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Edited Transcript of LUV earnings conference call or presentation 24-Oct-19 4:30pm GMT

Q3 2019 Southwest Airlines Co Earnings Call

Dallas Nov 6, 2019 (Thomson StreetEvents) -- Edited Transcript of Southwest Airlines Co earnings conference call or presentation Thursday, October 24, 2019 at 4:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Gary C. Kelly

Southwest Airlines Co. - Chairman & CEO

* Linda B. Rutherford

Southwest Airlines Co. - Senior VP & Chief Communications Officer

* Michael G. Van de Ven

Southwest Airlines Co. - COO

* Ryan Martinez

Southwest Airlines Co. - MD of IR

* Tammy Romo

Southwest Airlines Co. - Executive VP & CFO

* Thomas M. Nealon

Southwest Airlines Co. - President

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Conference Call Participants

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* Catherine Maureen O'Brien

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Duane Thomas Pfennigwerth

Evercore ISI Institutional Equities, Research Division - Senior MD

* Hunter Kent Keay

Wolfe Research, LLC - MD and Senior Analyst of Airlines, Aerospace & Defense

* Jamie Nathaniel Baker

JP Morgan Chase & Co, Research Division - U.S. Airline and Aircraft Leasing Equity Analyst

* Jose Caiado De Sousa

Crédit Suisse AG, Research Division - Research Analyst

* Michael John Linenberg

Deutsche Bank AG, Research Division - MD and Senior Company Research Analyst

* Savanthi Nipunika Syth

Raymond James & Associates, Inc., Research Division - Airlines Analyst

* Alison Sider;The Wall Street Journal

* Dawn Gilbertson;USA Today

* Tracy Rucinski;Reuters

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Presentation

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Operator [1]

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Good day, and welcome to the Southwest Airlines Third Quarter 2019 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. (Operator Instructions)

At this time, I'd like to turn the call over to Mr. Ryan Martinez, Managing Director of Investor Relations. Please go ahead, sir.

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Ryan Martinez, Southwest Airlines Co. - MD of IR [2]

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Thanks, Chad, and thank you all for joining us today. Joining me on the call, we have Gary Kelly, our Chairman and CEO; Mike Van de Ven, our Chief Operating Officer; Tom Nealon, our President; and Tammy Romo, Executive Vice President and CFO.

A few quick notes. We will be making forward-looking statements based on our current expectation of future performance, which could differ from actual results. And we will make reference to 2019 results that compare to the prior year non-GAAP results, which exclude special items. We have more information regarding forward-looking statements and a reconciliation of non-GAAP results in our earnings release from this morning.

Also, given the ongoing MAX groundings, just a reminder that the time lines and current estimations we are sharing today regarding the MAX are based on Boeing's targeted regulatory approval of MAX return to service in fourth quarter 2019. Any changes in current estimations could result in additional adjustments to our flight schedule beyond February 8 as well as further aircraft delivery delays and additional financial damages.

With that, Gary, Mike, Tom and Tammy will provide updates before we open it up for Q&A. So I will turn it over to Gary.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [3]

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Thanks, Ryan, and thank you all for joining us for our third quarter 2019 earnings call. All around, it was an outstanding performance, and I am prouder than ever of our people. We told you last quarter we were going to adjust to the MAX and operate a great airline, and our people did just that. Our customer feedback reflects that. It was just a great performance in terms of reliability and hospitality. So I'm very, very proud and very thankful for our people.

We also told you we will adjust for the MAX and produce satisfactory financial results, and I think we underpromised. These results were stellar. Strong revenues, better cost performance, record earnings. EPS was up 13.9%. And even without the $31 million tax benefit, EPS would have been up over 9%. And of course, our EPS would have been up over 43% were it not for the MAX grounding.

Our operations frontline employees have delivered exceptionally well. I'm going to also give another special shout out to our planners, or as I termed them last time, our replanners who continue to toil through ever-changing scenarios and known as network planning, operations planning, financial planning, just to name a few. They continue to work very long hours and produce amazing results that's just truly heroic.

I talked a lot about the importance of being prepared for the unexpected. As Herb talked, me and really all of us to do, we talked about the importance of low cost, ample cash, low debt levels, sensible growth, sensible capital commitments, but we can never talk too much about the importance of having great and talented employees and a very strong culture. And of course, an element of that culture we call the warrior spirit and their resilience. So we are truly blessed to have such great people.

