Southwest Airlines Co. (NYSE:LUV) Q4 2022 Earnings Call Transcript

Southwest Airlines Co. (NYSE:LUV) Q4 2022 Earnings Call Transcript January 26, 2023

Operator: Good day, and welcome to the Southwest Airlines Fourth Quarter and Full Year 2022 Conference Call. My name is Chad and I will be moderating today's call. This call is being recorded and a replay will be available on southwest.com in the Investor Relations section. After today's prepared remarks, there will be an opportunity to ask questions. . At this time, I would like to turn the call over to Mr. Ryan Martinez, Vice President of Investor Relations. Please go ahead, sir.

Ryan Martinez : Thank you, operator and welcome everyone to our fourth quarter and full year 2022 conference call. In just a moment, we will share our prepared remarks and then leave plenty of room for Q&A. Joining me on the call today is our President and CEO Bob Jordan; Chief Operating Officer Andrew Watterson, Executive; Vice President and CFO Tammy Romo, and Executive Vice President and Chief Commercial Officer, Ryan Green. A quick reminder, that we will make forward-looking statements which are based on our current expectation of future performance. And our actual results could differ from expectations. Also, we had special items in our fourth quarter results, which we excluded from our trends for non-GAAP purposes. And we will reference our non-GAAP results today. So please refer to our press release from this morning and our Investor Relations website for more information. And with that, Bob, I'll turn it over to you.

Bob Jordan : All right. Thank you, Ryan. I appreciate everybody joining us this morning. Well, we're disappointed to report a Q4 net loss, as we were on track to produce a healthy fourth quarter profit prior to December 21. We provided an 8-K investor update earlier this month that quantify the preliminary estimate of the financial impacts, so a Q4 loss is likely not a surprise. But I would like to take a few minutes to talk about the operational disruptions. And first and foremost, I want to apologize again to our customers and our employees for the impact the operational disruption had on them and all their holiday plans. We are intensely focused on reducing the risk of repeating that type of operational event, again, like we had last month, and we are highly focused on our customers and our plan going forward.

And customer refunds and reimbursements remain a top focus. While not proud of what happened, I am very proud of our people and all that they have done to take care of our customers and their needs. Well, in terms of the events themselves, we canceled more than 16,700 flights from December the 21 to the December 31. The first few days through December the 23 were specific to the winter storm, and we began to have additional disruptions in the operation on December the 24. As the largest carrier in roughly half of the top 50 U.S. travel markets, we were impacted by rolling storms to an extraordinary degree. We experienced gridlock and many of our largest airports along with a high frequency of short notice cancellations, which created urgent and repeating efforts to repair the aircraft routings and then our pilot and flight attendant schedules.

Given the overwhelming volume of flight cancellations over multiple days, combined with manual workstreams, we determined that the best course of action to get back on track operationally was to reduce our December 27 through December 29 flight activity by roughly two thirds. And that allowed us time to reset the operation to normal flight levels beginning on December the 30. But based on what we know at this point, our processes and technology generally worked as designed. But we were hit by an overwhelming volume of closing cancellations, which put us behind and creating crew solutions, which in turn pushed us to manual efforts and solutions and Andrew will cover that in detail more here in just a minute. So we've got several streams of work underway.

Immediately following the disruption, we move swiftly to put mitigation efforts in place to reduce the risk of future operational disruptions and to help fortify our operational resilience. We created an early indicator dashboard that closely monitors operational health and signals and alert if we approach predefined operational thresholds. We established supplemental operational staffing that can quickly mobilize to support crew recovery efforts at the first sign of a potential workload backlog. We enhanced our existing tools for crew members to communicate electronically to crew scheduling during irregular operations. And we're in the process of swiftly updating and upgrading our crew recovery tools and system to solve the backlog repair of crew member schedules, which was one of the key issues during the disruption.

Where the short term risk mitigation steps in place are underway, we're taking additional steps to review the events and determine any additional changes to our plans. We worked early on with a board of directors and they've established an operations review committee that is working with our management to understand the events and help oversee the company's response. We've engaged a third-party global aviation firm Oliver Wyman, for a third-party assessment of the event and help make recommendations of additional mitigation elements for us to consider. And that work will conclude here over the next several weeks. And with that assessment and our own, we will reassess our 2023 plans, keeping in mind that we already had a robust operational modernization plan in place for 2023 and Andrew will walk you through that in greater detail as well.

