Southwest's record revenue performance yields USD112 million profit

However, Southwest's net income did not have such a robust jump, coming in at USD112 million, up 21.3% during the second quarter from the USD91 million a year ago. This year's second quarter included USD2 million in special items related to non-cash, mark-to-market and other items associated with a portion of the company's fuel hedge portfolio.

But Kelly said that the results benefited greatly from the share shift the airline has been talking about for more than a year now, but has yet to quantify. In response to a question noting the huge fare increases from USD112 to USD132 for average fares in the 2009 versus 2010 quarters, Kelly cited changes to the average stage length to 883 miles but said much more was involved including the revenue program put in place in 2007.

"We have argued and demonstrated a significant market share shift is taking place," he told analysts. "We said in 2007 that we'd have to find a way to adjust upwards our rates to account for higher costs. I think what you are seeing is a combination of Southwest shifting out of short-haul markets into long haul and the fact we offered more choice to people who want more service and are willing to pay for it. We're up 24% in Business Select but in some weeks it's up 30-40%. The other material change over the last 12 months is the Early Bird. There was some concern that would cannibalise Business Select but there is no evidence of that. In terms of overall fares, our revenue management has evolved dramatically in the last 36 months. We are much more skilled in setting inventory levels at various prices and not giving away any more than we have to. We've also spent the last three years trimming out routes that were not performing well and may have gone too far and sacrificed convenience for the business traveller. At the end of the day, though, we've created better demand for our own product."

Future fare increases would be done modestly and gradually, he said, adding they'd be in addition to the ancillary revenue programmes still to be rolled out. "We want to keep fares as low as possible. We want to remain famous for low fares and to be America's low fare leader," he said. "A combination of these things got us to this point and the results are very handsome. We are doing this on carrying more passengers. It's not like we are raising fares and losing business."

However, he did suggest that the record load factors were probably losing some business. "That's something we are thinking about right now for 2011," he said. "We don't have a number right now but at the margins it's probably a couple of percentage points worth of business. The nice thing is demand for Southwest is very strong across all cities and regions. We've seen a very nice share shift from competitors and that helps us in making the judgments about adding back capacity and why we are growing 4.5% in the fourth quarter."

CFO Laura Wright added that utilisation, at 11:11 hours, is still well below peak of 11:40 hours per day and if the carrier were to increase utilisation, it could possibly increase capacity by 5-6%. "But the demand would have to be there," she said.

Kelly also discussed how Southwest is leading the industry. "We placed first in the domestic industry with the 21.1% revenue growth to USD3.2 billion in total operating revenues," he said. "That's the best in the industry and that comes on slightly down capacity growth at Southwest which means we also placed first in terms of year-over-year unit revenue growth at almost 22%. Our passenger counts were up, as was traffic and we experienced very strong yield performance. Yields were up over 17% while we had a record quarterly load factor of 79.3% which was up 2.3 points compared to the 2009 period. All that led to second best quarterly profit in our history behind second quarter 2006. Second quarter pretax margin (excluding special items) was 11%, up seven points from the year-ago period. This was, indeed, a strong performance, despite significantly higher fuel prices and other cost pressures."

Kelly said the company is making significant progress in reaching its 15%, pre-tax return on invested capital goal. "We'd need half a billion of annual revenues to hit that target," he said.

Kelly added the airline was headed for an all-time record load factor in July. "We have built considerable, industry-leading revenue momentum that began in second half 2009," he said. "We see no signs that the momentum will stall in second half 2010. Based on traffic and revenue trends to date, we expect strong year-over-year unit revenue growth in third quarter 2010. Our year-over-year growth rates will face more and more difficult comparisons, of course, due to the rapid revenue recovery that began at Southwest a year ago. Each of the three years preceding 2009 experienced more normal seasonal trends and provide a better gauge of second half 2010 potential revenue health."

Wright said passenger revenues rose USD500 million to USD3 billion and other revenues were up 46.9% to USD119 million. This outpaced cost the 12.5% increase in costs to USD2.8 billion.

"In addition to record loads and yields, we also had a record 20.7% increase year over year in passenger revenues," she reported. "Compared to the second quarter 2008, unit revenues grew by 14%. Total revenues reached USD5.8 billion in the first half which represents a revenue increase of over USD1 billion from the revenue received in the first half of 2007 although capacity was down less than 1% from the first half of 2007."

