Southwest Airlines at Raymond James Global Airline Conference

Corporate Participants

* Laura Wright

Southwest Airlines Co. - SVP, Finance and CFO

Presentation

UNIDENTIFIED PARTICIPANT: All right. Before heading out to lunch, next we have Southwest. As you know, in May, Southwest acquired AirTran, which is about a fourth of its size. And this acquisition should provide a platform for expansion as well including growth into international markets. And also, Southwest is doing some fleet updates over the next couple of years that we think will have some interesting implications both on the topline, as well as on the cost side as well.

But to talk more on that and what we have in-store at Southwest over the next few years is Laura Wright, the CFO.

LAURA WRIGHT, SVP, FINANCE AND CFO, SOUTHWEST AIRLINES CO.: Well, thank you, and good afternoon to everyone. Unfortunately I've got to start with this and let you know that my presentation today will include some forward-looking based statements. These statements are based on Southwest's current intent, expectations and projections, and they are not guarantees of future performance. A variety of factors could cause the results to differ materially.

Today's presentation also includes references to non-GAAP financial data. And for more information regarding the forward-looking statements, as well as reconciliations of our non-GAAP and GAAP financial results, please refer to the Investor Relations section at southwest.com.

Well, I'm going to spend just a minute on 2011, because it's history and really wanted to focus today on 2012 and the strategic initiatives that we have underway at Southwest Airlines. For 2011, we reported net earnings, excluding special items, of $330 million, that was $0.43 a share. It was disappointing to have our earnings down and it was gratifying to report our 39th consecutive annual profit when we saw our fuel bill rise by $1.7 billion over the previous year.

The real story of 2011 was very similar to 2010. It was a very strong revenue performance. We set records throughout the year. On a combined basis with AirTran, our topline revenues grew 12.7%. That was about a $1.9 billion topline growth. The results generated a pretax return on invested capital of 7%, and that is below our 15% target. It was also a strong year for cash flow generation. Our cash flow from ops was approximately $1.4 billion, easily surpassed our cap spending, which was under $1 billion. So we had free cash flow in excess of $400 million.

So I mentioned our return on invested capital target. We have a 15% pretax target and we've had that as long as I've been at Southwest and that's something that we achieved in our first three decades. And we remain committed to reaching those results.

We have four strategic initiatives underway. They're not new. They were the same things that we talked it out last year, but these really are aimed at covering that gap that we need to get to the 15% ROIC. And I've got some more information that I can share in terms of our progress to date on each of these initiatives.

But just to recap, they're the AirTran acquisition and integration, our new frequent flyer program which we launched last March, the fleet modernization program, I will go into a lot more detail on what we're doing there. And then, eventually we plan to replace our reservation system, which will allow us to offer international itineraries at Southwest and also provide more flexibility in our revenue management and scheduling.

So let me talk briefly about where we are on the AirTran integration. If we go back to 2011, well, actually I looked at the calendar today and we closed nine months ago today, so it was May 2. And it's been a interesting and busy year since we closed. If you look back to 2011, the accomplishments were really the back-office integration. So today if you look at finance, marketing, revenue management, purchasing, people, all of those have been integrated into Southwest Airlines and we're operating as one company from that standpoint.

The other very significant progress that was made in 2011 had to do with the seniority list integration with our labor unions. And I'm very pleased to report that we are, I think, again, once again, defied the rest of the industry with where we stand with respect to the SLI agreements.

To date, we've had three of our unions, membership approved the seniority list integration, the pilots were the first to do that. This week the flight attendants from AirTran and Southwest ratified the seniority list integration and our flight instructors have also done that. We've got one SLI that is out for vote with our mechanics and the vote should -- I think, [come in] in February on that. With respect to the rest of our work groups, conversations are well on their way in terms of coming up with SLI agreements on the employee side.

So when we look to 2012, what you should expect on integration is a lot going on on the operations, as well as a lot (technical difficulty) for that now in markets where we had overlap or we've got some rationalized capacity. We've got Southwest going into Atlanta on February 12 and we're going to start there with 15 daily flights, we'll be up to 21 by June and that Atlanta service that you'll see won by Southwest will be Atlanta to Southwest stronghold cities. So, for example, I have nonstop service from Atlanta to Austin, so a city for that AirTran doesn't serve today. We'll have Atlanta to LA, Phoenix, Vegas, San Antonio, again a lot of Southwest cities will get Atlanta service.

On the AirTran side, we're also doing a lot to redeploy capacity and really optimize their schedule much like we've been doing at Southwest for the past four years. With high fuel prices, we had to make a tough decision and we're going to close 15 of the smaller AirTran cities, they will be gone by August. But we've been able to redeploy that capacity into new markets and most of that is really coming in some of the near international markets. So AirTran has already announced two new cities that they will serve in 2012. Those cities are Cancun and Mexico City, but they're going to begin service to those cities from San Antonio and John Wayne. So those are strong Southwest stronghold cities that they'll be serving from.

