and A-List Preferred levels in 2024 and are looking to reward our customers for their loyalty and entice them to fly with us whenever they travel. We have an imperative to win more customers and drive more travel from our most frequent travelers, and these enhancements are designed to give them even more reasons to choose Southwest Airlines. We also launched a new product for our corporate customers last week that will help us continue to grow our market share in the managed travel space.

Our new product streamlines the process to book group travel for meetings, incentives and conventions, which is one of the fastest growing segments in the managed travel space. I’m very pleased with the response to the product so far as we already have millions of dollars in travel booked on the new tool in just the first few days. Finally, we recently introduced customer bag tracking, which gives our customers the ability to track their checked bags throughout their day of travel, both at the airport and in flight. This improvement was one of the investments we accelerated following last December’s disruption. By providing additional transparency and information to customers about where their bags are during their travel journey, we’re elevating the travel experience and removing friction for our customers.

This enhancement is an early release of our larger digital hospitality modernization plan. So, congratulations to the teams that worked so hard to bring these great enhancements and solutions to market for our customers. Ultimately, we have to continue to win customers while taking into account the challenges of higher cost inputs as we build both our long-term commercial strategies and our near-term revenue plans, and we are committed to doing just that. With that, I will turn it over to Andrew.

Andrew Watterson: Thank you, Ryan, and hello, everyone. I am going to wrap up our prepared remarks with a brief overview of our operational performance, an update on our winter operations action plan, and some additional details on our capacity and network plans for next year. Before I dive into those details, I want to commend both, negotiating committees that worked diligently on tentative agreement just to reach their flight attendants, which will be voted on by our employees soon. This agreement offers industry leading compensation increases and quality of life enhancements. I’m very pleased with our strong improvements in operational performance and very appreciative of our Southwest Warriors. We saw broad-based improvements in our operating metrics, which were recognized by our customers through increased trip Net Promoter Scores.

Our early morning originators, turn compliance and turn differential, completion factor, mishandled bag rate, long delay rate and on-time performance all showed substantial year-over-year improvement. If not for longer than anticipated block times from congestion, weather and runway construction, our performance would have been even better. All of this resulted in a trip Net Promoter Score that is nearly 4 points higher than last year. That is certainly driven by our proven reliability, but also our customer experience initiatives including our improved Wi-Fi. We are excited about this solid trend in the right direction. It gives us lots of reasons to be optimistic about 2024. And speaking of the right direction, I’m excited to share an update on our winter preparedness.

The disruption we had last winter was really hard on our customers and our employees. It weighs heavily on all of us here at Southwest Airlines. We have a lot of pride based on our 50-plus-year history. So, preparing to prevent something like that from happening again was and is an imperative. Of course, the disruption was triggered by an unprecedented storm that simultaneously hit several of our most critical stations, but there were many causes, not just one, that led to it. As a result, our action plan is divided into three categories: winter operations, cross-team collaboration and accelerating operational investments which were already on our roadmap, including technology. One thing that really impacted us with Elliott is a 25% of our crew are based in Denver and Chicago.

When we are unable to maintain sufficient throughput during winter operations, we can’t get our crew out into the network. When this happens, it puts great stress on our crew network, which is what happened with Elliott. So, a key part of our action plan is to have more robust winter operations, so we can be confident that we get our crews out in the network to operate through bad weather. So, we invested in key stations based on calculated throughput needed to maintain our crew network, we have added de-ice pads, de-ice trucks, increased glycol storage and mixing stations, increased snow removal, heater carts and other equipment to operate safely and effectively in winter weather. We have been conducting de-icing summer school to make sure we have plenty of ramp agents trained and ready to go for de-icing.