I want to talk about what's next. In addition to continuing to run a superb airline operation and deliver solid financial results, we want to do a couple of things. We want to conclude our discussions with the Boeing Company regarding compensation for the MAX-related damages. And secondly, we want to safely and methodically return the MAX to service. And regarding the time line of that, the FAA has revealed this week that they received the final software and related system documentation for the MAX from Boeing, and they're in the process of certifying the changes with the certification flight weeks away. While the FAA has been very clear and very careful not to commit to a date working with Boeing, we've assumed an ungrounding date of around mid-December. And that translates to a MAX in-service date for us of February 8 in terms of our flight schedules. So along the way between now and mid-December, if we judge that, that date won't be met, we'll roll our schedule yet again.

So recall that our second quarter assumption was that Boeing delivered by the end of September. So we're about 3 to 4 weeks behind that, which is why we've moved from what was a January 6 date to February 8. So the closer we get, the more confident I am. However, I'm still not highly confident about mid-December. I think Ryan has already made that clear. But what's important, of course, is that we give the FAA the time that they need to do their job, which I know they will. And of course, we're here to support them every way that we can.

Our plans and our outlook for the fourth quarter are very solid. We've got a schedule that's stable, if not optimal. Travel demand continues to be strong. Fuel prices are remarkably stable and moderate. And our cost outlook for everything else is below our original plan.

So we've given you the guidepost for fourth quarter in the press release. And the key to understand here is that we had to redo what turns out to be 9 complex schedules that make up the fourth quarter. And they're complex because of the wide variability caused by the holidays, and we simply didn't have time to redo 9 schedules. So we did one, or in essence, one. And that results in less peak flying than we would otherwise like because we didn't have enough airplanes, and it translates into more nonpeak flying than we would like.

So time has gone by since we've done that. Bookings look pretty darn good for the fourth quarter, and we're more bullish that RASM will be up during the quarter, and we've provided that guidance in maybe as much as 2%. And that's on capacity that is down just slightly versus a year ago.

Regarding next year, we are redoing our plan yet again as we speak. I don't have a capacity forecast for you for the obvious reason other than to say I can't imagine that it will be double-digit growth compared to 2019. And I would also say that more than likely, whatever you guessed it would be based on our July discussions, it's going to be less than that because the return-to-service schedule has pushed out.

So our 2020 market priorities will continue to be Hawaii, which is going extremely well. And based on what we published, so far, we'll have an emphasis on Denver, Baltimore and Houston. And obviously looking forward to having the MAX back so we can restore a lot of depth that is currently missing in a lot of our markets.

So Mike, Tom and Tammy, as always, are going to elaborate further. Those are the highlights. And with that, I'm going to turn it over to our Chief Operating Officer, Mr. Mike Van de Ven, to kick us off. Mike?

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Michael G. Van de Ven, Southwest Airlines Co. - COO [4]

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All right. Well, thanks, Gary, and good morning, everyone. I spend a lot of time talking about the importance of teamwork and especially in our industry where our customers are completely dependent on our people to take good care of them. And our people do take a lot of pride in that. They jumped through all kinds of hoops taking care of our customers and a lot of the MAX groundings throughout the second quarter. And it wasn't until June which finally had the MAX out of the schedule and sufficient numbers per aircraft incorporated in the network. So the third quarter was really the first clean quarter without having to scramble operationally due to the MAX impacts.

As I mentioned in our second quarter call, it was important for us going into the third quarter to deliver the operational reliability, hospitality and efficiency that our customers come to expect from Southwest. And our people were just magnificent. They delivered the best overall operation that Southwest has produced in at least a decade. Our on-time performance was -- for the quarter was 83.4%. That's the best since 2011. We carried 30.5 million bags in the quarter, and 99.6% of those were handled just as they were checked. And that's the best performance in our history. Our customers certainly noticed all of that. 2 out of 3 of them were net promoters of Southwest based on our survey results. That's the highest it's been in 5 years. And again, we're leading the industry with the lowest customer complaint ratio as measured by complaints in the DOT, and we're also leading year-to-date in that measure. So overall, an exceptional operational performance, and we accomplished those results with the lowest amount of aircraft time invested in blocks and turns in the industry.

With respect to our turns, we had a heavy focus in the third quarter on rolling out bag scanning technology. We introduced the scanners, and we trained 10,000-plus ramp agents in all of our domestic locations over a 5-month period. And that effort ended September 30. So that's a foundational investment that's going to help us track our bags with more accuracy, provide more customer service, automate aspects of the weight and balance process and move toward a paperless turn. So we expect this kind of operational reliability to continue. And at this point, in October, our on-time performance and our bag handling is shaping up again to be the best in years. The operation is solid, and our biggest unknown at this point is the MAX return-to-service timing.

