Southwest Q3 Earnings Call Transcript

123jump.com Staff
27 Oct, 2008
New York City

Southwest third quarter net income was $69 million or 9 cents per diluted share adjusted for one time hedging related charges. However, on the GAAP basis in the quarter airline lost $120 million or 16 cents a share. Revenue in the quarter rose to $2.9 billion.

Southwest Airlines Co. ((LUV))
Q3 2008 Earnings Call Transcript
October 16, 2008 11:30 a.m. ET

Executives

Gary C. Kelly – Chairman, President & Chief Executive Officer
Laura H. Wright - Chief Financial Officer, Senior Vice President - Finance

Analysts

Kevin Crissey - UBS
Jamie Baker - J.P. Morgan Securities, Inc.
Ray Neidl - Calyon Securities, Inc.
Daniel McKenzie - Credit Suisse
Duane Pfennigwerth - Raymond James & Associates
William Greene - Morgan Stanley & Company, Inc.
Gary Chase – Barclays Capital
Michael Linenberg - Merrill Lynch & Company, Inc.

Presentation

Operator

Good day and welcome to the Southwest Airlines third quarter 2008 earnings conference call. Today’s call is being recorded. We have on the call today Mr. Gary Kelly, Southwest’s Chairman, President and Chief Executive Officer, and Ms. Laura Wright, the Company’s Senior Vice President of Finance and Chief Financial Officer.

Before we get started, please be advised that this call will include forward-looking statements. Because these statements are based on the Company’s current intent, expectation and projections they are not guarantees of future performance and a variety of factors could cause actual results to differ materially. This call will also include references to non-GAAP results. Therefore, please see our earnings press release in the Investor Relations section of our website at www.southwest.com for further information regarding our forward-looking statements and for a reconciliation of our non-GAAP results to our GAAP results.

At this time I’d like to turn the call over to Mr. Gary Kelly for opening remarks. Please go ahead sir.

Gary C. Kelly

Thanks Tom and thanks everyone for joining us this morning on our third quarter earnings conference call. We are of course very pleased to report our 70th consecutive quarterly profit and that is excluding special items which Laura will cover. While we had a profit, we’re never satisfied to report lower year-over-year earnings.

We were faced with some pretty significant operating cost pressures during the quarter. Our unit cost ex special items was up 16% and of course that was driven by very significant fuel cost increases. Our jet fuel price per gallon increased 44% to $2.44 a gallon. The good thing is of course for Southwest and all airlines that fuel prices have come down dramatically and at least for the fourth quarter we’re expecting around $2.00 a gallon.

Our third quarter results included a very significant hedging gain of $448 million in cash. I think in addition to the fuel story of course the big news is we made very strong progress on the revenue front. We have slowed our capacity growth, we’re growing today at about a 1% clip, and we’re going to slow that further when we get to January. We have continued to prune our flight schedule of unpopular and less productive flights and will pick up the pace with that also in January.

We’ve had for the last year some enhanced revenue management, technologies and techniques. We think that that is producing very well for us. I’m very proud of our revenue management department. I think they’re doing an exceptional job of reacting to a challenging environment. Of course we know that with those kinds of cost pressures that I mentioned, we’ve got to get our fares up. We’re trying to do that modestly, we’re trying to do it gradually, and once again I’m very proud of our marketing and revenue management folks for their success with that. The revenue performance this quarter I think attests to the skill with which they’re doing that.

We have a great opportunity now that again I’m proud that our marketing folks are taking a great advantage of it to blast through the clutter with what we stand for as far as low fares. We love to be different, we love to be customer friendly, and we’re having we think great success, although it’s a little early, but we’re having great success thus far with our no hidden fees campaign.

We have continued to invest in our customer experience. Things that you all know are clearly we want to go past the one-size-fits-all approach that we’ve used in the past and in particular appeal even more to the business customer and while we know that we carry more business customers than any other airline in the world, we think that we can penetrate that market further. So, we’ve upgraded our boarding process, we’ve offered the business select product, and we have some great things coming in terms of an enhanced frequent flier program and also in-flight wireless connectivity for the Internet. So we’re very excited about not only what we’ve done but what we have planned for the future.

Very quickly on some current revenue and cost trends, you have our third quarter results of course where our unit revenues were up for the quarter 9.3%. We picked up the pace after Labor Day, no doubt supported by industry capacity cuts which are huge in our markets. We’re expecting in the fourth quarter capacity cuts in the 15% to 20% range on a seat basis. So, our unit revenues in September were up 11% and our revenue per available seat mile was up month-to-date in October even more, roughly 14%.

I would admit to everyone that it would be very dangerous at this stage to extrapolate those trends for the fourth quarter much less into 2009. The economic environment is far too volatile to make any kind of bold predictions, but I’m very happy to report the facts which are the results that we’ve seen thus far are very, very strong.

Now January through March we have already planned and published our new schedule. In that time period we’ve cut 190 daily departures out of the schedule and that results in a capacity reduction on an available seat mile basis of 5% to 6%. So, if indeed the recession deepens and impacts travel demand further, I think our capacity plans will absorb that shock hopefully perfectly beginning in January. If demand continues to be strong, I think we’ve got the right flights at the right times of the day. We’ll just have very full airplanes and very strong revenues and certainly nobody here will complain about that.

We’re very excited about Minneapolis-St. Paul. We’ve announced that we’ll begin service there in March and we’re also trying to be clear that this is not an aggressive move in our minds. While it’s always wonderful to add new markets, it is a very high fare market. One way fares are as high as $400 and it’s a short-haul market too. We’re announcing service to Chicago only at this point. So, we’re looking for I think a very successful startup in Minneapolis in March.