That’s just a few examples of tangible things we have done. We are now so much better prepared for these extreme weather events. Moving to cross-team collaboration, we now have our network planning and network operations teams under the same organization, allowing them to work together to make the best decisions quickly. We have formed a special operating group, called the Network Disruption Pod to coordinate decision making in our control center when there are high risk disruption events and have used this group for events this summer. Additionally, we have conducted multiple operations wide tabletop exercises, often called War Games involving winter weather scenarios to prepare our teams for the season. And we have talked a lot already about the immediate modernization of and enhancement to our systems.

Early on, there was a misconception that technology problems caused an operational disruption. It was the opposite. Operational problems caused technology problems. Since the disruption, we’ve bolstered those systems with upgrades to address the specific issues we experienced during Winter Storm Elliott. We’re also rolling out a proprietary new system that is unique in the industry that takes a crew first approach when developing solutions to large scale and regular operations. I share all that detail and really those are just a few examples to demonstrate the level of action we have taken. We are set up better than ever and feel confident as we go into the holiday — winter holiday travel season. Finally, I’ll wrap up by talking a little bit more about what we’re doing with capacity and the network next year to ensure that we are on a path to operational and financial excellence.

Going back to April, we committed to orderly and measured growth. Stable growth helps us regain efficiency, absorb our hiring, mature our workforce and improve our operational performance. We also have to take into consideration demand levels and travel patterns as we determine our growth and build our network. As we develop our 2024 capacity set, we are doing exactly that. In the past couple of years, we focused on growth to restore our network and fully utilize our fleet. That combined with business travel trends and our investments in Hawaii and new cities has created challenges to our current unit revenue performance. Therefore, as we look to 2024, we are moderating our capacity, which will allow the growth to be absorbed. And as we shared last quarter, we are taking actions to accelerate the maturation of our developing markets and to optimize our schedules to current travel patterns.

The most recent examples is today’s announcement that we’re shifting the bulk of the international service in Fort Lauderdale to Orlando. This will offer better connectivity in our domestic network via the nearly 140 daily departures at MCO. We are fully committed to delivering on a plan that enables operational excellence, improves operational efficiency and reiterating what Bob said at the beginning of the call, that generates value for our employees, customers and shareholders. 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. Please go ahead and begin our analyst Q&A.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from Savi Syth from Raymond James.

Savi Syth: If I might on the 2024 plan, you talked about inflationary headwinds to unit costs. And you historically don’t necessarily adjust capacity once kind of schedules are loaded. I was wondering if you could provide a little bit more color on how we should think about unit costs in 2024. Is this going to be up year-over-year, and some of the kind of bigger drivers of the unit cost trends?

Bob Jordan: I want to start just first with sort of just kind of where we are with the quarter. I mean, the quarter was really solid. I mean, record operating revenues, passengers, Rapid Reward program revenues, retail spend on the card, new members in the program, so I mean just really pleased with the quarter. And obviously another accomplishment was restoring the network and getting all of our aircraft flying. So, we do have higher sequential capacity and just higher capacity general than typical. And as you know, travel patterns are changing for — while it’s still strong, they are changing for leisure, but they are also changing for business as the — we are seeing gains, but that last 10 to 15 points of business recovery is a little bit stubborn here.

So, we are working on capacity. Don’t want to be slavies to capacity here. So we’re going in and we are reducing the first quarter. The shoulder periods are just tougher, January, February. We are not ready to talk about the whole 2024 plan. We’re working on that right now very diligently. But our overall planning capacity for the year has come down to the 6 to 8 range, which is essentially all carryover from the restoring capacity in ‘23, just carrying over into ‘24, But that’s going to result in things like nominal seats in the back half of next year that will actually be down as compared to 2022. So, I just want to set the — sort of lay the groundwork for how we’re thinking about capacity. It’s all about two things. It’s about maturing and absorbing the capacity that we have stored in ‘23 and ‘24, that’s really how we’re thinking about capacity.

As you pull down capacity, that will create pressure obviously on cost, it always does. We’re still working on our plan. We’re going to work both sides of the equation. We’re going to work the cost and the efficiency plan here. We’ve got a lot of opportunity to drive out efficiencies as we slow the growth and focus on pulling down our hiring and getting folks out of training, all those kinds of things. But we’re going to work the revenue side as well. But yes, I just would admit that it does put a little bit of pressure on our cost as we pull down capacity, always does. Tammy, if you want to say anything?