And as Gary mentioned, as you all know, we pulled MAX-related flying from our schedules through February 8. We had previously planned for an early November return to fly, and our expectation has slid at least a month. And as Gary mentioned, Boeing did confirm -- reaffirm yesterday that their target was to return the MAX to service in the fourth quarter. And we're in continued conversations with Boeing and the FAA as they complete their various milestones in the process, and we'll get a clearer picture of when the aircraft may be cleared to fly. If we don't have certainty of a mid-December return to service, we'll likely need to push our cancellations out further.

So once the aircraft are cleared to fly, our process to get them back into service is the same as I reported last quarter. It will take 30 to 40 days from the issuance of the airworthiness directive to get our manuals updated, FAA approval and our pilots trained. Our assumption at this point is that the pilot training will be computer-based training and we will not require simulator time. We will be coordinating the work necessary to bring the aircraft back into the operational fleet to correspond to the end of that pilot training period. So Boeing owes us 41 aircraft that we contracted for in 2019 that have yet to be delivered. And we add that to the 34 owned MAXes, and that gives us 75 aircraft of backlog to ingest into the fleet when the grounding is lifted. We believe that we can manage that at a rate of about 5 to 10 airplanes per week, which, if you do the math, implies 2 to 4 months before all of our 2019 and prior MAX aircraft are back into operational service. As Gary mentioned, our main objective in relaunching the MAX is to do it with a high degree of certainty and confidence. It's critical that the schedule and the aircraft availability come together so we avoid the unexpected customer disruptions that we had earlier in the year.

So in closing, I am so grateful to all of our employees. They are the heartbeat of Southwest Airlines. They're the best. The operational results for the third quarter were superb. Our plans to return the MAX to service were well thought out. They're vetted and are coordinated across all of our operating teams. And our focus remains on running a safe, reliable, hospitable and efficient operation. And I think we've got the best team in the industry to do it.

So with that, Tom, over to you.

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Thomas M. Nealon, Southwest Airlines Co. - President [5]

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Okay. Well, thanks, Mike. Good morning, everybody. I'm going to start -- I'm going to pick up right where Mike left off. I also want to echo what Gary and Mike said. We just had a tremendous third quarter operationally, absolutely rock-solid. The service and hospitality was incredible. We're the very top of the industry in terms of our service, and we delivered great financial results. And I really do believe, as Mike and Gary said, this is absolutely because we have incredible people that are just so committed to what Southwest Airlines stands for, so I just want to thank each of you for the great performance.

So with that, let me just jump right into the third quarter. Our RASM growth of 4.2% year-over-year was in line with the guidance we gave on our July earnings call and reaffirmed back in September. Throughout the quarter, we saw continued strength in passenger demand trends. Both leisure and business travel were strong, and we continued to see strong year-over-year passenger yields. We're obviously significantly impacted by the removal of the MAX from our schedules, and the result was that our capacity declined 2.9% in the quarter. We had an awful lot of moving parts. We made a lot of schedule changes because of the MAX. But in spite of this, both our domestic and international processes performed very well -- our businesses performed very well in the quarter. But we did it to make some choices around the timing of network investments on a market-by-market basis. But even with the MAX challenge, we generated record third quarter passenger revenues and record operating revenues as well as record RASM performance.

Our commercial team did an absolutely incredible job of minimizing a good portion of the MAX impact. And as expected, we experienced roughly 2 points of temporary year-over-year RASM benefit for Q3 compared against our original plan before the MAX grounding.

We also had a 0.5 point year-over-year RASM benefit from our new res system and revenue management tools as expected. And we also had a 0.5 point year-over-year RASM tailwind from 2018's suboptimal schedule as well as a 0.5 point tailwind from Flight 1380.

Our other revenues increased 8.6% year-over-year for the quarter. This is primarily due to the continued strong performance of our Rapid Rewards program. And on a year-to-date basis, our other revenue is growing at 11.4%. So we're continuing to see strong growth in spending. Our co-brand credit cards, I think, was really being driven by 2 things. First, our customers tend to keep our credit card top of mind and top of wallet. And I really see this as a function of the real value that our customers get from the program. So they tend to use our card as a primary credit card, which is very important. Second, we're seeing new credit card acquisition growth rates in the double digits on a year-over-year basis. And the acquisition growth rates of our business co-brand cards are even higher. So we're seeing tremendous growth in the size of our credit card portfolio.

