By Debora Tidwell (TMF Debit)
UNION CITY, CA (May 14, 1997)/FOOLWIRE/ --- Southwest Airlines reported their first quarter 1997 results on April 24th. This was a record earnings quarter for them. In fact they had several records during the quarter. Earnings for the quarter were $50.9 million which was $0.34 per share. That was despite high fuel prices (which were up 20.8%) and, as compared to last year at least, an early reimposition of the ticket tax which went back into effect on March 7th. Earnings were up 54% over last year.
Each month during the quarter was better than the same month last year. March especially was very strong and a pleasant surprise to them because of the ticket tax and it was a record month. They benefitted from very strong RPM (revenue passenger mile) yields.
FARE INCREASES. They had some fare increases that went into effect on February 10th. Those were well accepted and very productive. The overall unit revenue production is very good. They do have some opportunities to take fares up, but the artistic part will be making decisions that maximize revenues. The revenue production is very good right now, so their inclination is to say that they don't think there are any big fare increases in front of them. They also had a very significant emphasis on improving the mix of their full-fare versus their discount traffic and they were very successful with that initiative. The February fare increases were obviously positive for them but they were actually quite modest. They only increased their walk-up fares $2-3 and the discount fare category went up on average from $2-10. The bigger benefit in the quarter is just their focus in trying to generate traffic at full fares versus discounted fares. That is more art than it is science, but clearly they are in a period here where they have a very strong revenue generating base.
OPERATING INCOME. Operating income was up 51.9% and that resulted in a net margin of 5.7% versus last year's 4.3%. If you compare that margin for the quarter to previous years, especially if you adjust for fuel prices, it is a very strong performance -- the best since 1993.
OPERATING REVENUES. Operating revenues were up 14.8% to $887 million. Load factor was 62.1% which was up 1.6% from last year. March's load factor was off some from last year. It was benefitted from having Easter in it and was impacted by increased fares and their stronger mix of undiscounted traffic. They expect that load factor trend that is trailing last year's load factors to continue under the assumption that their current fare structure stays in place. They do have a "Friends Fly Free" promotion that is underway. That sale is good for purchase through May 20th and for travel throughout the period that the schedule is open. The RPM yields were very strong during the quarter, they were up 2.4% to a record $0.13. They had RPM yield strength even though the average length of haul was up almost 6%. That increase in haul length probably penalized RPM yields a good 5 percentage points.
OTHER REVENUE. They saw good growth continuing in the freight category. A lot of that is driven from carrying more mail for the government. Other revenue was up 34%. The increase was generated by selling frequent flyer credits to various credit card companies. They have had an increased initiative in that area and it is obviously paying off for them. They would expect the other revenue comparisons to continue at least throughout this year. They think they will continue to see very good growth in that category.
COSTS UP DUE TO HIGHER FUEL PRICES. On the cost side, their cost per ASM (available seat mile) was up 2.6% to $0.0761. That's the bad news. The good news is that was all from fuel prices. If you were to keep fuel prices on equivalent levels, unit costs would have been slightly below last year. At this point fuel has come down from $0.71 per gallon to around $0.60-$0.61 per gallon and they hope that fuel will stay the same or go lower in the second quarter. Fuel prices alone increased operating expenses in the quarter by $23 million.
SALARIES & BENEFITS. Salaries and benefits were up 2.8%. That was virtually all driven by higher profits and therefore higher profit sharing and Southwest is happy to pay that. The profit sharing for the first quarter was $14.9 million. The 401(k) match was $9.2 million for the first quarter. Last year it was $9.4 million and $8.4 million respectively.
MAINTENANCE COSTS. Maintenance unit costs were the big pleasant surprise during the quarter. They were down substantially on a unit basis by almost 17%. That was well under budget. It was all due to fewer engine overhauls. They did fewer than expected. What they expected to do was also far fewer than they did during the same quarter last year. Part of it is timing. Engines are pulled and sent to the shop based on the number of cycles on the engine or sooner if the performance isn't where it needs to be or if it is at unacceptable levels. They have had fewer pulls of engines scheduled for this year. But, they have also had a number of initiatives underway in maintenance to reduce their overall engine costs and improve the performance of the engines and they were certainly seeing some benefits of that in the first quarter as well. They are able to keep engines on-wing longer, they are performing better and that is translating into lower costs.
MAINTENANCE COST REDUCTION INITIATIVE. They are just at the very beginning of this initiative to impact engine costs and they are very excited about what they have learned thusfar. They spent a great deal of time during the first quarter studying what they can do about curtailing their engine cost increases in the future and they are very confident they can do that.
MAINTENANCE COSTS SHOULD BE SAME AS LAST YEAR. They don't expect engine costs to be down for the full year, i.e., for the first quarter trend to continue throughout the year. They had very heavy maintenance costs during the first, second, and third quarter of 1996 and that is unusual to string 3 quarters together of very heavy costs. They had very modest costs in the fourth quarter and very modest costs in the first quarter so they suspect that they will get back to more reasonable levels in the second quarter and perhaps for the balance of the year. The best prediction they can give at this point is that they don't expect their maintenance costs on a unit basis to vary significantly from last year's number.