AirTran also recently got route approval authority to serve Cancun from Denver, as well as Austin, Texas, and again those are strong Southwest cities where AirTran will be able to offer international service. And ultimately, when you think it is international service at AirTran, it'll ultimately all be part of Southwest. So when we get to August of 2012, combined we'll serve 97 cities between the two companies.

Let me talk to you a little bit about how we're doing on the synergy side. In 2011, the net synergies that were realized attributable to AirTran were $80 million. One-half of that related to costs and those were primarily G&A, overhead, procurement, financing costs and one-half was on the revenue side. As I mentioned earlier, we took over revenue management and marketing and we saw some really significant improvements on the AirTran revenue model in the fourth quarter.

As we reported in our fourth quarter earnings call, our yields in the AirTran Company were up 17% during the fourth quarter. So we're really making some inroads on the revenue side. For 2012, we expect the net synergies to exceed $200 million, and the current expectation is about one-third of that will be net cost synergies and about two-thirds of that will be net revenue synergies. And again, the revenue synergies are going to be driven by the network changes that I've talked about, as well as the revenue management changes.

Our forecast remains $400 million in net synergies by the 2013 time frame. And the other thing that I wanted to point out is we've had a lot of discussions about labor, because we all know that our costs, our labor costs are higher than AirTran's and that is [an expected to] synergy. The aggregate amount of that is expected to be about $150 million. We expect that to come in between 2012 and 2014. But on an annual basis and an aggregate basis, we expect that the net cost synergies will be positive in each year after taking into account the labor to synergies.

The next initiative, I'll move on from AirTran, is our new frequent flyer program, which was launched in March of last year. When we launched this program and told you all about it, our expectation was that the new program would generate hundreds of millions of dollars in incremental revenue by 2014.

The real driver of the changes to our program was based around improvements in our business partner income. But it also was aimed at improving just the frequent flyer loyalty and the number of frequent flyers who are actually flying -- buying Southwest for their travels. And I'm very happy to report that after only 10 months, the results have exceeded where we expected that where we would be at this point in time.

On the business partner side, which is where we basically sell points to the credit card companies, hotels, et cetera, the cash sales in 2011 increased by $250 million year-over-year. And just for the fourth quarter alone, the annual increase in cash sales was $100 million, it was $50 million in the third quarter. So our belief that we were behind in business partners, so we didn't have our first share, I think, has proved true.

That revenue, the way you account for it, it's basically deferred and so it does not hit revenue when you get the cash sale. It will flow through our P&L when our frequent flyers redeem those points for travel. And as a result, if you look at our air traffic liability account on our balance sheet at the end of the year, it was up significantly. But over $250 million of the increase was deferred revenue from our business partner income. So we feel very confident that we can achieve the hundreds of millions of net revenues that we originally set forth.

On the other side of the frequent flyer program, we had terrific results there as well. We've seen a growth in our members, the actual number of frequent flyer members. And during the fourth quarter alone, in our member acquisitions, they were up over 50% from the fourth quarter of 2010. We've also seen significant growth in our credit card applications. And of our flying members, the number of flights that they're taking has increased, as well as the revenue fare premium [out of] the prior year. So, again, very pleased with where we stand on that program.

The next one, this is probably the newest one and where we probably have the most new information to share with you today. But it's our fleet modernization plan and this has several components to it. First of all, we're going to take our first 737-800 in March. So we're about a month away from our first delivery. In our configuration, the 800 will have 175 seats, that's 28% more than we have on the 737-700. It's got excellent seat mile characteristics as well. In 2012, we'll take 33 800s and we're going to retire 40 of our 737-300s, our classic airplanes. So we'll see significant improvement in fuel burn, as well as a significant reduction in maintenance expense.

We also announced a couple of weeks ago that we are going to retrofit our 737 Next-Gen fleet, that's our 700s with a new interior. The new interior is a customer-friendly interior made of new products. It will have thinner cushions, it's environmental-friendly, but it also allows us to add six seats or one additional row of seats to the airplane without sacrificing passenger comfort. So we have 372 airplanes in the Southwest fleet, plus the 52 700s that are AirTran. As they are converted to Southwest, they'll be retrofitted with the increase in seats and the interior as well. So conservatively, we're estimating that the incremental revenue associated with the additional seats will be $200 million annually as a result of this effort.

And then the final item I wanted to point out is, we announced in December that we would be the launch customer for the 737 MAX. That's basically a re-engined 737 Next Gen. Those will start coming in late 2017. And when you look at all the airplanes that we have, they will allow us to retire all of our 737 Classics, which are 3s and 5s, as well as the 717s and believe it or not, we'll be retiring 700s as we reach the end of this decade as well.

Balance sheet remains very strong. As of close of business yesterday, unrestricted cash and short-term investments in the $3.6 billion range. In addition to that, we have an $800 million line of credit that is untapped and fully available. Expect that we'll be able to fully fund our cap spending in 2012 of $1.3 billion through cash flow from operations.

