Southwest kicked off the 3Q reporting season with the three little words that have now become painfully familiar in airline executive suites – excluding special items. Isn’t that like saying close but no cigar? Certainly, judging from headlines, that is how financial reporters see it.

CEO Gary Kelly would not agree since he pointedly declared the airline made a profit as he opened yesterday’s investor call. “After many adjustments to this most challenging of revenue environments, I am obviously very happy to report a profit for the third quarter,” he said. “Excluding special items, we reported a modest profit of $23 million which was $0.03 a share but like a lot of hard-fought gains, that number doesn’t tell the story. But regardless a profit is a profit and in this terrible environment, we’ll certainly take it.”

Contrast with the lead in yesterday’s press release: “Net loss for third quarter 2009 was $16 million, or $.02 loss per diluted share, compared to a net loss of $120 million, or $.16 loss per diluted share, for third quarter 2008. Third quarter 2009 results included special items (net of profit sharing and taxes) consisting of a charge of $27 million relating to the company's early-out program and a net loss of $12 million, relating to non-cash, mark-to-market and other items associated with a portion of the company's fuel hedge portfolio. Excluding special items, third quarter 2009 net income was $23 million, or $.03 per diluted share, compared to $69 million, or $.09 per diluted share, for third quarter 2008. The third quarter 2009 net income, excluding special items, exceeded Thomson's First Call's mean estimate of $.02 per diluted share.”

Lest you think this belittles the industry’s, and Southwest’s, progress, the point should be made that Southwest narrowed its loss remarkably and beat analyst estimates for the quarter. It is likely that its report hints at similar statements from other airlines especially regarding ancillary revenues, cost initiatives and fuel volatility. Another theme likely to echo Southwest, is the modest fare increases that has captured so much press attention this week.

Southwest’s increased revenue per passenger about 1% in October compared to the year-ago period, although it had slipped in the third quarter by 2.2%. In addition, in the first increase since January, revenue was up 3% in September over the year-ago period.

"A number of revenue initiatives were planned for 2009," Kelly said. "First and foremost, through our sophisticated aircraft schedule optimization process, approximately 10 percent of our flights were eliminated from our system over the last year, which were unprofitable and less popular flights. We made the decision to keep our fleet essentially flat in 2009, to be prepared for weak travel demand. Even so, we produced available capacity through optimization efforts that was redeployed during the last year to substantial new markets: Minneapolis/St. Paul, New York LaGuardia and Boston Logan. These large markets fit well within our expansive route system, and have achieved instant success. We look forward to adding Milwaukee next month."

CFO Laura Wright pointed to this year’s initiatives including excess bag, pet and unaccompanied-minor fees which brought in $10 million. The flight-schedule optimization added more than $100 million to the to its bottom line “These increases were offset by less charter revenue and business partner income,” she said, adding the airline expects positive trends in other revenues to improve in the fourth quarter.

Kelly pointed out that load factor gains, at 11% in September compared to September 2008, were on leisure travelers reacting to fare sales over the summer. "Favorable year-over-year, load-factor comparisons are continuing thus far in October, with month-to-date passenger unit revenues up approximately 1% from the respective year-ago period," he said.

He added advanced bookings for the fourth quarter are good but still, the fare mix prompted the carrier to keep capacity flat next year removing aircraft as new aircraft are delivered. The airline cut capacity 5% this year with sharp reductions this month, which dropped capacity 10% from the year-ago period. Another 8% will come out in November and 6% in December.

“Full fare demand remains weak," said Wright pointing out that full-fare passengers were down significantly from 24% in the 2008 third quarter to 17% this year. "Still, our revenue trends continue to significantly outperform the industry, which is strong evidence that our revenue initiatives are working."

Kelly pointed out fuel remained volatile, something that can be expected to be repeated by all carriers reporting over the next week. "I don't believe the worst is behind us if for no other reason because of higher energy costs," Kelly said. “There is no evidence of any significant change in business travel demand to help bail us out. But we're going to continue to work vigorously on implementing more new revenue initiatives and, of course, as always, do all we can to control our cost and look no further than the improvement in our productivity in the third quarter yet again. I think the results speak for themselves. We are leading the industry in customer satisfaction according to many sources and not the least of which is the U.S. Department of Transportation."

Wright discussed the carrier’s cost initiatives and, significantly, pointed out that airport costs continued under intense pressure, echoing recent press reports about high airport fees becoming a deciding factor in whether to serve a point.
“Turning to our cost performance, excluding the charges associated with the early-out program and the related profit sharing impact, our third quarter unit costs decreased 1.9%, largely due to the significant year-over-year decrease in fuel costs,” she said. “Our economic fuel costs decreased 17.4% to $2.13 per gallon. However, the year-over-year fuel cost decline is relative when you consider how extraordinarily high the energy market was this time last year. In fact, fuel prices remain very volatile and significantly above historical levels, currently around $75 a barrel. Based on our current cost trends and our fourth quarter capacity plans, we currently estimate our fourth quarter 2009 unit costs excluding fuel to be in the $0.075 range.