Tammy Romo: You covered everything really well, Bob. Just, Savi, to give you maybe just a little more color on where we’re seeing the obvious cost pressures. Clearly, as we’ve wrapped up a lot of agreements this year with our labor group, we have seen more inflation than normal in labor. And that’s driven by the higher wage rates. And we’ve been, as you know, accruing for those throughout the year. And then outside of labor, we’re — we’ll see some inflationary pressures in maintenance as our 800 fleet is coming off of the holiday. So, just wanted you to keep that in mind as that wind down. But we are very — all that said, we are focused in on our 2024 plan. We are going to work really hard here to drive efficiencies and certainly leverage our network opportunities.

So, a little premature to give you guidance for the year, but we’re going to keep working really hard on our plan here to manage our CASM-X costs going forward. And we haven’t backed off of our Investor Day, what we shared with you at our 2022 Investor Day. Our longer term goal is to grow CASM-X in the low single digit range, and that would be on mid single digit capacity growth.

Savi Syth: That’s all very helpful. I appreciate that. And maybe kind of following up on that. Just on the fleet side, I know you have a contractual fleet here. Is your goal to again take as many aircraft and then offset it with retirements or how should we think about the aircraft deliveries next year, and maybe Boeing’s ability to meet it?

Bob Jordan: Yes. Savi, the goal number one with our — and we’ve been talking about reflowing our fleet order book with Boeing. Goal number one was to just get to orderly steady growth in the fleet plan. I think, if you look at — we were stacking a lot of aircraft up that were delayed, and I think it pushed beyond even what you saw in the plan, a delivery expectation of 143, I think in 2024, which, of course, we’re not doing. So, I’m really happy, Boeing has been a great partner. We’ve got a new fleet plan that takes us — that is very orderly. It takes us through 2031 at very attractive pricing, and there is a lot of flexibility in the new order book. So, we can flex up and we can flex down, as you see demand trends changing both ways.

Just thinking about 2023, we’ve been talking about, again, taking control of the order and delivery plan and planning to that in our schedules, we plan to 70. Boeing looks like we will now be able to take 85 this year from Boeing and we’ll just offset that directly with retirements, which of course is a — that’s a solid financial trade. And then, our goal next year is to take 85. Now, Tammy, do you want to add anything?

Tammy Romo: You covered it all.

Bob Jordan: But again, the new order is all about reflowing this so that the growth is orderly and steady and we have access to a lot of aircraft at attractive pricing and we have a lot of flexibility.

Operator: Our next question comes from Catherine O’Brien from Goldman Sachs.

Catherine O’Brien: Maybe just a follow-up on the cost question, if you don’t mind. Two things. I know you’re not prepared to talk about exact guidance on 2024, and I totally appreciate that the growth plans have changed. But I think last quarter you said you were committed to driving cost down year-over-year. Are we just back at the drawing table for that? And then, on the labor inflationary pressures you’re talking about, I know you’ve been accruing this year. So, what’s driving that incremental into next year? Is that just wage rate increases are higher than they used to be or something else in the pay package?

Tammy Romo: Just to give you a little more help there, it really boils down to two factors. One is, we have moderated our capacity growth plans and we are continuing to see labor rate pressure. And just to really take you maybe through our fourth quarter cost profile to help you as you sort of model for first quarter. If you exclude the 15-point year-over-year disruption related impact to our fourth quarter CASM-X outlook, we would actually be down 1% to 4% year-over-year. And as Bob mentioned earlier, in terms of our cost profile, while we’ve had some structural cost increases here, our cost advantage relative to the industry and the legacy carriers is still very much intact. But if you move sequentially from fourth quarter, the cost headwinds are stemming mostly from overall inflation, namely labor cost.