We intend to continue to pay down some more debt. We've got about $560 million that matures in 2012. And as of the end of the first quarter of this year, we will have retired $1 billion of debt since we acquired AirTran on May 2 of last year. And that gets us to a balance sheet leverage, including all of our off-balance sheet aircraft leases, of around 47%. We did announce a share repurchase back in August of 2011. The Board authorized $500 million of share repurchases and to date we have bought back $225 million.

So let me close with a 2012 outlook. The traffic trends have remained strong. Demand has held steady and we are currently projecting that our January year-over-year PRASM on a combined basis will be up in the 7% range. February is on track to be up in a similar range. And at this point, we expect March to be a more difficult comparison because of the timing of Easter versus last year.

For 2012, we don't plan to grow our available seat miles. They will be essentially flat for the year and that includes the additional seats that we get from the new interiors in the 800s. We're going to be up about 1% in 1Q and that's internally attributable to an extra day this quarter being a leap year. In second quarter, our ASMs will be down between 1% and 2% and you'll see a little increase in the third and fourth quarter which really comes from the extra seats.

Our plan for the year assumes high fuel prices, but stable fuel prices. Our current forecasts for 1Q based on the existing -- the current forward curve, our hedges and taxes is about $3.35 a gallon, and for full-year '12 we're forecasting $3.30 per gallon.

So for January, we actually saw WTI trade between $98 and $103, so we actually sit within about a $5 band and certainly our forecast assumes that we have stability throughout the rest of the year.

On the non-fuel costs, we expect the most inflation in 2012. We are seeing inflationary cost increases in our salaries, wages and benefits, in our airport costs and some in maintenance. In addition to this inflationary cost increase, we also will have some cost increases in 2012 related to the fleet modernization program that I talked about.

So the retrofit of our 700 fleet, that will be expensed for P&L purposes and it won't be capitalized. We are not calling it out as a special item. That will add about $40 million to maintenance expense for the year. And as a result of our decision to accelerate the retirement of our older 737 Classics, we're shortening their lives and we're going to be accelerating some non-cash depreciation into 2012 as well. So that's currently estimated to be about a $50 million hit.

For the first quarter of 2012, our ex-fuel unit cost, excluding profit sharing and special items, is about 4%. And if you look at the two items I mentioned involving the retrofit of our fleet and the accelerated depreciation, that accounts for about one point of that 4% increase.

Again 2012 we're managing for free cash flow. And as we stand here today with a strong demand environment and somewhat stable fuel prices, we have a very solid profitability outlook for 2012.

And with that I'm ready for questions.

Questions and Answers

UNIDENTIFIED AUDIENCE MEMBER: (inaudible - microphone inaccessible)

LAURA WRIGHT: Yes.

UNIDENTIFIED AUDIENCE MEMBER: (inaudible - microphone inaccessible)

LAURA WRIGHT: Yes. So Jim's question was, we have commented that we don't intend to grow the fleet until we can hit our return target or be inside of our 15% return target. And that is definitely where we stand today. That being said, Jim, we will always be aware of what's going on in the marketplace from an opportunistic basis, so from a strategic basis, but certainly are committed to staying to a flat fleet until we have our return targets in sight. I really -- the scenario that you pointed about others adding capacity, I think until you know what the exact facts and circumstances are of any actions, it would be very hard to answer that question. But we certainly know that we need to hit our return target and that is first and foremost on the minds of our leaders.

UNIDENTIFIED AUDIENCE MEMBER: (inaudible - microphone inaccessible)

LAURA WRIGHT: Yes. So the question was, what we're seeing on the fare side. 2011 was a pretty incredible year when you look at what happened on the fare side. So at Southwest, we actually had eight fare increases in 2011, which is -- you think of any business to raise your prices eight times in one year, that's pretty significant. The good news is the demand is holding up and load factors remain strong. And I think it's too early to tell what's going to happen on the pricing front. Revenues need to grow. There's a lot of ways you can do it beyond just raising block-up fare tickets and so we are very focused on improving yields overall. And again, I think we pointed out what we've been able to do in the AirTran's network with yields far in excess of what you see going on on the ticket side. That so far looks good.

UNIDENTIFIED AUDIENCE MEMBER: (inaudible - microphone inaccessible)

LAURA WRIGHT: What percentage of our fuel is hedged? For 2012, for the first half of the year, we have minimal hedge protection. So late last year, we decided to reduce our fuel hedges in the first half of the year and reduce our premiums. So our premium expense in 1Q and 2Q is $5 million and $6 million. So that compares to 35-ish million per quarter a year ago. So very modest coverage for us in the first half of the year. If we go to the second half of the year, we've got from 40% to 60% coverage and it really starts to come in in the 105% to 110% range. So more on the catastrophic side.

UNIDENTIFIED PARTICIPANT: (inaudible).

LAURA WRIGHT: Thank you all for being here. Enjoy your lunch.

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