Legacies Expect Huge Losses
The entire US industry is to be commended for its sacrifice and discipline since fuel spiked in the first half of last year. Internationally, some legacies have only just started the painful sacrifice this year feeling the twin bites of the recession and increasing competition from low-cost carriers. Still, the continuing crisis cannot be understated as industry 3Q losses are rolled out over the coming weeks. Collectively, the legacies are expected to lose about $1 billion. JetBlue and AirTran expect to make money this quarter and it is likely that the regionals will follow as the strongest of the segment has shown consistently.

The investor calls have become all too familiar as analysts try to shake the snow out of their crystal snow globes by questioning the esoteric minutiae of airline operations. The big items over the next week will be the rise of ancillary revenues and it is interesting to note that Southwest sees more opportunities for raising money through fees without going to first and second bag fees. Certainly, the airline crowed about two of its recent initiatives – Early Bird Check-in, which contributed $2 million in the quarter, and Business Select, which remained unaffected by Early Bird and netted $15 million. It also maintains it is gaining traction from its no-fee zone campaign the bounce can be as much as 2-3%.
“I think the low-fare brand in particular is a very, very strong based on not only the numerical result that you see but also based on all the constant surveying that we are doing with our customers,” said Kelly, pointing to its aggressive advertising touting the policy. “The good news is that that play is working for us and it appears that it will continue for the foreseeable future but certainly there is no visibility much beyond December that you can count on. But right now the bookings for October/November/December, at least what we have in place, are quite good and again, no doubt at lower fares than a year ago.”

He said that while the airline is gathering more empirical evidence as to the impact of its no-fee zone, its assumptions are largely anecdotal. “The hardest fact that we have, in addition to just the change in our revenue production versus our competitors, is the awareness among our customers and non-customers that we don’t charge for the first two bags is huge and so we know that we are getting credit for the fact that we are not charging bag.”

However, Pilot and Airline Financial Analyst Bob Herbst disputes this in his latest analysis published Wednesday at Seeking Alpha. His charts through September show, compared to American and Continental, Southwest did not have a market share increase as the two mainline carriers added on baggage fees. A third chart illustrates load factor for the last eight months and shows Southwest’s load factor oscillated just as they did for Continental and American.

“There is no evidence to show Southwest’s competitors lost passenger traffic as they increased add-on baggage fees,” said Herbst. “The real question should be how many hundreds of millions of dollars is Southwest giving up by not joining the crowd? Southwest typically gets credit for being more of an industry leader than a follower. This time, Southwest needs to do some catching up.”

He went on to scotch rumors that the year-over-year drop in operating revenues has anything to do with ancillary revenues. “The fact is, all airlines have had a drop in revenue including SWA,” he said. “Legacy carrier revenue has also been pressured lower by large reductions in international yields and historically weak demand for the premium/business fares. For those not aware, the third quarter of last year had the highest average air fares in history. As the recession moved full steam ahead into 2009, passenger/traffic demand fell off a cliff. Typical to the industry, in order to entice passengers, airlines reduced fares. The simple fact is the year-over-year drop in revenue has occurred because fewer people were willing to fly at the higher fares and not because of baggage fees.”

Kelly, however, told analysts yesterday he doubted that adding first and second bag fees, which netted millions for the legacy carriers, would be helpful. “We’ve argued this analytically and we know that if we increase fares we are going to see a drop off in traffic,” he said. “I don’t think it’s a reach at all to suggest that we are getting 2% or 3% of our customers because we are not charging for bags and a little number of a big number is a big number. We have done surveys that would suggest that if we start charging bags that a fair percentage of our customers would change their behavior. That is all theoretical, of course, but its well beyond 2% or 3% that say they would react differently if we were to start charging for the first bag.”

He also pointed out that the company expects to raise $40 million this year from excess baggage fees. "It's been our view that we're at worst neutral by not charging the bag fee, and we believe that we're ahead of the game by getting more customers by not charging the bag fee."

Worldwide, as delegates at the World Low Cost Airlines Congress heard recently, fees are approaching 15% of revenues and could go higher. Indeed, the European low-cost carriers, too, indicated there was more to be had through fees but cautioned that, should they approach 50%, regulations would be in the offing. Related Story

"There are substantial ancillary revenue opportunities besides bag fees that we are continuing to pursue," said Kelly, citing plans for an enhanced Rapid Rewards program, and southwest.com, the functionality of which has improved, as well as its international code shares with WestJet and Volare.

Kelly agreed with European low-cost operators that fees should reflect increased services rather than charging for services that had once been part of the ticket price. "We would much prefer to explore opportunities to provide more service to customers and give them the choice to spend more money with Southwest Airlines," he said, noting the difference between such programs which are voluntary compared to baggage fees, which we said were not really voluntary. "Our frequent-flier program and Southwest.com both position us well to pursue that strategy."