Total operating revenues for the six months ended June 30, 2010 increased 16.6% to USD5.8 billion, while total operating expenses increased 9.8% to $5.4 billion, resulting in operating income in first half 2010 of USD417 million, versus USD73 million in first half 2009. Excluding special items in both periods, operating income for first half 2010 was USD516 million, compared to USD213 million for the same period last year. Net income for first half 2010 was USD123 million compared to break-even results for the same period last year.

Wright said the plan implemented in 2007 to enhance revenues was working, despite a still-weak economic environment and business travel well below pre-recession levels. "The revenue strength in the quarter was driven by revenue initiatives coupled with fewer fare sales and strong demand," she said. "Yield improvement strengthened throughout the quarter with May up 16% and June up 19% resulting in an all-time record of 7.3% growth in RPM yield. Business travel continues to strengthen with full fare mix up just under 20% up almost two points from the second quarter of 2009 and down less than a point from the first quarter of 2010."

Focus on credit cards

Focus areas for increasing other revenues, according to Kelly, include not only upgrading its frequent flyer programme - the No1 item on passenger wish lists when they are surveyed - but increasing its credit card share. "We don't get our fair share of frequent flyers relative to our seat share or our fair share of frequent flyers' overall flights or their credit card spend," he said. "We've delved into this and we see significant opportunity to win more business customers, more flights from customers than we get now and a whole lot more credit card spend. The combined value is gigantic. The value of the credit cards is a very large number. Admittedly this is all speculative but whenever you are talking about market share changes you have to understand it takes time to build. But the easiest penetration will be with the credit card."

Kelly also said that WiFi capability would not become fleet-wide until 2013, saying the offering has to have time to mature since take rates were still so low. "It's been slow to take off so the time we are taking really means we are not missing out on anything yet."

He also addressed plans to fly internationally, saying nothing is off the table but it would not happen any time soon. We'll decide by the end of the year whether or not to do that work," he said. "You have to understand there is still plenty of domestic opportunity. All domestic carriers don't serve the entire domestic marketing and we want to attend to that first. This will be a multi-year effort so you won't see us flying into international markets any time soon."

Full-fare demand

Wright reported some stabilisation in full-fare demand with short-haul markets up three points year-on-year for the full-fare mix in the second quarter. "Business has not fully recovered but we've had a strong demand in our Business Select product which was up 24% producing USD24 million in incremental revenues compared to USD18 million last year," said Wright. "There is also strong demand in our Early Bird product which brought in USD23 million in revenues compared to USD17 million in the first quarter and USD13 million in 4Q-2009. In addition, there has been no noticeable impact from Early Bird on the Business Select product. Early Bird continues to increase on the total number of passengers."

Wright also reported that the July passenger unit rate was up 17% and bookings for August and September remained strong. Based on revenues and booking trends, the company is expecting another significant year-on-year improvement in the third quarter although at a lower rate than that experienced in the second quarter. Other revenues included USD13 million in pet, unaccompanied minor and excess bag fees which is expected to continue at a lower rate through the rest of the year. She cited fewer charters as well as reaching the anniversary of the imposition of those revenue initiatives during 3Q-2009 when such initiatives generated USD12 million.

Operating expenses

Turning to costs, Wright reported that operating expenses rose, representing a 13% unit cost increase although that was better than expected. Ex fuel and special items, second quarter costs were up 6.3% on a unit basis owing to a deferral of advertising costs of USD8 million originally planned for the second quarter some of which was moved into the third quarter. In addition, unit cost pressure was also eased by a USD18 million refund of excess security fees charged by the Transportation Security Administration since 2005.

Total second quarter 2010 operating expenses were USD2.8 billion, compared with USD2.5 billion in second quarter 2009. Operating income for second quarter 2010 was USD363 million, compared with USD123 million in second quarter 2009. Excluding special items, operating income was USD414 million in second quarter 2010, compared with ISD183 million for the same period last year.

A 32.4% increase in fuel costs was cited for increased 13.6% increase in second quarter unit cost, ex items. Second quarter 2010 economic fuel costs included USD39 million in unfavourable cash settlements for fuel derivative contracts.

She also reported that non-fuel unit costs were expected to be USD7.11 cents or up 6% from the third quarter of 2009 similar to what the company experienced in the second quarter. Full-year unit costs ex fuel and special items is expected to increase in the 6-7% range compared with the previous year, upping its earlier estimate on high profit sharing and revenue-related expenses.

