Southwest posts record 3Q results for robust future

More importantly, perhaps, was his response to a question on why projected capacity increases are so robust for the first half of 2011. He indicated that 4Q2010, compared with 4Q2008, is "going to be a very handsome increase". He said results can only get better from there because the business traveller has yet to return to the air in the numbers experienced before the recession.

"The fact that we are seeing such strength in October is very material to what we are contemplating for the first quarter (2011)," he said. "We're going to have another record load factor in October. We'll have another record load factor in November. We see very strong demand for the next 60 to 90 days, which we think will carry through to the first quarter of next year. An optimised schedule that has new markets in it, will justify that amount of flight activity. The fact that we can add that capacity at an incremental cost makes the profit opportunity quite handsome for all the obvious reasons. It's just utilising the assets that we have and the workforce that we have to provide better flights, and we're confident that the revenues would be there."

Kelly said capacity deployed through June 2011 will add to profitability. "What we're telling you is that we'll have more profits with the plan that is being pursued as opposed to less," he assured analysts. "It's a task that to hit our return on capital goals. Obviously, we're very hopeful we can do that next year. The biggest wildcard for us is fuel prices."

What is interesting about the strong demand environment is that it continues to rise, despite an industry-wide increase in fares between 15% to 18%, according to FareCompare and AirlineForecasts. The continuing strong demand seems to defy economic theory that says for every 1% increase in fares there is a corresponding dip in demand, between 0.8% and 1.5%.

The question remains as to whether 2010 has been a year of satisfying pent-up demand as leisure and business travellers return to the skies. It seems logical that we can expect a decline in demand as fares continue to rise and that pent-up demand is satisfied. But airlines are reporting strengthening demand in the fourth quarter and beyond. Fourth quarter 2009 began the turnaround in earnest and such increases on top of a tougher comparison is surprising. But, as Kelly pointed out, the economy is still soft and business travellers have not returned to 2008 levels, making prospects for the future promising.

"[The third quarter] suggests that we're continuing to build momentum," he said. "That's logical because you haven't seen the full return of the business traveller. If one believes that is gradually occurring over time, all else being equal, you ought to continue to see strengthening of revenue momentum. That was our prediction from earlier this year, and, so far, that's playing out pretty well. We're not seeing the levels of business traffic in Southwest that we had in '07 and '08. Certainly, what I've heard from counterparts around the industry, no one is representing that their business travellers have recovered to that level. You've got that upside in any event."

In response to a question as to why the industry is seeing such growth in the fourth quarter, CFO Laura Wright reminded analysts the trend began in September 2009. "If you compare us to two years ago, our unit revenues are up about 13.5% in a still pretty depressed economic environment," she said. "In terms of why the sequential trends, there seems to be a lot of factors working together. Certainly, what we've seen at Southwest is increased loads, record load factors in 14 of the last 15 months. We're slow at picking up business traffic, but at the same time we seem to be picking up more incremental leisure traffic as well. It just seems to be a very good combination for us."

The Southwest advantage

Kelly added that demand is picking up. "It's hard to find anybody who thinks that the economy is really strong, so I do think that the environment is such that consumers are looking for value," he said. "I read all the time about business travellers looking for value and buying in advance to get better ticket prices is an example. That's an environment where we really shine and the 'Bags Fly Free' message, of course, just pounds that home. I believe that we're going to continue to outperform our competitors. There aren't any real competitors that are able to offer the same kind 'wow' factor."

More details will be revealed in December but Southwest has surveyed its traveller mix compared with other airlines. "If you extrapolate that into the number of customers that we carry, we're among the leaders in the country in terms of the number of the business customers that we serve," said Kelly. "Arguably, historically, at least in the last couple of years, we've been the largest with Delta, Northwest combining and now United Continental, they will probably outboard us in terms of business customers. The point is, we already serve a whole bunch of business customers."

Southwest's strategy as a no-fee zone as far as bags and change fees are concerned, is clearly paying off. It testified to Congress last summer that it has gained over USD1 billion in additional revenue from the share shift because it does not charge for bags. Considering that Southwest could raise USD450 million if it began charging bag fees, according to AirlineForecasting Managing PartnerVaughn Cordle, it is actually yielding a net benefit of USD500 million by not charging.

"Clearly, we're gaining share," Kelly continued. "That's an undeniable fact domestically. We're gaining share relative to the last several years. A lot of that share is the consumer, but it's also business travelers. Just with the product enhancements we've made, giving the road warriors more choice, we do believe that we're seeing more business customers come Southwest's way. There is variety of things going on in our 16.1% unit revenue improvement. We've deployed 10 different initiatives or more and it's hard for us to take apart what value is being driven by each one. What I hear from business customers is the fact that an enhanced boarding process with the Business Select product, with enhanced frequent flier benefits, has caused them to change their flying behavior and bring their business to Southwest.

"The fact that we allow more flexibility in changing flights where we do not charge the change fee is huge with business customers," he continued. "The bag fees may be not so much. That's probably more benefit for consumers, but even the bag fees is an attribute that some business customers like. It's a basket of things. Clearly, there is much better revenue management than there was three years ago. There is much better schedule optimization, too. We've created itineraries that are more marketable for connecting customers. Connecting passengers are up more than our non-stop passengers. They are not at the expense of non-stops. We're still carrying the same amount of non-stop passengers."