I want to reiterate that Southwest has a very long history of innovation and continuous improvement. We've been investing up to $1 billion per year on technology, both recurring and investments been included and we have implemented numerous large scale technology and business projects over the past five years, including things like the first implementation of the Amadeus Reservation System in North America, co-developing an innovative network planning system. That's now part of the Amadeus product portfolio, ETOPS certification and processes for Hawaii flying, new aircraft maintenance systems, a DDS platform capabilities and connection to three other platforms, a new pair product, and automated ancillary services capabilities, and we're in the process of wrapping up the replacement of our revenue management system, which actually involves three RM systems simultaneously in production, which is an absolute technical feat.

That list is not meant to be comprehensive, but hopefully it gives you an idea of what we've done and what's underway. We're also currently budgeted to spend $1.3 billion of our 2023 annual operating plan on investments, upgrades and maintenance of our IT systems, which is higher than what we spent in 2022. The recent disruptions will likely accelerate some of our plans to enhance our processes and technology, but I suspect that the operational modernization opportunities that Andrew outlined at Investor Day have largely captured the key workstreams and we will dedicate the capital needed to execute in a timely and efficient manner. We currently plan to stick with our 2023 growth plans. We were properly staffed for 2022 flight schedules including the holidays and we continue hiring this year to be properly staffed We currently plan to stick with our 2023 growth plans.

We were properly staffed for our 2022 flight schedules, including the holidays, and we continue hiring this year to be properly staffed for our 2023 flight schedules. Our plans call for adding over 7,000 new employees in 2023, which is actually a decrease of nearly 40% from 2022 hiring levels. We have the order book from Boeing that we need in 2023. And with the short-term mitigation elements that we put in place, we believe we are well prepared to execute our network restoration plans this year. Nearly all planned 2023 capacity additions will go to restoring the network and adding breadth and depth in existing Southwest markets. And that network restoration should significantly help our operational resilience efforts over the long term. Andrew will also cover that in more detail.

Finally, we continue to work hard on labor agreements for our people. And I'm very proud of the fact that we were able to reach agreements with several of our unions recently, including our flight instructors, our facilities maintenance techs, our customer service agents and, just earlier this week, a tentative agreement with our dispatchers. We continue negotiations with the unions representing our ramp and ops employees and mediation with unions representing our pilots and flight attendants. And we intend, as always, to have competitive market compensation packages for our people. In closing, we still made tremendous progress in 2022. And despite some impact here in Q1, we believe we still have a solid plan for 2023. We are holding ourselves accountable to the plans that we outlined at our early December Investor Day, and it is still our goal to achieve the long-term financial targets that we outlined.

And I know that our people are up to the task. I'm just extremely proud of them for their dedication to the cause that is Southwest Airlines, and they remain absolutely our greatest asset, the heart and soul the company and a tremendous source of pride for me personally. And with that, I will turn it over to Andrew.

Andrew Watterson : Thank you, Bob, and hello, everyone. I will focus the majority of my comments on the operational disruptions to provide some additional color to what Bob shared. We experienced a historic event with a combination of challenges we hadn't experienced before. However, as Bob mentioned, our crew scheduling software didn't stop working during the disruptions, but a combination of our processes and the technology couldn't keep up with the pace of cancellations at the height of the weather disruption. That forced crew scheduling into fully manual mode to develop solutions, and they simply couldn't keep up with the volume of changes. Based on what we know today, it appears that the last domino to fall was when we could no longer use our automation for crew scheduling.

Automation works very well for us, but when a problem gets stated, the automation doesn't have the ability to look backward as it tried to solve future problems. To simplify, the decision support tool helps us solve two issues. One, repair the assignments of individual crew members; and two, solve crew coverage problems for individual flights by reassigning crew members and using reserve crew members. If a crew member's individual schedule is not repaired before the next assignment begins, then we aren't able to use the automation to repair the individual schedule. Consequently, without updated crew member schedules, the software can't reassign crew members to solve for flights with crew coverage issues. So the disruption uncovered a functional gap in our technology.