Our Rapid Rewards program continues to perform very well, and we are very pleased with the structure and the economics of our program as well as with our Chase relationship. The view of the program is simplicity and the value that it brings to our customers. No seat restrictions, no blackout dates, it's easy to earn, it's easy to redeem points. So there's really value to our customers, and they love it, which is why it's an award-winning program year after year after year. So our loyalty program is hitting on all cylinders, and we couldn't be more happy with where we are.

And my last point on Q3, as I'm sure most of you have seen by now, we did announce in early August our plan to expand into the global distribution systems, or GDSs, with new agreements with Travelport and Amadeus. And we'll have the highest level of GDS participation with industry-standard capabilities, which will make it easier for travel management companies and corporate travel managers to do business with Southwest. And this opens up a whole new pool of corporate customers that we haven't had access to through our current distribution platforms. And I also think it's important to note that the vast majority of domestic business travel is booked as coach travel, which we happen to be pretty good at.

Our product has a lot of distinct advantages that business travelers and corporate travel managers truly value such as low fares; a strong network with high frequencies; roughly 75% of our customers fly nonstop; no fees for changes to itineraries, which, by the way, that's a big deal for business travelers, spend a lot of money; and no bag fees; a great loyalty program and so on and so on. So we have a great product for the business traveler. But the GDS channel is a channel where we've never truly competed. But as you expect, once we do go live in this channel, we intend to compete very hard to win the business traveler.

We are targeting to have our GDS capabilities up and running by mid-2020, and we expect initial ramp-up will contribute $10 million to $20 million of EBIT contribution for the second half of 2020. Initial revenue impact is very modest. We also know there's a big opportunity to grow this piece of our business substantially over the next several years. So we're building out our technology literally as I speak. And we're also well into the build-out of our Southwest business sales team and our business-to-business service capabilities.

So at the end of the day, Southwest will have strength in 3 business-to-business distribution channels: first, self-service through our new SWABIZ platform, which is largely targeted at small and medium companies; second, direct connect distribution to the ATPCO exchange platform; and third, our full-function GDS capabilities, which will go live, as I said, in mid-2020. So a lot to come on this, and we'll talk about this more going forward.

So that's it for Q3. Let's jump into Q4. So from a flight schedule perspective, we've been very focused on maintaining the integrity and the strength of our network in spite of the fact that we have significantly fewer aircraft than originally planned. And that phrase is not just a throwaway phrase. When I say we want to maintain the integrity and strength of our network, what it means is we want to maintain the depth and frequency of service to key markets. It means we want to maintain our high degree of point-to-point direct flying. It also means we want to maintain our high-quality connecting itineraries. And I think our network planning team, as Gary alluded to, has just done an incredible job of adjusting and republishing and republishing our schedules multiple times. And to a very large extent, they've done just that. They've maintained the integrity and strength of our network throughout the process.

The same to be said for our revenue management team. They've done an equally incredible job of managing the revenue environment. In the second and third quarters, they were successful in offsetting the yield dilution on the MAX-related rebooking of customers.

Now in terms of the removal of MAX flights in the fourth quarter, we've had our work cut out for us. We'll have a 68-aircraft deficit by year-end, which is double the number of MAX aircraft we grounded in mid-March. And as you know, Q4 always has the most complex set of schedules simply because of the seasonality and the peak versus offpeak nature of the quarter.

Our working assumption as we were building these schedules months ago was that the MAX will be back in service for all of fourth quarter. So that was our base assumption. And based on that, we published 9 separate flight schedules covering the November and December time frames, and these were very well optimized for the holiday and nonholiday time periods.

The reality of today versus our base schedule assumptions are quite different, and the result is that our flight schedule adjustments in Q4 are very unique set of challenges in comparison to what we were solving to in Q2 and Q3. So we're now solving to a deficit of 68 aircraft in a highly seasonal period.

Most practical approach for us was to revise our published schedules in such a way as to smooth our flying during the fourth quarter versus our original plan of optimizing around peaks and troughs. A net effect is you'll have less flying once optimal during peak, and that's due to lack of aircraft, and more flying once optimal during the nonpeak periods simply to ensure the connectivity between the flight schedules. This is not ideal. It's certainly not an optimized schedule. But it does satisfy the 3 important criteria that we center on as a team. And those are, first, we want to minimize any disruption to our customers during the holiday travel. Second, we need to ensure that we had a schedule that was operationally feasible and as efficient as possible. And third, we wanted to contain and minimize the impact on operating income. So again, this isn't optimal. We have been able to achieve these objectives, maintain the quality of our product and our operation while producing strong financial results.