AGENCY COMMISSIONS. Agency commissions were up 6.1%. That was driven primarily from increased passenger revenues which were up almost 15%. Their travel agency mix is about where it was last year. They were 42.9% agency sales last year and it was 43.6% this year.
OTHER OPERATING EXPENSES. The only other significant cost category is their other operating expenses. They were down almost a percentage point from last year on a unit basis and they are seeing a benefit in that category from several of the cost reduction initiatives they have underway in purchasing. On the other expense line, interest expense was up a couple percentage points because they issued $100 million of 30-year bonds at 7-3/8%. They got those issued just prior to the recent rise in interest rates. They have renegotiated their progress payment schedule with Boeing for future aircraft deliveries. That has resulted in lower deposits with Boeing and, as a consequence, lower capitalized interest. That is why the number is down 36% from last year. Interest income, on the other hand, has almost doubled because their cash balances that are invested have virtually doubled year over year.
TAX RATE. The tax rate for the quarter and what is estimated for the year was 39%. That is below last year's first quarter estimate of 39.75%. If you look at the full year for 1996 it was actually 39.25%. So their estimate going back to the first quarter last year was a little high for the full year of 1996 so they are down slightly from where they ended up rate-wise for the year and it is simply because they are expecting earnings to be higher for the year at this point.
CASH. They have cash at the end of the quarter of $652 million. Their line of credit of $460 million is fully available so their liquidity is the strongest position ever. They have issued $100 million of senior notes, the 30-year bonds. Operating cash flow was $93 million and the capital spending for the quarter was $115 million, so they virtually covered their capital spending with operating cash flow. The full year estimate of capital spending is still $725 million. Next year they think it will be slightly higher than that. Plus next year they also have $100 million in notes that come due. Long term debt at the end of the quarter was $739 million. Stockholders equity was $1.7 billion. Their capitalization is very strong. They are the only airline with an A credit rating across the board. Debt to total capital on the balance sheet was only 30% and even if you capitalize all the off-balance-sheet leases, they are below 60% so they have a very strong financial position going forward.
CURRENT TRENDS. Their April traffic looks similar to March from a load factor perspective in that they will most likely lag last year's load factor for the month. March was benefitted by Easter and April was hurt by not having Easter so that has to be taken into account. The bookings for the remainder of the quarter suggest that these trends will continue. They have higher fares and they continue to push for a stronger mix of traffic. They believe that is the best way to optimize revenue per ASM. They do have results for early April on RPM yields and as a consequence of the initiatives they have underway the RPM yields were strong. They are obviously impacted in March and more so in April and going forward by the reimposition of the ticket tax. The tax wasn't in effect during the second quarter last year. So, the comparisons are going to be tough as a consequence of that. They ought to see slightly higher yields than last year, or at least that's possible. But that has a big assumption -- that trends continue -- and they can't predict that because of all the uncontrollables.
On a unit cost side, fuel prices have receded. They feel pretty good about those levels. All other unit costs except fuel ought to be relatively close to last year. The dependencies are, as usual, what is maintenance spending.
NEW RESERVATION SYSTEM. Their new reservation system will be implemented by year end and they think they will see some nice cost benefits from that in 1998. Longer term they think distribution costs have tremendous potential to come down further because of their ability to sell direct to customers and to sell through the Internet. They have intense efforts underway in purchasing and they think they will see $20 million savings annually from those initiatives. In the first quarter this year they began intense efforts in maintenance which they will see full-year effect in 1998.
BOEING 700. They are the launch customer of the Boeing 700 aircraft. As a consequence of being the launch customer they got very favorable pricing on that aircraft. That will help. The aircraft flies farther, faster, quieter and also is more fuel efficient and will require less maintenance. So that is another help on the cost initiatives. They have efforts underway in all areas of the company.
EXPANSION. They are still planning to grow this year at about 9%. In the first quarter their ASMs were up 9.1%. Right now they are projecting second quarter ASMs to be 10.9 billion which is up 7.6%. Third quarter would be 11.5 billion which is up 9.5%. Fourth quarter would be 11.4 billion which is up 9.6%.
AIRCRAFT DELIVERIES. They ended the quarter with 246. They will be getting 6 more deliveries in the second quarter, these are all 300s. They get 6 more in the third quarter and then in the fourth quarter they get the 700s and there are 4 of those. So, for the full year that is 19 new airplanes from Boeing. They currently plan to retire four of the older 200s in the fourth quarter, so they will net 15 additional aircraft in the fleet, plus they put two more airplanes into service that were delivered late last year. They put 17 into the schedule in 1997. That was the exact same number they put into the schedule in 1996. They have firmed up options for 1998 deliveries so they now have 21 firm next year.