However, this issue is in the process of being addressed. In terms of the moving parts of our point-to-point network, you can think of it in 3 buckets. You have the flight network, the aircraft network and the crew network. We feel very confident in the flight network and schedules we have published for sale, and we are very adequately staffed to operate our fourth quarter flight schedules. We feel very confident in our aircraft network, and we have a sophisticated technology product that we call the Baker that produces new aircraft solutions during irregular operations. At no time during the disruption did the point-to-point journeys of the aircraft present us with an unsolvable problem. For our crew network, the functional gap that was revealed in our crew scheduling software is in the process of being addressed and should be updated in a matter of weeks, which represents quick work by GE Digital and our teams to address the most notable cause of the event that we are currently aware of.

So in terms of where we go from here -- this happen again, our access fall into three buckets: immediate mitigation efforts aimed at the last domino to fall; department level assessments and actions; and a systemic review supported by a third-party. Bob covered the immediate mitigation for implemented, our dashboard, supplemental staffing, crew communication tool enhancements, et cetera. He also covered a third-party review of the events and the Board's involvement in working with management to oversee our response. I want to briefly cover the second bucket, which is department actions. Each department has undertaken its own analysis to identify additional measures the departments can make to improve its management of significant disruptions while leaving the cross-departmental improvements to the systemic analysis conducted with a third party.

Some examples of the department efforts include implementing a new crew scheduling phone system targeted for Q1 of 2023, create a network disruption pod and NOC, or network operation control center, to better integrate crew data and to fly cancellation decisions; increased the number of crew schedulers;, evaluate our cold weather preparedness and items such as assessing VIP procedures, protocols and tools to increase throughput; ensuring we have sufficient ground support equipment fuel that is viable in subside temperatures. This list isn't meant to be comprehensive either. Just to share you -- just to share with you that we have already identified some smaller scale opportunities for improvement. And we will have taken actions even before we get to the third-party recommendations.

But in terms of the review by Oliver Wyman, we think it is a valuable exercise to understand how the accumulation events led us to the final result. And we still want to see if there are opportunities to improve performance on bad weather days to integrate and to our modernize operation efforts. We recently had an opportunity to test some of the new mitigation efforts implemented recently during the FAA technology outage earlier this month with a Notice to Air Missions or NOTAM system. Our NOC worked around the clock in constant contact with the FAA and the industry to make sure that our NOTAM was restored and valid before we pushed any of our flights. We took the time to ensure verification, safety and compliance, which is why we had not dispatched flight before the FAA ground stop.

And it is another example that we will not sacrifice safety. We did not sacrifice safety during the December event, the NOTAM event, and we simply won't going forward. Safety is paramount. And we used our new warning indicators. We deployed additional head count to assist crew scheduling, even though we didn't end up needing them. And we executed target cancellations that help protect how we ended that day to assure a good start the following morning. So while we had a difficult start to that day, thanks to the swift actions taken and enhanced processes in place, we were number one in the industry in on-time performance the next day. Part of the organizational changes when I stepped into the Chief Operating Officer role was to combine network planning with the operations functions in order to further align commercial and operations objectives.

And we recently announced a related org change by promoting -- VP network planning, to SVP network planning and network operations control. The goal of this move is to create a tighter feedback loop between scheduled design and schedule execution in order to add resiliency and reliability to our network. This is another action that I believe will help us tremendously. Since the disruptions in late December, our operational performance has been solid. The month of January has seen several ATC outages, historic precipitation in California, where we are the largest carrier, and multiple snowstorms in Denver. Through Monday 23, we are number two in on-time performance out of 10 airlines, trailing American Airlines by less than 1 percentage point.

As a reminder of what we shared at Investor Day, I want to recap two areas: our operations focus areas and our capacity plan. First, much of what we are talking about in terms of operational improvement and technology upgrades, I addressed at our December 7 Investor Day. In particular, in the areas of operating quality and frontline staff and tools. In the area of operating quality, I noticed a focused area called network design recovery. While it was not planned as part of our 2023 delivery at that point, we had begun work in that area at the time of Investor Day. We had already selected over Wyman to assist us beginning this January. As part of our reevaluation of our 2023 priorities, we'll accelerate this work. In the area of frontline staffing tools, I noted focus areas of mobility/digital tools and continuous improvement.