Now in falling energy prices again just to underscore, that is a very good thing for Southwest Airlines and the industry. Laura’s going to speak to that more. We will of course need to manage our hedge portfolio and I think in times of falling prices like this it’s better to be lighter with the hedge as opposed to heavier, and our folks are doing a great job of managing that. We’ve got really good caps in place at good levels through 2012 especially, so actually falling prices are a great opportunity for us and certainly not a problem.

And then finally before I turn it over to Laura, this is an environment with the world in the state that it is, we’ve just got to be prepared and we are in the process of drawing down $400 million of our line of credit. We did that to coincide with today’s quarterly discussions so that we could explain that. But you get cash when you can; not when you have to have it; and we are in essence making sure that we have our financing in place for next year’s deliveries, because again, we certainly share the concerns around the world about the economy and especially for next year.

So with that I would like to turn it over to Ms. Wright to take us through the quarter.

Laura H. Wright

Thank you Gary and good morning everyone. Our earnings this quarter are quite confusing due to the complicated accounting rules under SFAS 133. Our GAAP results included special noncash charges of $247 million which were related primarily to mark-to-market adjustments on our future periods’ fuel hedge portfolio as required under this complex accounting standard. Excluding these special charges and other special items, our third quarter 2008 net income was $69 million or $0.09 per diluted share which exceeded Wall Street’s mean estimates of $0.07. This represented our 70th consecutive quarter of profitability excluding special items. On a GAAP basis we reported a net loss of $120 million or $0.16 per share.

Under SFAS 133 we’re required to mark-to-market any hedges that do not qualify for hedge accounting. Most of our portfolio qualifies for hedge accounting, but for those hedges that do not qualify in any given period we’re required to record the change in mark-to-market and any ineffectiveness in our income statement. In periods of rising fuel costs we generally record unrealized gains on contracts settling in future periods.

As you may remember that in the second quarter our GAAP earnings included $361 million of noncash gains as we saw energy prices soar, and we recognized these large unrealized gains in our GAAP earnings. With the drop in oil prices during the third quarter we essentially had to rebirth a large portion of these mark-to-market gains that we recognized in prior periods, which is what drove the GAAP net loss.

As you all know we have a successful hedging program that has been managed carefully over the years and hedging continues to be an integral part of managing our costs related to jet fuel purchases, and we believe it is more meaningful to evaluate our performance including the impact of the true net cash settlements which totaled $448 million in the third quarter that exclude the impact of mark-to-market adjustments for unrealized gains and losses for contracts settling in future periods.

Moving to revenues, we’re pleased with our third quarter record revenue performance of $2.9 billion and the acceleration in our unit revenue trends. Our third quarter unit revenues grew 9.3% to $0.11 on a year-over-year basis. Despite an estimated $11 million revenue loss from Hurricanes Ike and Gustav, our passenger revenues increased 11.5% to $2.77 billion.

Our July and August unit revenues both increased about 8% compared to the same period last year, and our trends strengthened in September with our unit revenues growing 11% versus a year ago. Thus far in October we’ve seen further improvement and our month-to-date RASM growth is around 14%.

These strong unit revenue trends are evidence that our revenue initiatives are working. The cumulative effect of our fare actions and our enhanced revenue management efforts drove most of the 9.3% increase in our unit revenues for the third quarter. Our full fare mix was 24% which was in line with the second quarter and up slightly from last year’s third quarter’s 23%.

We also benefited during the quarter significantly from our schedule optimization efforts and the other airline capacity cuts. Our business select revenue in the third quarter was approximately $20 million and based on the continued progress on our revenue initiatives, domestic competitor capacity reductions, and the revenue and booking trends thus far we currently expect another solid increase in our fourth quarter 2008 operating unit revenues. However, the current worldwide financial crisis does create uncertainty around future demand and we currently are expecting lower load factor trends to continue throughout the fourth quarter compared to the same period last year.

Our freight revenues increased 15.6% to $37 million primarily due to increased freight and we expect a comparable increase in our freight revenue for the fourth quarter.

We also had a strong other revenue performance. It was up 17.6% to $87 million and that was primarily due to higher charter revenues. We expect another year-over-year growth again in the fourth quarter but not at the same rate that we experienced in the third quarter.

Turning to costs, our third quarter unit costs excluding special items increased 16% largely due to the significant increase in our fuel costs. Even with the $448 million in favorable cash settlements from our derivatives, our economic fuel costs increased 44.4% to $2.44 per gallon. However, our economic fuel costs were still $1.17 better than the unhedged fuel price per gallon of $3.61.

Looking forward we’ve increased our fourth quarter 2008 hedge position to nearly 85% at an average crude equivalent price of about $62 a barrel and based on this position and yesterday’s market prices, we expect that our fourth quarter economic fuel price will be in the $2.00 range versus the $2.44 that we paid in the third quarter.

So on a very positive note, the declining energy prices are providing some much needed relief on the cost side. However, fuel prices still remain significantly above historic levels and our conservation efforts are ongoing and imperative in the current environment. Our gallons of fuel per ASM declined by 3.5% this quarter compared to the same period of last year.

Looking forward our hedging positions are as follows. Again, the fourth quarter is about 85% hedged at $62 a barrel. We have an average floor of about $53 for the fourth quarter, and for 2009 we’re over 75% hedged at approximately $73 a barrel with an average floor of around $61.