The estimated fourth quarter revenue penalty from the MAX grounding is expected to be greater than the third quarter, and that simply because we have more MAX aircraft built into the original plan. And unlike Q3 where we had a 2-point temporary RASM benefit during -- due to the MAX, we expect any fourth quarter RASM benefit to be immaterial. The 2 or 3 points of estimated RASM benefit from removal of MAX flights will be offset by the RASM drag from the unoptimized schedule revisions in the slightly higher offpeak flying.

But that being said, our fourth quarter base business trends continue to be very solid. We are continuing to see healthy leisure and business travel demand. That's across the booking curve. And we're expecting a solid fourth quarter RASM performance year-over-year in the range of flat to up 2%. All in, and with our fourth quarter RASM outlook, this puts us well above our 2019 RASM growth goal in excess of 3%. And all things considered, that's a result that we are very proud of.

Just a few other things. I'm sure that you saw we recently implemented system-wide $5 one-way fare increase. And based on where we are in the booking curve for the fourth quarter, I think this likely helps 2020 more than it will the remainder of this year. But we do continue to see solid demand across the booking curve, and we do believe the revenue environment continues to support yield momentum and yield strength.

And just a few quick comments on Hawaii. With the recent announcements of more Hawaii flights, we'll now be up to 12 daily California to Hawaii flights, and we'll also have 34 daily interisland flights. The demand for our service to Hawaii continues to be very, very strong, and our load factors continue to exceed our system average. The demand for our interisland service is also very strong, and this also includes a very strong mix of local customers, which we're thrilled about. Our brand and customer experience scores continue to perform above our total system Net Promoter Score. And that's true for both our long-haul flights to and from Hawaii as well as for our interisland flights.

As far as our status on beginning service from originally announced California cities, we still have San Diego left to connect, and we'll do that in the near future. And we're planning for additional flights in 2020 to continue building off our initial success.

So looking forward to 2020, we obviously still have some uncertainty related to the MAX return-to-service date. And Mike and I are very close on this. And as he said, once we can return the aircraft to service, we will be focused on a measured ramp-up of the MAX aircraft. And we're anxious to get the ASMs back to the schedule in a smart way as we begin to restore and grow our network. We will not restore every flight that we removed due to the MAX grounding, but we'll certainly want to restore the vast majority of our network, which we expect to produce favorable results almost immediately.

You can see from our flight schedules published through mid-April that we are very focused on continued investment in Baltimore, Denver, Houston, California and Hawaii. And beyond these cities, we have a very long list of attractive growth opportunities, and we will be focused on strengthening our depth and frequencies between strong nonstop city pairs. Next week, we'll be publishing our next set of schedules that take us out through June 6. So stay tuned for that.

So with that, I'm going to pass it over to Tammy.

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [6]

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Thank you, Tom. And my thanks to everyone for joining us today. We had another solid quarter of earnings and EPS growth, along with margin expansion, which is notable considering the extraordinary challenges resulting from the grounding of the MAX. I am very grateful for the incredible resiliency and hard work of our employees and extremely proud of how our Southwest family rallied together to produce strong results despite an unanticipated 6 to 6.5 point reduction on our capacity this year due to the MAX.

Gary, Mike and Tom outlined most of the challenging -- the challenges we're managing through. So I will round out our remarks with commentary on our cost performance, fleet and capacity plans and balance sheet and cash flow, including the related MAX impact.

Turning first to our nonfuel cost performance. The largest driver of the 7.6% year-over-year increase in our third quarter CASM, excluding fuel and profit sharing, or CASM-Ex, was an estimated 6 to 7 point impact from the MAX groundings and resulting flight cancellations. Our third quarter year-over-year capacity growth was approximately 8 points lower versus our plan, which will also be the case in fourth quarter. Excluding the MAX-related unit cost pressure, the remaining modest year-over-year increase was driven largely by increases in salary, wages and benefits as well as maintenance expense. While these cost pressures were anticipated, we did come in favorable to our latest guidance of 8% to 10%.