Again, these were specifically slated to deliver by the end of 2023 but will be evaluated again as part of the reassessment of our plans, given the challenges with crew communications we experienced. I want the third-party review to conclude before I opine on what exactly needs to be done and over what time line, but we have good line of sight to potential improvements in several operations areas that span multiple years, including 2023. Now we need to finalize our plan for 2023 and determine what sequence of improvements are most appropriate in terms of technology and tools investment. And secondly, our 2023 capacity growth is now up to 16% to 17% year-over-year, but this is apples to apples in line with the old 15% that we outlined in Investor Day.

Nothing has materially changed in our capacity plans for this year. The increase is simply due to lower capacity in Q4 2022 due to the flight cancellations. We were headed all along toward network restoration, and the December events had nothing to do with staffing levels or our capacity plans. Speaking to 2023 capacity plans, it is nearly all going back in the key Southwest markets and adding market depth. These are markets that we borrowed from to fund new airport expansions in the pandemic. And as leisure demand remains strong and business demand improves, we have opportunities to build this back up. And this is lower risk capacity growth primarily in markets where we have the number one or number one share in a strong Southwest Airlines customer base.

Our goal is to have the network fully restored by the end of 2023. And by summer 2023, we should be about 90% done. And in doing so, it should help fortify the operation with better itineraries, depth and reaccommodation options for customers, crews and aircraft when we do have weather or delays that create regular operations. So we plan to continue our investment in the network this year. And on the topic of 2023 schedules, last month, we extended our flight schedule for sale from July 11 to August 14. This included the -- in the Southwest points of strength as well as bringing back longer-haul markets, all part of our continued network restoration and accounts for anticipated travel demand for the peak summer travel period. Denver grew at just over 300 flights a day, the highest ever daily total account for any Southwest Airport, and Baltimore hits approximately 220 days departures, which is higher than summer 2019.

We will peak with total daily flights of nearly 4,400 in July 2023. Our next schedule through October 4 will be published on February 9. I want to wrap up by reiterating that we are intensely focused on reducing the risk of repeating the type of operational event we had last month. And we are also focused on moving forward and running a great operation each and every day. So while there will be lessons learned, we aren't losing focus on the fact -- on the blocking and tackling that is necessary to efficiently operate our network. I'm confident that our people will continue to do just that, and I'm thankful for their focus on running a safe and reliable operation and providing excellent customer service to our customers. Finally, I would be remiss if I didn't commend the negotiating teams of TW 557 who represent our flight instructors; and AMFA, who represents our facilities maintenance technicians.

These negotiating teams worked tirelessly to reach agreements for their memberships, and I am pleased we can reward these employees with well-deserved pay increases and quality-of-life enhancements. I'm also pleased that we just recently reached a tentative agreement with TWU 550, who represents our flight dispatchers, and they will be voting on their TA soon. We continue negotiations with the unions representing our other work groups that await a tandem agreement to vote on, and we intend to continue to pay competitive market compensation packages to our employees. So with that, I will turn it over to Tammy.

Tammy Romo: Thank you, Andrew, and hello, everyone. I will provide a quick overview of our financial results and share some additional comment on our 2023 outlook. As a result of the operational disruptions in late December, driving a $620 million negative after-tax net impact, we reported a fourth quarter net loss of $226 million, excluding special items. These results are clearly disappointing and not where we expected to be. Our quarterly performance leading up to December 21 was strong and trending in line with our previous guidance expectation aside from CASM-X, which I will cover in a minute. As Bob mentioned, we still made tremendous progress in 2022 despite the operational setback in late December generating full year 2022 net income of $723 million, excluding special items.

Despite the negative revenue impact from the flight cancellations in December, we generated record fourth quarter operating revenues. Brian will speak to our revenue performance and outlook here shortly, so I will turn to our cost performance and outlook. Beginning with fuel, our fuel hedge performed well last year, especially in a volatile market environment. In total, our full year 2022 fuel hedge benefit was roughly $950 million with roughly $170 million in fuel expense savings in fourth quarter alone. For 2023, we are 56% hedged in first quarter, 51% hedged in the second quarter and 47% hedged in second half 2023, which equates to 50% hedged for the full year. Based on the January 20 forward curve, we now estimate our first quarter fuel price to be in the $3.25 to $3.35 per gallon range, up $0.25 from our previous guidance and our full year 2023 fuel price to be in the $2.90 to $3 per gallon range, up $0.05 from our previous guidance.