As of yesterday the estimated fair value of our fuel hedge portfolio for the fourth quarter of ’08 through 2014 is approximately $550 million. Our premiums associated with the cost of our hedging programs were $20 million in the third quarter and this is recorded in other gains and losses. We expect that expense to be around $22 million for the fourth quarter.

Excluding fuel and special items, our unit costs increased 6.5% over last year to $6.86. The year-over-year increase was primarily due to continued pressure in maintenance, airport costs and fuel tax expense. We currently anticipate that the maintenance and airport cost pressures will continue into the next quarter. Therefore, based on the current cost trends coupled with increased cost headwinds associated with minimal capacity growth in the fourth quarter, we currently expect our fourth quarter 2008 unit costs excluding fuel and special items if any to increase from third quarter 2008 to $6.86. On a year-over-year basis we currently expect our fourth quarter unit costs excluding fuel and special items to increase comparable to the year-over-year increase that we experienced during the third quarter.

Despite these current cost pressures our operating cost advantage remains as strong as it has ever been especially as compared to the legacy airline. However, at these current levels the cost increases are unprecedented for Southwest Airlines and they require that we not stand still. We must aggressively manage our costs and be prepared to take necessary actions to preserve our low-cost advantage and to protect our low-fare brand.

Our salaries, wages and benefits unit costs increased to $3.25 this quarter over the same period last year. The increase was more than anticipated due to the cost impact from Hurricane Ike, higher than anticipated workers’ compensation claims, and accruals associated with our ongoing labor negotiation. Our stock option expense in the quarter was $4.4 million, our profit sharing expense was $18.2 million, and our 401(k) contribution was $43 million.

Excluding the impact of profit sharing, 401(k) and stock option expense we expect our fourth quarter 2008 salaries, wages and benefits unit cost to increase from fourth quarter 2007’s $2.09 but to not exceed third quarter’s $3.01.

As expected we had a significant increase in our maintenance costs on a unit basis to $0.72. This 16.1% year-over-year increase was primarily driven by engine repair costs which represents more than half of our maintenance expenses. In June of this year we transitioned our jet 700 engines to a new MCPH agreement with GE versus our previous agreement that was on a combination of fixed price and time and materials basis.

Based on current trends and factoring in the new engine contract, we expect the year-over-year increase in the fourth quarter maintenance unit costs to be in line with the 16.1% increase we experienced in the third quarter.

Our landing fees and other rentals per ASM increased 12.3% to $0.64 due to higher space rentals from both increased space and rate increases. We continue to experience airport cost pressures as the industry continues to reduce capacity. With the further capacity cuts, the company currently expects our landing fees and other rentals for ASM in the fourth quarter to be slightly higher than the $0.64 per ASM recorded in the third quarter.

The third quarter effective tax rate was approximately 41.5% and we currently expect that the fourth quarter tax rate will be in the 39% range.

Turning to the balance sheet and cash flows. Even in these turbulent times we remain financially stable with a very strong balance sheet which is one of our biggest competitive strengths. We’ve always been financially conservative and as a result we remain well prepared to withstand the shock of the current economic environment.

We ended the third quarter with unrestricted cash and short-term investments of $3.4 billion including $1 billion in short-term investments which consisted of $71 million in offshore rate securities and $970 million in investments with maturities greater than 90 days. We also have an additional $169 million in auction rate securities that were recorded in other assets. Included in our cash balance at quarter end was $2.5 billion in cash collateral deposits related to our fuel hedge and as a reminder we also had a corresponding liability recorded in our accrued liabilities for this cash collateral balance.

Our leverage at the end of the third quarter including all aircraft leases was under 40% and we had approximately $350 million on deposit with Boeing for future aircraft deliveries. The value of our unencumbered aircraft is approximately $10 billion and we remain the only US airline with an investment grade credit rating.

We continue to exercise conservative cash management and our liquidity remains healthy. Our core cash is in excess of $1 billion; however due to these uncertain times we’ve made the decision to access $400 million on our $600 million revolver to boost our liquidity to serve as a bridge to the financing that we would likely do in 2009. This $400 million is not reflected in yesterday’s ending cash balance of $2.2 billion referenced in the earnings release as we have not yet received funding. Even with the additional $400 million from our credit facility, our leverage will still be at a modest level that we are comfortable with.

Due to three Boeing aircraft deliveries that are likely to be pushed from 2008 into 2009, and I’ll discuss that more in a minute, we’ve reduced our ’08 cap spending to the $900 million range down from the $1.1 billion estimate we last communicated to you. Our 2009 cap spending is still expected to be in the $1 billion range.

Turning to the fleet, during the quarter we acquired five new 700s from Boeing as planned and we returned two leased 300 aircraft ending the third quarter with 538 aircraft. Our third quarter available seat mile capacity increased 2.2%. We have three remaining Boeing deliveries scheduled for the remainder of this year that we will likely not take delivery of due to the machinist strike at Boeing and if that’s the case, these three deliveries will be pushed into 2009.

So to summarize where we are for 2008 fleet, we now expect that we’ll take delivery of 26 new airplanes this year and by the end of the third quarter we had returned eight leased 300s to lessors and we currently plan to return three additional 300s to lessors in the fourth quarter for a total of 11 and that will get us to our planned 2008 net aircraft additions of 15 aircraft.

For the fourth quarter we expect to grow our ASMs by about 1% and the full year 2008 available seat mile increase is expected to be in the 3.5% to 4% range.