In addition to good cost control across the board, we saw cost efficiencies and labor costs related to the strong operational and on-time performance that Mike covered earlier. We also received some favorable airport settlements during third quarter as well as lower-than-expected airport rate increases. Overall, I'd like to commend our employees for executing our cost plan to keep us on target this year, excluding the significant year-over-year unit cost pressure from MAX-related flight cancellations.

We started the year expecting fourth quarter 2019 CASM-Ex to decrease around 2% year-over-year. We've had about 1 point of year-over-year CASM-Ex shifting from earlier period into fourth quarter, and we are expecting a fourth quarter unit cost penalty from the MAX groundings to be approximately 6 points. Therefore, we now expect our fourth quarter 2019 CASM-Ex to increase in the 4% to 6% range year-over-year.

The key drivers year-over-year are increases in salary, wages and benefits, maintenance expense and airport costs. It is worth noting that we have taken actions this year to mitigate what impacts we could, including on the cost side. As I've said previously, our fourth quarter capacity is about 8 points lower than it would have been absent the MAX groundings. However, we expect that we will be able to offset about 2 to 3 points of unit cost inflation due to the benefits from higher offpeak flying in fourth quarter, which nets us to our 6-point penalty. We will continue to focus on these areas to lessen the unit cost penalties, but despite our best efforts, the impact to our overall unit cost inflation in fourth quarter continues to be significant.

Looking at our full year nonfuel costs. We currently expect CASM-Ex to increase approximately 8% year-over-year. With some unit cost mitigation in fourth quarter, the MAX groundings are now expected to drive 5 points of year-over-year inflation to full year 2019, slightly better than we previously estimated. And again, our employees have done an incredible job executing on our plan to control cost pressures.

Excluding the impact of the MAX groundings to our 2019 costs, our core year-over-year unit cost performance is in line with our original plan to keep CASM-Ex inflation to 3% to 3.5% for 2019. And that includes factoring in the incremental $10 million of maintenance expense to keep 7 of the 737-700 aircraft that we were going to retire as well as the $42 million bonus for our mechanics, both of which occurred after our initial 3 to 3.5 point unit cost guide back in January.

A quick note on first quarter 2020. We expect continued year-over-year unit cost inflation due to the level of fixed costs we carry regardless of the depressed capacity from the MAX grounding currently out to February 8, 2020, and as we gradually ramp back up. In addition, we estimate incremental return-to-service costs in the tens of millions next year.

Moving on to fuel. Our third quarter fuel price was $2.07 per gallon, near the lower end of our guidance range. Market energy prices spiked following the Saudi Arabia oil attack around the time of our mid-September 8-K update and then moderated in the second half of September. The recent volatility in the energy market served as a reminder of the importance of having meaningful insurance with our fuel hedge program. We are approximately 65% hedged for fourth quarter 2019. For 2020, we are nearly 60% hedged. For 2021, we are around 50%. And we have been adding to our 2022 hedging position, putting us at around 25% protection.

For fourth quarter 2019, based on market prices as of October 18, we expect our fuel price to again be in the range of $2.05 to $2.15 per gallon. The fourth quarter crude oil forward curve is slightly lower than third quarter, but fourth quarter heating oil cracks are currently estimated to increase around 20% sequentially.

Our fuel efficiency continues to be significantly impacted by the MAX groundings. We came into 2019 expecting a solid year-over-year improvement in fuel efficiency largely driven by the operating performance of the MAX aircraft, which is expected to produce a 20% fuel burn improvement over our retired Classic fleet and a 14% improvement over our next-generation or NG fleet.

Third quarter ASMs per gallon declined 0.9% year-over-year, and fourth quarter ASMs per gallon are also expected to decline year-over-year in the range of down 1% to 2%. Once the MAX returns to service, we expect to reverse this trend and get back on track with our fuel efficiency improvement goals.

Wrapping up the income statement. As you read in the highlights of our press release, we did record a $31 million reduction to income tax expense late in the quarter, which related to a clarification of regulations that allowed an increase to the amount of tax bonus depreciation relating to our 2017 tax return when the rate was 35%. This represented $0.05 per share that was not factored into our previous guidance. Even excluding the tax adjustments, this quarter was a solid beat to expectations.

Now turning to fleet and capacity. We have not taken delivery of any aircraft since the MAX groundings in mid-March. We retired one 737 aircraft during the third quarter to end the quarter with 752 total aircraft. We haven't officially updated our contractual delivery schedule with Boeing at this point, which continues to reflect 44 total MAX deliveries this year, with 41 remaining as of the mid-March grounding.