Our first quarter guidance includes $0.16 of hedging gains and a hedging premium expense of $0.06 per gallon. We recently added to our 2024 fuel hedge portfolio and are now 39% hedged with a fair market value of nearly $561 million in total for 2023 and 2024. We will continue to seek cost-effective opportunities to expand our hedging portfolio in 2024 with the goal to get to roughly 50% hedging protection. Moving to our non-fuel cost. We experienced a significant cost increase in fourth quarter primarily as a result of the December operational disruptions, including a lower capacity from the flight cancellations. The year over three-year negative impact to fourth quarter CASM, excluding special items, fuel and profit sharing, our CASM-X was 23 points.

In addition to the impact from lower ASM, the majority of this headwind was driven by the estimated redemption value of rapid reward points offered to customers impacted as a gesture of goodwill and travel expense reimbursements to customers. There was also premium pay and additional compensation for employees, but that made up a much smaller portion of the 23-point CASM-X impact. Excluding the impact from the operational disruptions, our fourth quarter CASM-X was roughly 4 points higher than the high end of our previous guidance range of up 14% to 18% compared with fourth quarter 2019. This was primarily due to additional labor accruals at year-end. As a reminder, we have been accruing for all open labor contracts since April 1, 2022, and these accruals are dynamic as we continuously evaluate market compensation.

Looking forward, we continue to experience year-over-year inflationary cost pressures as well as cost headwinds due to operating at suboptimal productivity levels. We now estimate first quarter CASM-X to increase in the range of 2% to 4% year-over-year, which is approximately 2 points higher than our previous guidance of flat to up 2%. This 2-point increase is due to the continuation of premium pay for a portion of January relating to the December operational disruptions as well as an increase in labor accruals for open contracts. For full year 2023, we now estimate CASM-X to decrease in the range of 6% to 8% year-over-year compared with previous guidance of down 1% to 3%. The vast majority of the change in guidance is related to the year-over-year impact from lower fourth quarter 2022 capacity as well as higher fourth quarter 2022 cost attributable to the December 2022 operational disruption.

We have also increased our labor accruals this year, which results in a slight offset year-over-year. Putting aside the effects of the December operational disruptions, we continue to expect our second half 2023 CASM-X trends to improve from first half 2023 year-over-year. Turning to our fleet. We ended 2022 with 770 aircraft, which is net of 26-700 retirements. We received a total of 68 aircraft deliveries from Boeing MAX 8, which was two more than our previous expectation of 66 aircraft. However, we are still short 46 aircraft from the 114 contractually scheduled 2022 MAX deliveries due to Boeing supply chain challenges and the timing of the -7 certification. These 46 orders are reflected as 2023 deliveries in the order book included in our press release this morning.

However, we don't expect to be caught up on MAX deliveries by the end of this year. We continue to expect 100 MAX-8s this year, which remains our planning assumption, and we continue to expect to retire 27 -700 aircraft which will bring our fleet count to 843 at the end of this year. We have also recently exercised options for delivery in 2024, as outlined in our press release. Our full year 2022 CapEx was $3.9 billion, relatively in line with our previous guidance. In regards to our CapEx plans for this year, we continue to estimate spend to be in the range of $4 billion to $4.5 billion, which includes $1.2 billion in non-aircraft capital spending. Bob and Andrew touched on our current thoughts regarding technology spend this year in light of the operational disruption.

But I want to reiterate that we are focused on executing our operational modernization plans outlined at Investor Day, which includes our current expectation to spend approximately $1.3 billion this year, including both capital and recurring spend on technology investments, upgrades and system maintenance. And our total CapEx range should allow for additional CapEx investments as needed. Moving to our balance sheet. We ended the year with cash and short-term investments of $12.3 billion after paying a total of $3.1 billion to retire $2.9 million in principal of debt and finance lease obligations during 2022. This includes the $1.2 billion principal prepayment of our 2023 notes, which leaves a modest $85 million in scheduled debt repayments this year.