We continue to utilize our schedule optimization techniques with each published schedule eliminating unproductive flying to fund the growth in attractive markets like Denver and San Francisco and our 66 cities that we will begin in March of next year in Minneapolis-St. Paul.

While we haven’t finalized our 2009 growth plans, our first quarter 2009 ASMs are expected to decline in the 5% to 6% range compared to the first quarter of 2008.

Regarding our 2009 fleet plans, we recently announced the deferral of four 2009 Boeing deliveries to 2016 which reduced our aircraft deliveries to 10 for next year. However, with the three aircraft originally scheduled for delivery in the fourth quarter of this year that likely pushed into the next year, we now next expect that we will take 13 new airplane deliveries next year.

We have three 300 leases that we plan to return next year and we have potential alternatives to reduce our fleet further if needed. So all-in our ’09 flight funds aren’t yet finalized but we currently expect to add no more than 10 net aircraft next year.

Our updated Boeing delivery schedule is included in the press release for your reference.

And last item is the capacity by region for the quarter. Northeast was 14%, Northwest was 4%, Southeast 15%, Southwest 14%, Midwest 17%, and the rest was 37%.

So Tom that concludes our prepared remarks, and Gary and I are ready to take questions.

Question-and-Answer Session

Operator

And ladies and gentlemen, the question-and-answer session will be conducted electronically. If you would like to ask a question, please do so by pressing the “*” key followed by the digit “1” on your touchtone telephone. If you are using a mute feature, please make sure that it is turned off to allow your signal to reach our equipment. Again that’s “*1” at this time to ask a question. We’ll take our first question from Kevin Crissey with UBS.

Kevin Crissey – UBS

Thanks and nice quarter guys. Can we talk about the…what price would you have zero fuel hedge collateral? What oil price roughly? I know you probably have a lot of different contracts. When would 1.1 become zero?

Laura H. Wright

A good question Kevin. As of yesterday we were holding about $1.1 billion in cash collateral and the value of the hedge was about $550 million. The cash collateral associated with that $1.1 billion is probably around $700 million, so when we do simulations of collateral, I think we gave you where our floors were and every counterparty agreement we have is different. So we have some agreements that don’t require us to post collateral because of our credit rating. When we look at really where we might have to put up a meaningful amount of cash, we’ve probably got a good $20 off from yesterday’s closing prices. Again that’s something that we manage for and we’ve managed for that in the past and you can expect that we are actively managing that risk today.

Kevin Crissey – UBS

Okay. I’ll just leave it there. Thanks.

Operator

And we’ll take our next question from Jamie Baker with J.P. Morgan.

Jamie Baker - J.P. Morgan Securities, Inc.

Hello. Hi Gary. Actually, same topic, following up on Kevin’s question, a rough estimate as to how much cash you’d have to post if oil settled around $60 a barrel? And as a follow up in that scenario, how do you envision potentially topping off cash? I mean, would it be sale lease-backs, more bank debt? I’m just curious what forms of potential capital raising you might prefer on a go-forward basis.

Laura H. Wright

Jamie, I think at a $60 range that you’re talking about we’d feel pretty comfortable that anything we would have to do is very manageable with the cash that we have today and what we’re doing in the market.

With respect to…what was the second part of your question?

Jamie Baker - J.P. Morgan Securities, Inc.

I was just wondering in terms of capital raising potential going forward what forms you might prefer to pursue?

Laura H. Wright

I think that is an open-ended question with the markets where they are today. Clearly there is capital available to Southwest Airlines. I would admit that is not as attractive as it was two weeks ago or clearly a month ago. But we can look at bank financing, private markets, clearly a part of our sales as you mentioned.

Jamie Baker - J.P. Morgan Securities, Inc.

Okay and again just back to the first topic, you said a $20 drop you might have to post something sizable. Any more detail on what your definition of sizable is?

Laura H. Wright

I’d say it’s just within a few hundred million dollars.

Jamie Baker - J.P. Morgan Securities, Inc.

Okay. Fair enough. Thank you very much.

Gary C. Kelly

And Jamie the only thing I would add to that is that we’re actively lightening our hedging position so that we help mitigate that exposure as well. So, the hedge percentages that Laura has provided in the press release, what I’m trying to clearly communicate is that you should expect that they will come down. Because this is a moving target and because it’s not a promise to keep them down, we may make a judgment to increase them back in the future and take advantage of this opportunity. But there’s some exposure here but we’re not close at $70 a barrel to any material collateral requirement. It’s the opposite at this point.

Jamie Baker - J.P. Morgan Securities, Inc.

Okay. Excellent. Thank you for that color Gary.

Operator

And we’ll take the next question from Ray Neidl with Calyon Securities.

Ray Neidl - Calyon Securities, Inc.

Yes. Going forward it looks like you’re actually doing capacity cutback in the first quarter of 5% to 6% I think you said on ASMs. Is there any chance if the economy remains weak, some economists are saying it’s going to be a four to six quarter recession, that we may see for the first time Southwest actually shrink in 2009? And if that’s the case, surplus aircraft, what would you do with those? Because in that type environment I imagine the value of even new aircraft are going to go down.

Gary C. Kelly

Well I think Ray starting with the fleet, at this point our plan is to grow the fleet no more than 10 airplanes. And like the second quarter, that’s pretty much what we said. We haven’t decided how many airplanes we’ll actually add to the fleet next year and it could be zero. Under that assumption that the fleet growth is somewhere between zero and 10, it’s possible that we could put more flights per aircraft back into the schedule later on into the year, but I think something would have to happen for us to change our minds there. So, I think that it’s possible that the full year capacity for 2009 will be down in available seat miles compared to 2008.