Kelly noted the increase in load factor is being driven by more connecting passengers which is also driving a need to adjust operations to accommodate the rising number of connections.

"One would infer that could be more heavily weighted towards consumers," he suggested. "It's a variety of things, and in fact, with the recession, you'll always find with a drop in business travel, that's our bread and butter, short-haul markets, and they are lagging in the recovery compared to our medium and longer-haul markets. I do think that when the business traveller does come back, we're going to see, hopefully, a very strong response, especially in our shorter-haul routes."

Progress of the AirTran merger

There was little to report about the progress of the AirTran merger except that discussions with Boeing confirmed earlier contentions its 717s would be an asset to keep.

"We've been able to embrace a number of additional experts within our company and also talk to the Boeing company about the airplane," said Kelly. "We're pretty excited about it. We've only confirmed what we thought before about adding it to the fleet with respect to opportunities we might have with regards to economics."

In response to a question about how the Southwest effect will impact Atlanta which already has low fares from AirTran, Kelly said it was a matter of optimizing the AirTran network. First he pointed to the two dozen cities in the Southwest system that AirTran does not service.

"We see that fares are quite high," he said. "We know we can come in, lower fares and stimulate the market. That is huge. Campbell-Hill came up with an estimate of two million incremental O&D passengers. We just looked at that subset of markets. Our number wasn't two million, but it was still really big.

"The AirTran route system is probably not fully fleshed out," he continued, moving to his second argument. "In other words, even where they do have service, especially if it's service to an existing Southwest city, we see the opportunity to at least consider adding frequencies and tap into the strength that we have on the destination markets. We're loathe to tell our competitors our game plan, but an obvious one is Chicago Midway where we have a lot of customers in Chicago. It's one or our largest cities. We may very well have opportunities to add to the AirTran route map and generate a lot more customers. Then there are places that we don't serve that AirTran does where they may not have enough frequencies either. Of course, in 2008, they were forced for economic reasons to withdraw a lot of capacity from Atlanta because of high fuel prices. Some of that could, at least in theory, be considered for restoration. So, I really think its three basic pools of opportunities there."

Kelly also said that, while the additional slots gained in Newark, thanks to the United/Continental merger and at Washington National thanks to AirTran, will be good as they are actually "close to the minimum that we're comfortable with". Southwest is, then, clearly seeking more slots at Newark, LaGuardia and National.

"Eight is just not enough at LaGuardia," he said. "We'll be in the neighborhood of something that we're comfortable with. We're okay with the National and New York position. But, if we can get more, we're interested in more. I'm just not assuming that will happen, though, this is a long-term view that we'll be fine with that level of capacity in those three airports."

In the US Airways call, Chair and CEO Doug Parker indicated that the various slot exchanges occurring confirmed his, and other's, position that if an airline wants slots, it must buy them. However, he also said that Southwest's historical position has been to use the government to gain more slots such as in its objection to the Delta/US Airways slot swap. That is still pending and, while the competitive environment has changed with more slots in the hands of low-costs carriers now in both New York and Washington, Kelly is clearly hoping that the continuing deliberations between the DOT, Delta and US Airways may yield more slot opportunities for Southwest.

Volaris, new loyalty programme coming shortly

It appears as though the long-awaited rollout of either the Volaris partnership or the company's new Rapid Rewards 2.0 will be announced shortly. But, judging from the sparring between Kelly and analysts to try to pin down a time frame, the closest they could come was "before December," according to Kelly. And, given his statement that Rapid Rewards will come next year, the odds that it will be the Volaris announcement rose.

"We'll get this stuff done eventually," he said, adding its long-awaited new reservations systems must await integration with AirTran and may even experience a years-long delay. "Volaris, we'll share some specifics on that soon. Next in line would be Rapid Rewards. We'll share some specifics on that pretty soon. Then the new res system. The new attributes associated with a new reservation system likely won't begin to come online for probably 18 to 24 months at the earliest. I can't imagine that we'll be completely converted to a new reservations system given this new AirTran initiative for three years. We'll probably start that work in earnest in a couple of months, but even that is just a target date. Volaris and Rapid Rewards are very, very close and you'll find more about those two very soon."

While it is benefiting from its policies on bag and change fees, in reality it is its reservations system that is unable to handle the complexities of ancillary fees. Consequently, analysts have been impatient to see a new reservations system, that would also accelerate Southwest's entry into the international arena.

Results

Southwest posted third quarter GAAP net income of USD205 million or USD0.27 per diluted share, CFO Laura Wright reported, adding the airline posted a new margin of 6%. Excluding special items, net income was USD195 million or USD0.26 per diluted share. This represented a significant swing over third quarter 2009, earnings ex special items of USD31 million or USD0.04 per diluted share.