Our leverage is at a very manageable 47%, which we expect to decline over the next several years. Our balance sheet remains strong, and we continue to be the only U.S. airline with an investment-grade rating by all three rating agencies. In closing, I am immensely proud of the progress our people made throughout 2022 and their continued resiliency through numerous unexpected challenges. While the last several weeks have been tough, we have not lost sight of the priorities and focus areas that we outlined at Investor Day. In addition to the operational modernization plans we already mentioned, we are eager to wrap up negotiations with all of our open contract labor groups. Although it's disappointing, we expect another loss in first quarter this year due to a carryover revenue drag from the operational disruption, we remain steadfast in our focus to generate consistent quarterly profitability.

And even with the first quarter headwinds, our 2023 plan continues to support solid profits with year-over-year margin expansion for full year 2023. Furthermore, we remain determined to achieve our long-term financial targets to grow our profits, margins and returns while delivering on our commitment to provide outstanding customer service and reliable operations that have been a source of tremendous pride over our 51-year history. And with that, I will turn it over to Ryan.

Ryan Green : Thank you, Tammy. I'll provide a bit more detail on fourth quarter trends and our revenue outlook for first quarter. First, as Bob mentioned, we are very focused on taking care of our customers impacted by the operational disruptions last month. We've sent gestures of goodwill. We processed all bags for return to customers. We processed nearly all customer refunds and have completed more than 80% of the reimbursement requests we've received from customers for reasonable expenses related to alternative transportation. We're processing the remaining requests as quickly as possible and plan to have those largely completed by next week. We will continue working hard every day until all requests are resolved. Turning to our trends.

At our Investor Day in early December, we shared that our fourth quarter revenue outlook remains strong. Leisure revenue trends were strong, both in load factors and yields and for both holiday and nonholiday time periods. Managed business revenues also continue to be strong, and all of that held true right up to the operational disruptions that began on December 21, and we were tracking right in line with our operating revenue guidance to that point. But in the last 10 days of the month, we incurred an estimated $410 million revenue penalty due to the operational disruptions. As the end of December is typically a low demand period for business travel, we experienced less of an impact on business travel trends than with leisure. We still came in at the better end of our managed business revenues fourth quarter guidance range at down 20% compared with fourth quarter of 2019.

And despite the $410 million impact, we still generated record fourth quarter revenues of $6.2 billion and a record passenger yield of $0.177. We saw other positive contributors in the fourth quarter from our loyalty program with fourth quarter records and new co-brand card acquisitions and retail sales. In addition, we benefited from the continuation of increased take rates for upgraded boarding, and our portfolio of new cities and development markets also performed in line with expectations in fourth quarter, absent the event. So in all, there was plenty to be encouraged by in terms of underlying trends in the fourth quarter. We continue to feel good about our 2023 revenue plan. Admittedly, we are starting off first quarter with a $300 million to $350 million headwind, which we assume is attributable to the operational disruptions in December.

However, booking trends have improved sequentially this month, and we believe the vast majority of the first quarter impact is isolated to January and February travel. For March 2023, leisure booking and yield trends appear strong and in line with what we would expect from a high-demand travel month. And based on recent improvements in close-end booking trends, we expect March 2023 managed business revenues to be roughly restored to pre-pandemic 2019 levels. Beyond that, we expect that our GDS and Southwest business initiatives will provide the opportunity to grow managed business revenues sequentially beyond March. So we are optimistic about both the improving sequential trends we're seeing as well as the early read on March bookings. And based on these trends, we currently expect first quarter operating revenues to increase in the range of 20% to 24% year-over-year.

And then finally, while we have limited visibility further out on the booking curve, we continue to see no noticeable signs of a slowdown in macro travel demand and our booking trends. Our commercial focus areas and initiatives that we outlined at Investor Day remain unchanged. We continue to focus on driving value from network restoration, new market maturation, Southwest business and GDS, our new fare product, revenue management system modernization and in-flight customer experience enhancement. In closing, I want to acknowledge that we are mindful that we have a few new headwinds in 2023, both on the revenue and the cost side. And as a result, we will continue to work even harder on our revenue plans and revenue generation this year. Ultimately, we need to offset higher costs, and revenue is part of that equation.

We still believe there is strong demand ahead of us, and we're encouraged by the revenue trends we currently see in March. So with that, I turn it back over to Ryan Martinez.

Ryan Martinez: Thank you, sir. We have analysts queued up for questions. So a quick reminder, to please keep your questions to one and a follow-up if needed. And operator, please go ahead and begin our analyst Q&A.

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