REGIONS. Their West coast business now accounts for about 22% of their system, this is on a capacity basis. If you look at the rest of the Western markets that is 32% and is pretty much what they reported last time. Heartland is at 19% (TX, AR, OK, LA). Midwest is about 15% and the East coast is continuing to grow with about 12% there. They are seeing very heavy load factors in the Eastern part of the system. They are seeing heavier load factors on nonstops that are longer haul. Some of these nonstops are very low frequencies. The proportion of nonstop passengers to the total, however, has not varied at all in three years. The demand is very strong and the new markets that were added over the last year are maturing very rapidly. Their plan for the year was to add fewer new cities, allow the new markets time to mature with a hope that there would be a positive benefit to revenue per ASM and that plan is working very nicely. The Eastern expansion has gone very well. That region as a group has very strong load factors. They have been able to push the fares along there and it has developed very nicely.
BALTIMORE. They were asked how the Baltimore service was working out. They responded that it is going really well and they have increased Baltimore by around 50% over the last twelve months -- lots of new destinations and even a lot of the existing markets have grown very strong. They think it is a real gem in their system. They think they have huge potential out of Baltimore going forward and it is going to continue to get more flights. They have 45 flights a day going in and out of Baltimore now and it's growing.
NEW MARKETS. Jacksonville was started in January and they are grouping that in these new markets -- it is developing very well. Jackson, Mississippi is their other new city is announced for this year and they start service there in August of 1997. For the rest of the expansion plans this year, they are adding service to existing city pairs -- Nashville to Detroit, LA and Oakland, for example. Their strategy and philosophy on adding new cities hasn't changed. The beauty of Southwest is that they have lots of opportunities outside of the hubs that they can grow into. With the kind of success they have seen with the last couple years' growth there is just no reason to go kick the big cats, so they are very much going to continue to stay away from the hubs. They do have the flexibility with their aircraft deliveries this year to add another new city. They don't have any firm plans to do that but they do have airplanes toward the end of this year that are not allocated yet so they are keeping their options open.
LONG HAUL FLIGHTS. Long haul flights have received a lot of attention but represents a very small proportion of Southwest's system. If you look at markets that are over 1000 miles on an ASM basis, it is still 10% or less of the system. So there is really no change in the strategy of Southwest. There certainly is no change in the character of Southwest. They were asked if they were using other cities than Nashville to implement more long-haul flying. They responded that Nashville is not a real secretive strategy. There is a void in that market because American Airlines pulled down which offers Southwest an obvious opportunity to go replace some of those flights. Geographically it fits in nicely between various regions of Southwest's system where they have a dominant presence. The other geographic points that they have added service over the years would be St. Louis and Kansas City, both of which have a fair number of departures already, so they are pretty well-developed cities on the local front. Nashville is the one that really has lots of opportunities and is the one that is most logical for Southwest to develop.
DIVERSIFYING THE SYSTEM. They are still a short-haul, niche carrier and are simply diversifying their system as they grow with some longer-haul markets -- simply because their past experience has shown that they can be very profitable on those routes. They fly those 1000 mile routes at roughly $0.04 per mile, so they are very productive. They are also hedging in the event that the FAA funding structure is changed such that they are penalized short-haul carriers. They think that is extremely unlikely, but of course if they can hedge and be profitable with that hedge, it makes a lot of sense to do it. The Chairman of the House Ways and Means has reported that his committee has decided that they want to extend the excise tax and that is a very recent development. All indications are that Southwest won't see any change in the funding that would be punitive to Southwest.
AMERICAN AIRLINES STRIKE. They were asked if the American Airlines pilot strike had an impact. They responded that it hadn't. They think there are several issues related to the American strike. One was the strike which created bookings away from American. But then when they didn't go on strike, the "no show" factor was impacting because they were false bookings, in effect. They couldn't tell from their results that it was positive or negative. The other thing that happened is that American got out there with a very aggressive sale. Southwest's load factor was down after February 10th, but Southwest attributes that to the items already mentioned -- pushing fares up some and pushing for a stronger mix.
HEADCOUNT INCREASES. The company was asked about headcount increases. They responded that what they have done since 1994 is pour lots of resources into their distribution function, mainly reservations. That is as they have transitioned away from having a 60% agency mix down to a 40% agency mix. All of the headcount increases to speak of during that time period have come through reservations. So they think they have stabilized that function and feel good about the service levels they are offering. Ticketless travel was also an impact there because it is more work for a reservation agent. All of that seems to be stabilized and that suggests that the large headcount increases like we have seen over the last three years are behind them and should taper off.
INTERNET RESERVATION SYSTEM. They were asked how their Internet reservation/ticketing product was going and responded that it is growing, still very modest, they think the maximum number of bookings on a daily basis that they have taken are roughly 2000 out of a normal day of 300,000-400,000. So, it is still a very small number but the message clearly is that they are positioning themselves to take advantage of whatever the market wants to use as the booking vehicle in the future. They think an airline like Southwest with a very simple fare structure and route structure and well-known as being low-fare will fit in very nicely with that type of direct distribution strategy.
SUMMARY. They are the low-cost leader in the industry and that remains. With the cost initiatives they have on the books and underway that lead should widen. Their competitive position is very stable and very strong. They have an excellent balance sheet which gives them a lot of flexibility to step up growth when the opportunities arise. They are enjoying very strong operating cash flow which simply adds to that financial flexibility and they are very focused on growing earnings in 1997 much faster than capacity by improving their margins.
* A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.