Based on Boeing's targeted regulatory approval of MAX return to service in fourth quarter 2019, Boeing has proposed a revised MAX delivery schedule that has us receiving 7 MAX aircraft during fourth quarter 2019. That would result in the remaining 34 MAX deliveries shifting out of 2019 and into 2020.

We continue to expect to retire 10 more 737-700s this year for a total of 11 versus our original retirement plan of 18. We postponed the retirement of 7 of our own -700s to help with our 2019 aircraft deficit. Assuming 7 aircraft deliveries in fourth quarter 2019 and netting out our 11 retirements this year, we expect to end 2019 with a total fleet of 749 aircraft.

For 2020, based on Boeing's targeted return-to-service time line, we expect to be back on our aircraft delivery schedule around mid-2020. This would result in 72 MAX deliveries in 2020, and we currently expect to retire 20 to 25 of our 737-700 aircraft next year, resulting in a total fleet of approximately 800 aircraft by year-end 2020.

Our third quarter available seat miles declined 2.9% year-over-year. For fourth quarter 2019, we expect our capacity to decline in the range of 0.5% to 1%, which would put our full year 2019 capacity down approximately 1.5% year-over-year.

With ongoing uncertainty of the MAX return-to-service date, we are not ready to provide annual 2020 capacity guidance at this point. We have published flight schedules through April 13, 2020, which includes the removal of the MAX through February 8. And based on those published schedules, we currently expect first quarter 2020 capacity to increase in the 2% to 3% range year-over-year.

Now turning to the balance sheet and cash flow. We ended the quarter with very healthy cash and short-term investment of approximately $4 billion. Our cash balance is higher than usual as we haven't been making aircraft delivery payments since mid-March. Due to a lower number of expected aircraft deliveries in fourth quarter 2019, we now expect our 2019 CapEx to be in the range of $1.1 billion to $1.2 billion with aircraft-related CapEx of approximately $300 million.

Our 2019 aircraft CapEx is down approximately $700 million from our original CapEx plan, which will shift to 2020 assuming our aircraft delivery delays are caught up next year. As a result of the MAX groundings, we've incurred a $435 million operating income penalty year-to-date. Still, our cash flow generation has been very strong.

For the first 9 months of 2019, we generated $3.2 billion in operating cash flow and $2.4 billion in free cash flow with $1.45 billion of share repurchases and $372 million in dividend. Our current $500 million accelerated share repurchase program wraps up next week, and we have $1.9 billion remaining on our current share repurchase authorization.

In closing, I'd like to extend another huge thank you to all of our employees. Despite the significant impact from the MAX groundings on our operations and financial results, we generated record operating revenue, record RASM and record net income and earnings per share in third quarter. Our margins and returns on capital were solid, considering a 2-, 3-point impact to each from the MAX grounding. Absent the impacts, we would have expanded margins even further and grown returns in third quarter year-over-year. Our balance sheet and cash flows remain very strong, and we continue to provide meaningful returns to shareholders.

Overall, I am pleased with our strong financial results this quarter, and I'm very happy with the execution this year, especially considering the $435 million year-to-date operating income penalty from the MAX grounding and resulting flight cancellations.

Excluding the MAX impact thus far on a unit basis, we remain on track to achieve our unit revenue and unit cost goal for this year. This is simply outstanding and a true testament to the unwavering fortitude and true grit of our Southwest family.

All in all, we have a lot to be proud of, and we are eager to get the MAX back in service and resume our growth once the FAA deems it's safe to do so.

With that, Chad, I'll turn it back to you now to take analyst questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes today from Duane Pfennigwerth with Evercore ISI.

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Duane Thomas Pfennigwerth, Evercore ISI Institutional Equities, Research Division - Senior MD [2]

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Appreciate all the uncertainty around next year, but based on what you just outlined, if we assume you hit your stride by the third quarter, is low-teens growth in the ballpark of what your plan would be?

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [3]

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Low -- give me a number. Give me like...

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Duane Thomas Pfennigwerth, Evercore ISI Institutional Equities, Research Division - Senior MD [4]

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13%, 14%.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [5]

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No. No, I -- we'd be below 10% easily. Do you agree, Tammy?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [6]

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Yes.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [7]

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You're talking about for the year or for the quarter, Duane?

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Duane Thomas Pfennigwerth, Evercore ISI Institutional Equities, Research Division - Senior MD [8]

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For the third quarter, for the back half essentially, yes.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [9]

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Oh, I don't have a number in my mind. But what do you think?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [10]

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It's premature. Yes, it's just premature. And yes, we're not prepared, Duane, to give you capacity guidance at this point for all the obvious reasons. I'd be happy to kind of walk you through kind of how we're thinking about the full year 2020. But...