So essentially what we’re doing is with the same number of aircraft, we are flying fewer flights per aircraft on a daily basis beginning in January and the image that you should have in your mind is that we’re going in to our daily flight schedule and eliminating unpopular flights which tend to be at the off-peak times of the day. And the easiest illustration is just to suggest a late night flight that has very few people on it. So, it’s unproductive activity for us and not that many customers use it. So that view would have to change with the fleet plan that I described for us to have increased capacity next year, and I don’t see that again as a probable change that we would make.

We’re trying to take this one schedule at a time.

My own…this is Gary’s opinion, this is nothing that I can use any empirical data to convince you with, but I feel like we’ve been pretty aggressive with our January schedule changes and my guess is that all else being equal, in other words no change in the economy, that we might have if anything gone a little bit too deep, but the point being that we wanted to make a fairly significant statement here with our schedule and we want to evaluate those results.

Of course what is also happening around us is our competitors are reducing capacity much more aggressively. We’ve got reductions that are occurring in the fourth quarter of this year and there are more reductions planned for next year. So, we’ll just have to see given all these moving parts whether we’ve got our schedule at the right place but odds are, long story short, we’ll have less available seat mile capacity in ’09 than in ’08 when it’s all said and done.

Ray Neidl - Calyon Securities, Inc.

Okay. It looks like in bad times we go for both yield and load factor, which is probably a good move. The other thing that you’re working on because you’re trying to get additional traffic is not charging for the first bag. How is that working? Are you seeing that stimulating traffic?

Gary C. Kelly

Can’t tell but I can, as we did, say that we had 14% unit revenue growth in October on top of a capacity increase and I feel really good about that. Anecdotally we can tell you all kinds of stories about customer reactions to our low-fare no-fees approach. I think it remains to be seen whether that will move a large number of passengers Southwest’s way. We’re certainly not going to lose passengers in this environment and as you know, in a recessionary environment we always do better than the industry because of our overall low-fare brand. This helps us reinforce that, so I feel very strongly that the timing couldn’t be better for this opportunity to come our way. It’s a gift and we’re trying to take full advantage of it. But in the end the customers are going to tell us what they want. If they want fees and they want fares unbundled, we’ll do that. It’s just based on our knowledge of our customers, and we carry more customers than any other airline in the world. We don’t think that’s the right thing to do and so far I feel like we’re being rewarded for it.

Ray Neidl - Calyon Securities, Inc.

Yeah. Thank you Gary.

Operator

And we’ll take our next question from Daniel McKenzie with Credit Suisse.

Daniel McKenzie - Credit Suisse

Yes, hi. Thanks. Just a couple of quick questions. Looking ahead at the portfolio fuel hedges, it appears that you do have a chance to reset some of your hedge levels and hedge positions and I’m wondering how you’re thinking about that. Is that a possibility to go and dig back in say for the next several years out? And if so, how do we think about that from a cash perspective?

Gary C. Kelly

Well, I think both Laura and I probably should take a swing at answering your question. Volatility is bad in terms of planning and I don’t think anybody really knows where fuel prices are going over the next three months, and all I have to do as evidence is look back at the last three months and then the previous three months to that to see the wild swings that the market has gone through.

I am very concerned then that here in North Texas we have a major natural gas development project underway which is in essence being suspended because of the radical swing in natural gas prices. So, we’re all concerned from a longer-term perspective about crude oil supplies and that’s certainly not helped with this wild swing in prices, and therefore we’re very concerned about a sharp spike that blows right past $150 a barrel when we run into supply/demand imbalances.

So we’ve got to protect against that and then the art of this now is trying to figure out exactly how and when to do that. Right now in October prices have no bottom and so we can’t be oblivious to that; we have to manage to that. At some point we’ll want to adjust our strategy and continue to be adequately hedged into the future. Right now we need to have a lighter hedge and find some confidence in how low prices go.

So yes, as I said in my opening remarks, low fuel prices is a good thing for Southwest Airlines and this is an opportunity that we’ll want to take the best advantage of that we can. I’ve got a lot of confidence in our finance department. They’ve been doing this a long time and the results are stellar. But I can’t tell you exactly how this will play out, exactly what levels we’ll want to cap, all of those things but the cash position is much improved going forward.

In fact, Laura let me let you speak to that.

Laura H. Wright

Sure. I think that the recent decline in industry prices is actually quite exciting as we look in the near term. Just in August we were forecasting a fuel headwind for Southwest in ’08 of $900 million to $1 billion versus last year and we were anticipating our fuel costs next year were going to be another $700 million to $800 million higher than ’08. So the good news is that the decline we’ve seen in energy prices assuming they stick here for a while with the softness or headwind this year is down in the $700 million range and the headwind over ’09 is down to $150 million range. That two-year increase is basically then cut in half. So, we’re optimistic about that and to Gary’s point we’re going to have to figure out when’s the right time to shore up future years but we want to protect for the downside in the near term.

Daniel McKenzie - Credit Suisse

Okay, good. Thanks. Very comprehensive. And just one second question here. It would be remiss to overlook that it’s been two years since the labor contract became amendable. I know that you guys generally don’t like to talk about that, but I just wondered if you can share any perspective about the pilots’ contract.