Labour costs increased 9.8% on a unit basis on wage rate inflation and profit sharing and will likely result in third quarter labour unit costs comparable to the second quarter at USD3.71 cents.

Kelly hinted at moving to more part-time employees to tackle the labour cost problem. "We are very mindful of the challenge," he said. "One thing we've been waiting for is stability and we do seem to be getting that now. We've taken some convenient flight times from our customers from a competitive perspective that has its costs so we are looking at adding back flying which will help on the cost side as well as the revenue side. We have to make sure we take advantage of the variability of staffing and we know we have not taken advantage of that at this point. That's a fancy way of saying we may want to use more part time in certain areas in the future than we have done."

Airport landing and other rental unit costs were up 15.7% on airport rate increases and fewer favourable audit results, said Wright, which would likely send third-quarter airport-related unit costs in the mid-80-cent range.

Southwest ended the quarter with USD3.4 billion in cash and short-term investments. Leverage is forecast to be in the low 40% range by year end, she said, adding Southwest generated USD400 million in free cash flow in the second quarter

"Given the current economic outlook and trends, we continue to approach route expansion through optimising our flight schedule rather than fleet growth," said Kelly. "We remain committed to reaching our financial targets before we return to any significant level of fleet growth. For 2010, our capacity will remain essentially flat with last year. For 2011, we are estimating a modest year-over-year capacity increase with no fleet growth. Although it is too early to commit, at present, we have no plans to grow the fleet in 2012, either. We will continue to monitor trends for changes and are prepared to adjust our schedule, accordingly."

Kelly virtually crowed about the response to its new Panama City Beach, Northwest Florida service launched in May. The fear had been that this experimental partnership with the St Joe Company would turn into a disaster with news surrounding the BP oil spill. But Kelly reported that Southwest's eight daily flights are flying full.

"I've been down there and the beaches look great so don your swimsuits and get down there ASAP on a Southwest flight," he said. "The business has been extraordinary. There was virtually no service in the area before May 23 and we had no idea what to expect. From the very first flight we've had very full aircraft with the demand strongest from Nashville and Houston. I'm absolutely stunned by the rapid response to the flight and it's unlike anything we've seen having success right out of the box. They get 15 million visitors per year there and we only need 1% and it didn't seem like much of a reach to get that." Delta serves the airport through its Delta Connection leading many to surmise the pent up demand was a response to having the choice of only regional airline service which is often more expensive.

The company updated its schedule to replace its 737 Classic fleet to improve operational and economic efficiency with no net change to fleet plans. The Boeing schedule revisions included conversion of six purchase rights to 2014 options, acceleration of three options (two from 2015 to 2013; one from 2016 to 2014), and exercise of 25 737-700 options for firm delivery in 2011 through 2016. In addition, the company now has 98 purchase rights through 2021.

Net cash provided by operations for 1H2010 was USD913 million, and capital expenditures were USD298 million, resulting in more than USD600 million in free cash flow. The company expects to generate free cash flow all of 2010, based on current trends and projected 2010 capital expenditures of less than USD600 million. In addition to a fully available, unsecured, revolving credit facility of USD600 million, as of July 26th, the company had USD3.4 billion in cash and short-term investments, which does not include USD185 million in cash collateral held by its fuel hedge counterparts. The company's total fuel hedge collateral obligations, as of 26-Jul-2010, also required approximately USD165 million of aircraft collateral.

Southwest Airlines operating statistics (unaudited): 2Q2009 vs 2Q2010

	Three months ended June 30
	2010	2009	Change
Revenue passengers carried	22,883,422	22,676,171	0.9%
Enplaned passengers	27,554,201	26,505,438	4.0%
Revenue passenger miles (RPMs) (000s)	20,206,229	19,683,479	2.7%
Available seat miles (ASMs) (000s)	25,471,845	25,552,927	(0.3%)
Load factor	79.30%	77.00%	2.3 pts.
Average length of passenger haul (miles)	883	868	1.7%
Average aircraft stage length (miles)	650	647	0.5%
Trips flown	287,222	289,573	(0.8%)
Average passenger fare	$131.82	$110.52	19.3%
Passenger revenue yield per RPM (cents)	14.93	12.73	17.3%
Operating revenue yield per ASM (cents)	12.44	10.24	21.5%
CASM, GAAP (cents)	11.01	9.76	12.8%

Source: Company reports