"Overall, we had a very strong quarterly performance delivering a record third quarter profit excluding special items," Wright told analysts. "Our revenue performance was very strong, continuing the momentum that we had in the first half of the year. Our passenger revenues for the quarter increased by nearly USD500 million to a record USD3 billion. Our other revenues increased nearly 50% or about USD40 million, primarily on USD29 million of EarlyBird revenues this quarter. When combined with our 11% improvement in freight revenues, our total operating revenues for the quarter increased almost 20% to a record $3.2 billion. On a unit basis, our passenger revenues grew 16.3% and our operating revenues grew 16.1% on a unit basis compared to the third quarter of last year."

Kelly pointed to a long list of revenue-related records in the third quarter, including record third quarter load factor at 80.9%. He also cited the many revenue initiatives the airline has rolled out recently as well as a number of revenue management techniques designed to drive increased revenues per flight.

Southwest's sequential trend from the second quarter was better than historical average, Wright noted, adding compared to the third quarter of 2008, total revenues grew by USD266 million on about 3% fewer available seat miles, resulting in a two-year unit revenue increase of 13.5%.

"It truly was a phenomenal revenue performance," she said. "Our passenger yields were up 13.4% on an increase in full-fare passengers and fewer discounts in sale fares. Our third quarter full fare mix was 18%, which is up about a point from the third quarter of last year and down about 1.5 points from the second quarter of 2010."

Wright reported third quarter traffic levels resulted in record monthly load factors each month. In addition, she said demand for Business Select remained strong with 21% more Business Select passengers from a year ago, which produced USD22 million in incremental revenue, up from USD18 million in the third quarter of last year.

"Other revenues increased almost 50% to USD129 million, which includes USD29 million in EarlyBird revenues and USD14 million in revenues from pets, unaccompanied minors and excess bag charges combined versus USD2 million a year ago for EarlyBirds and USD10 million a year ago for pets, unaccompanied minors and bags," she said. "We expect another year-over-year increase in our other revenues in the fourth quarter but at a much lower rate than experienced in the third quarter, taking into consideration that we had USD24 million in ancillary revenues in the fourth quarter of last year on these initiatives versus only USD12 million in the third quarter as these initiatives as they were just being introduced."

She said the strong revenue trend is continuing with an 11% increase in October month-to-date unit revenues from the year-ago period.

"Our October results, thus far, suggest a sequential change in nominal CASM for September that again exceeds historical sequential average changes for this time period," she said. "Bookings thus far, for the remainder of October and for November and December, also look strong."

She cautioned the year-on-year comparisons may become tougher owing to last year's CASM acceleration as the quarter progressed.

"The good news is that, despite the mixed economic data that we read about every day, our bookings and price and our sequential revenue trends, at least thus far here in October, indicate sustained momentum of our year-to-date revenue results.

Expenses

Kelly pointed to two rising cost factors: fuel and airports costs. However, he said a mitigating factor would be capacity increases.

"In fact, if I were to complain about one cost category it would be the significant increases in airport costs," he said, echoing many other airlines who have been complaining since the capacity cuts caused such costs to rise at the beginning of the recession. "It's not coming in a very good time. We all understand how long-lived those construction projects and processes are, but that's a fact that's confounded us. The concern is that we'll see another significant increase next year. Our capacity plans, again, actually help mitigate that to a degree because a lot of those cost increases are fixed. So, to the extent that we can add more capacity, it drives down the unit cost. The other point to reiterate with the capacity increase is that we believe we drive more revenue and more profits with that approach as opposed to not. Fortunately, we have some opportunities to add some profitable capacity here in the near term."

He also echoed his counterparts on rising fuel prices, saying they were higher than anticipated in 2007. "So, if there is a concern in the plan next year, that's it, but the revenue production is better with the capacity plan that we're deploying."

Third quarter operating expenses, excluding special items, increased 10.5% year on year, a 7.1% increase on a unit basis on higher fuel costs. Continuing increases will create year-on-year headwinds next year.

Excluding fuel and special items, third quarter costs increased 5.1% on a unit basis. Higher salaries, wages and benefits accounted for over three points of the year-on-year increase, as profit sharing increased in the third quarter compared to the year-ago period.

Wright cited continuing inflationary pressures on both airport and labor costs. Indeed, this was a theme struck by all airlines as market shifts and capacity cuts caused airports costs to rise. Southwest pilots just received a profit-based increase of 3%. Based on these, and other cost trends, Southwest is estimated a year-on-year increase in fourth quarter non-fuel unit cost of about 6%.

The company currently has approximately $3.7 billion in core, unrestricted cash and short-term investments. It generated USD285 million in free cash flow for the quarter, and year-to-date cash flow from operations are approximately USD1.3 billion with almost USD900 million in free cash flow.

"We currently expect that our 2010 capital spending will be less than $500 million," Wright reported. "For 2011, we are currently forecasting capital spending to be in the USD800 million to USD900 million range."

Fourth quarter capacity is expected to be up about 5.3% year on year year with full-year capacity remaining flat at 0.4%.

"For 2011, as demand has continued to strengthen, we have attractive opportunities to better utilize our existing fleet and we are currently expecting to increase our capacity in the first quarter of next year in the 8% range and in the second quarter in the 5% range," said Wright.