Gary C. Kelly

We reached the two-year mark in September of ’08 and I think every day that goes by we get closer I think to a resolution there. It’s been at this point now 14 years since we last negotiated under Section 6 a pilot contract, so it’s taken a while. There was a lot of cleanup to do and I hope that we’re getting close but I don’t think it’s appropriate for me to make a lot of predictions there. I need to honor the negotiation process and let it run its course.

Daniel McKenzie - Credit Suisse

Okay, great. Thanks. I appreciate it.

Operator

And we’ll take our next question from Duane Pfennigwerth with Raymond James.

Duane Pfennigwerth - Raymond James & Associates

Hi, good morning. I’m wondering if you could just tell us by your numbers what competing capacity was in the third quarter versus the 15% to 20% that you think it is in the fourth quarter.

Laura H. Wright

During the third quarter when we started the quarter, our competitor’s seats were down about 7% in July/August in our direct markets. That grew to about 18% in September and for the fourth quarter in our direct markets; our competitor’s seats are going to be down in the 17% to 18% range.

Duane Pfennigwerth - Raymond James & Associates

Okay. Do you have now the monthly split given what was month-to-date you were seeing RASM up 14%? What do you see capacity sort of October, November, December?

Laura H. Wright

It’s 17%, 18% for the quarter and the best I remember it’s right in that 17% to 18% for each of those three months. So it’s pretty steady in October, November and December.

Duane Pfennigwerth - Raymond James & Associates

So why wouldn’t the month-to-date RASM trend continue for the quarter based on what you can see?

Gary C. Kelly

Oh, I think it’s for the obvious reasons. In other words, the world has changed here in the last six weeks and I think it would be inappropriate for us to not recognize that. Looking at the bookings for November and December, we have to look at them by the way on a combined basis because the calendars don’t match up very well for Thanksgiving travel, you can’t draw any real meaningful conclusions this far out. If we use October as an example, we’re seeing strength in our bookings much later than normal.

On the other hand we are not promoting and discounting and offering sales of seats this year, which is the first time in my recollection that we’ve ever done that. So one would expect that the booking curve would be later but all that is a long-winded way of saying that there’s no way to get comfortable in this environment that future booking trends will be strong because it is such a different operating environment.

We know that fares are higher compared to a year ago. We know the economy is in a complete recession. The one shock absorber that’s in place is the reduction of seats and capacity, and it’s a darn good thing or I think we’d all be talking about something different, but I’m not trying to argue you out of your view but I’m just trying to honestly tell you that in this kind of environment, we’ve got to be prepared for a weak economy and weaker demand which I think is destined to happen whether it happens in November or December or January, I couldn’t tell you but I think it’s bound to happen and particularly with business travel.

Duane Pfennigwerth - Raymond James & Associates

Thank you for that color Gary. I guess the question is, is it based on your conservative nature and your need to be prepared or is it based on something that you can currently see?

Gary C. Kelly

It’s based on the former.

Duane Pfennigwerth - Raymond James & Associates

Thank you.

Gary C. Kelly

There’s nothing that we can point to today that would suggest that our revenue momentum will stall but in fairness again to answering your question, we don’t have enough evidence to draw a meaningful conclusion. Laura, if you go out to December, what percentage of bookings do you even have in place at this point? 15%? It’s just a very small number. I was talking with Dave Ridley earlier this morning, our Senior VP of Marketing, and we have several bookings per flight booked out in the first quarter which you just can’t draw any conclusion from. So there’s just no way to be confident about revenue trends in this kind of environment. We would be foolish to be bullish in this environment in my opinion.

Duane Pfennigwerth - Raymond James & Associates

Thanks very much.

Operator

We’ll take our next question from William Greene with Morgan Stanley.

William Greene - Morgan Stanley & Company, Inc.

Yeah, hi. Good morning. Gary, I’m wondering if you can talk a little bit about the revolver draw-down. Was there a clause in it that caused you to think you were going to lose it for some reason, either some MAC clause or something? And if not, why would you draw it down and sort of take the interest expense?

Gary C. Kelly

I think that’s a very fair question. There is no scientific answer other than I think I mentioned this earlier today. I’m an old CFO as you know. You get cash when you can; not when you have to have it and in this kind of a world that we live in with the financial disaster that we have to contend with, it makes no sense to me not to boost our cash target in what could become a very, very difficult scenario. At the beginning of the year I didn’t think some of the venerable Wall Street names that we know would go away this year Bill. So, I just don’t see that there’s any upside to being aggressive with that view.

Now all we’ve done is simply accelerate our financing for next year’s capital spending. What we’ve told you all for years is that our cash target is somewhere between $1.5 billion and $2 billion. If you go back 90 days, because of the extraordinary rise in fuel costs, we had near $6 billion in cash. So one way to think about this is that if you look at it in that environment and you go, “Why would you need to do any more financing when you’ve got far more cash than you really need?” The fact that fuel prices have collapsed has dramatically changed our cash balance and so, I think Laura and I both feel like we need to boost that $1.2 billion up to the $1.5 billion to $2 billion range. It’s just not any more complicated than that.

I want the money in our bank account; not somebody else’s.

Laura H. Wright

And Bill, on your first question in terms of the need to draw, there’s no truth to any of that. We have no issues with respect to any of our covenants or MAC clauses that caused us to draw.

Gary C. Kelly

No, there is no issue there. I will admit to you, and I mentioned this earlier, the timing around the earnings call was straightforward because we’re all gathered together and we assumed that it might raise some questions. It just provides an easy way for us to explain to you what our logic is all combined, but no, there is no covenant issue or anything like that.

William Greene - Morgan Stanley & Company, Inc.

And you have $200 million left but I guess by the same logic we shouldn’t assume that’s actually available?

Gary C. Kelly

You should absolutely assume it’s available. Of course it is.

Laura H. Wright

It’s completely and very much available.

William Greene - Morgan Stanley & Company, Inc.

But you didn’t draw it down.

Gary C. Kelly

No. We’re trying to kind of split the difference there. We didn’t feel like we needed all $600 million of it and $400 million we thought was a good enough number.

William Greene - Morgan Stanley & Company, Inc.

Okay Gary, let me just turn to a different issue. You mentioned the CASM advantage over the industry and that’s in fact true, although on a labor CASM basis, not so much true anymore. I’m wondering if you can talk a little bit about how you think about that, because historically when we’ve had an airline with among the higher labor costs in the industry, it’s been a tough position? How do you think about managing that?

Gary C. Kelly

Great question Bill. I want for our Southwest Airlines people and our customers we want to be the best in every single category. We want to have the best customer service, we want to have the best employees, and we want to have the lowest cost structure and that also means up and down the line in every single category. We have an enormous cost advantage ex fuel, ex labor and I see that as a very sustainable cost advantage prospectively. I think most everyone who follows the industry would agree with that hands down. We do have more parity on the unit labor cost component of our structure and I think over time I would want us to beat our competitors on that line item as well. I think with the overall economic environment and our need to slow our growth and just to be cautious about the kind of commitments that we make, whether it’s buying airplanes or whether it’s committing to hiring employees or compensation, we’ve got to be very cautious and very conservative and there’s nothing new with that thought or that statement. So we’ll hopefully execute according to that view.

I will say that once again if you look at our performance here that our employees continue to deliver and I’m very proud of them. They are the best in the industry and our productivity continues to improve quarter after quarter after quarter, and of course they’re the ones that are delivering the great customer service that we have and producing the 3% to 4% fuel consumption gains that we’re getting and I just couldn’t be more proud of them so we’re going to do our best to take great care of our people.

William Greene - Morgan Stanley & Company, Inc.

All right. Thanks for the color. I appreciate it.

Operator

We’ll take our next question from Gary Chase with Barclays.

Gary Chase – Barclays Capital

Good morning guys. Two questions for you. The first is on the capacity plan. I wondered if you could just elaborate a little further. The down 5% to 6% for the first quarter, at least I don’t think is new and previously you’ve been saying things like, “Well, we may not grow at all during ’09,” which kind of implied to me that there was going to be enough seasonality in the schedule where down 5% to 6% for the first quarter wasn’t going to translate into that kind of number for the year. Is that still the right read? On the one hand you see that and you kind of wonder why capacity wouldn’t be down 5% to 6%. Would that just be because the economy is stronger than people now fear it is? Can you just help us with that?

Gary C. Kelly

Gary, we’ll sure try. Are you asking why wouldn’t the down 5% to 6% for the first quarter extend through the whole year?

Gary Chase – Barclays Capital

Yes. Are you planning on for say in order for it to be even flat for the year, you’d need to have the second and third quarter presumably up a good bit. Is that the idea?

Gary C. Kelly

Yes, I’ve got your question. Well I think the…first of all we have not admittedly, it’s still October, we haven’t locked down on how many airplanes we are going to deploy into the schedule next year. So that’s one part of the answer. We don’t know yet.

Number two is we do have opportunities to, even if the fleet is zero next year, we could put more flying into the schedule after what’s published either on a daily basis or on the weekend and so that could create more trips and more available seat miles. I don’t think that will happen and I would admit that. I don’t think that it would be unreasonable to extend the assumption of down 5% to 6% into the second quarter, third and fourth. I’m just telling you the truth that we have not made decisions yet certainly for the second half of the year. Pretty soon we’re going to have to publish our schedule out through May and that’ll give you more insight. But I don’t think anybody’s working any harder in our company than our schedule planning department. They are evaluating a variety of scenarios to try to optimize our profits with our schedule and we do have opportunities to add a substantial amount of flying. But we need more airplanes to do that and of course we’re trying to weigh the risk of that versus the opportunity in those markets. But it’s very possible that our capacity next year will be down in the 5% to 6% range but I’m not willing to commit to that yet.

Gary Chase – Barclays Capital

And just to clarify something you just said. You said you haven’t yet locked down on the net aircraft additions, that’s a function of your choice, right? It’s not that there’s uncertainty around the Boeing strike or something that’s preventing you from knowing that? It’s you guys have not determined yet how many you’d like to have. Is that fair?

Gary C. Kelly

I think that was the assumption that Laura laid down for us. It was assuming that we get the aircraft delivered by the end of next year for the ’08 and ’09s, the three and the 10, then yes I agree Gary. But to be practical here, we don’t know how long the strike’s going to be. But one of the things that Laura has been I think sharing for several quarters is that we are continuing to probe the aircraft market for buyers and the odds are if we find a healthy buyer at a healthy price, we’ll sell a handful of aircraft. That would be our desire in this point. We don’t plan to sell a whole bunch of airplanes but that’s part of the answer here right now is we don’t know exactly how many airplanes we will have next year, and obviously we prefer not to have them just sit around doing nothing.
Gary Chase – Barclays Capital

Okay and then secondly just on the…and I want to congratulate you by the way on a very clever ad campaign around the new fees.

Gary C. Kelly

Well, thank you. It was all my idea if you liked it. You know that’s not true.

Gary Chase – Barclays Capital

Just philosophically you talked a few quarters back, I mean as little as a few quarters back, about the need to drive a lot of additional revenue. Obviously the fuel dynamic has changed dramatically since then and I guess what I’m asking is, as we look at this campaign you have to go towards no fees should we be thinking that you’ve decided you’re not going to pursue as deep an opportunity set there as you had been thinking when the numbers were as high as $1 billion and $1.5 billion of extra revenue? Or was it never really the plan to go down this path and there are other opportunities that you’re going to pursue to drive that same magnitude of revenue opportunity?

Gary C. Kelly

Well, our revenue goal is still very ambitious and the $1.5 billion is in my opinion the minimum target that we have. We have multiple initiatives underway to hopefully ensure that that target remains doable and reasonable. No, you shouldn’t read anything into our activities thus far as backing off of our target, and obviously our target may have to change according to operating cost levels and fuel cost levels. But the no fees campaign should work and our revenue performance in the third quarter and thus far in the fourth quarter is very encouraging. I’m very proud of those results that our people have produced, and that’s with no fees. There’s this assumption I think that people are making that the fees are additive and there’s certainly no evidence yet that that will be the case.

If we discover that you’ve got some price insensitive customers that are willing to pay add-on fees, that’s still an opportunity for us to pursue and I’m not guaranteeing that we will never ever charge fees. I think that that also would be foolish, but we think we’ve got a great opportunity here to differentiate Southwest Airlines once again in a very positive way. It’s part of a bigger brand opportunity that we have. We carry more customers than any other airline and we want to continue to grow that, and we think we have opportunities to move customers over to us. We carry more business customers than any other airline and we’re making significant investments there. So, it’s not the be all end all. It’s just one part of a larger plan that we have to drive revenues. Southwest.com, enhanced rapid rewards, extending into co-share relationships internationally. More new enhanced revenue management techniques are in front of us, and we think have very significant opportunities.

And I think the biggest thing that’s going on in 2008 and 2009 is the schedule optimization and we have high hopes for the adjustments that we’re making in January to March that that will produce some significant load factor boosts and revenue gains per available seat mile basis.

So it’s going to take every one of those and we think that the no fees approach will also earn us more customers that will more than pay for what incremental fees would be. So that’s our view and we’ll know. We’ll know in a year or two or maybe sooner or maybe later whether that was the right choice or not, but the way we see it this is just a gift from our competitors and we’re taking full advantage of it.

Gary Chase – Barclays Capital

Thanks for the color Gary.

Operator

And ladies and gentlemen, we have time for one more question for our analyst portion of today’s call and we’ll take our last question from Michael Linenberg with Merrill Lynch.

Michael Linenberg - Merrill Lynch & Company, Inc.

Good morning everyone. Two quick questions here. When we think about the planned capacity reduction in the March quarter of 2009, the 5% to 6%, and certainly as I think back I can’t think of a time where Southwest has cut capacity in the past. And yet we have seen some cost headwinds on an ex fuel CASM basis. What type of CASM increases, I realize the potential upside on the revenue side but what’s the early read on ex fuel CASM and maybe where are the opportunities to bring down costs in the March quarter?

Laura H. Wright

Mike, we gave you some guidance on fourth quarter on ex fuel CASM. Our capacity ASMs are going to be up about 1% in the fourth quarter and we expect that our year-over-year ex fuel ex special CASM’s going to be up in the same range in the fourth quarter that it was in the third quarter. Clearly, as we go into the first quarter of next year with ASMs down 5% to 6% versus up 1%, that’s going to put continued pressure on our first quarter ex fuel CASM. Gary talked about the rest of the year next year. We have not locked in on the ASMs for the second through fourth quarters so I really don’t have any color there but we expect that we’ll continue to see actually more pressure in the first quarter with less capacity.

Michael Linenberg - Merrill Lynch & Company, Inc.

Okay, good and I understand it’s obviously very early. My second question and I think it was maybe Gary who had answered this when asked to characterize what a sizable hit or a sizable impact would be regarding posting of additional collateral to the counterparties if oil prices fell another $20, and I think Gary you said like a couple of $100 million. Is that a net number? Are you including any potential cost savings that you would get for lower fuel prices and call it the small piece of unhedged although it sounds like going forward you’re going to have more and more exposure? Does that include the benefit there? And I’m assuming that if oil goes to $60, we’re sort of looking at the same revenue environment although things could definitely change on the revenue side?

Gary C. Kelly

No, it does not. I’m glad you asked for that clarification. That’s the risk associated with having a hedging portfolio that extends out for four and five years is it creates that potential leverage. It works well when prices are going up and we have to be careful with that when prices are going down. So, the drop in fuel costs would overwhelm that number but they wouldn’t be realized of course. It would be over time and all of the questions that have been asked about the cash collateral are very appropriate. I think my net answer at least is that we’re managing that aggressively, which you have to do. You can’t just sit still and let that happen because it could put a short-term crunch on a company. The only answer is to reduce the leverage and that’s exactly what we have underway, and I feel confident that our folks will do that very expertly.

Michael Linenberg - Merrill Lynch & Company, Inc.

Okay, well very good. All right, thanks. Good quarter.

Operator

At this time I’d like to turn the call back over for any additional or closing remarks.

Laura H. Wright

That concludes this portion of the call. Thank you everyone for listening in and our IR folks will be ready to take your calls. Have a great day.