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [11]

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Well, I would just say, we -- I think Tammy and Mike have both said that -- Mike is assuming 5 to 10 airplanes a week. I don't know whether we can do that or not. I mean this has never been done before. It's just not a routine thing. And we don't have -- we're in the midst of updating our plan for next year to take the MAX off of January 6 return to service and don't have a plan yet for February 8. And to be honest with you, we're just going to wait a little while here and see if that's realistic before we go to yet more work to do that only to throw that away and do yet another plan.

So I think all I was trying to help you with earlier is to say that we'll be something less than 10% for the year, and we'll judge the rate of return based on several factors. I don't want us to pay for airplanes and then have them sit. So some of this we'll have to just work out with Boeing. But we've said we can restore the fleet between 2 and 4 months, but I think there's a lot of assumptions in that and especially you look at the way things have gone. So we're dependent upon our people, Boeing and the FAA to return each airplane to service. And there's just -- I'm just admitting to everyone that there's uncertainty with regard to exactly how that's going to get done.

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Duane Thomas Pfennigwerth, Evercore ISI Institutional Equities, Research Division - Senior MD [12]

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All very fair. I agree with your comments and your praise for your planning and your replanning teams. Can you talk a little bit about how the network response evolved from the initial shock to the system with the grounding and maybe here to the fourth quarter? It feels like initially, you were giving up all sorts of traffic. And over time, it feels like you figured out how to retain your highest-quality traffic, and maybe the share that you're giving up is pretty low quality in nature. I would appreciate your thoughts.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [13]

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Well, Tom, do you want to make a comment on that first?

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Thomas M. Nealon, Southwest Airlines Co. - President [14]

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Yes. I think we've been -- I'm looking for a note here, actually took them for myself. But we've been pretty diligent about trying to trim out some of the longer-haul flying where we can. And we've put -- we haven't taken it all out, by the way. We've taken some out. And what that allows us to do is put connecting traffic in, so we're maintaining the presence in the markets. We're trying to seasonalize a little bit. We pulled some out of the international, just as an example. And what you're seeing is -- us do is invest in more short- to medium-haul flying. In fact, you look at what we just published. You're seeing Denver and Baltimore, a little bit in Houston, you're seeing more short- and medium-haul flying. We're getting just a lot of aircraft utilization, and that's pretty high-quality flying. And it's really being directed toward city pairs that are very strong for us. So I think we're doing a pretty good job of optimizing the network given what we have to work with right now.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [15]

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Yes. And I think -- Duane, I think your idea there is a decent one. In other words, I don't think it would be correct to assume that we have lost share on 100% of our system. I agree with your logic there. Without studying a little bit more sort of market by market, I'm reluctant to just readily agree that there's a large percentage where we haven't lost because I do have a sense that even where we've been able to sustain frequencies in markets, that there may be a shift between locals and connects and because -- I agree with Tom. We've taken long-haul segments out and have tried to serve those city pairs on a one-stop basis.

And so I just -- it's just more complicated than that. But we've at least been able to sustain for the most part as an entity our short-haul routes, our medium-haul routes. We've shaved some long haul in international, which Tom mentioned. So it's not across-the-board. But still, we're not happy with the fact that we're 8 points below where our capacity would have been. And clearly, we're temporarily losing some share, which we don't like. And we've heard our competitors, which they're right to do, share that they have picked up some traffic as a consequence.

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Operator [16]

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The next question comes from Hunter Keay with Wolfe Research.

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Hunter Kent Keay, Wolfe Research, LLC - MD and Senior Analyst of Airlines, Aerospace & Defense [17]

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I've got 2 questions on the same topic. What are the gating term -- gating items for getting your fares on Sabre? And how much of an incremental pretax income should we expect if you're able to come to terms with them?

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Thomas M. Nealon, Southwest Airlines Co. - President [18]

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Well, what are the gating issues with Sabre? Well, we've worked with Sabre for a long time. We know Sabre pretty well. They know us pretty well. And obviously, they're the largest U.S. GDS player, so they're important. And we certainly -- you're right. It would be crazy not to talk to them as we're going through this. But very simply, we just weren't able to get to commercial terms with Sabre, which was unfortunate. But I'm thrilled we have 2 very good partners in Travelport and Amadeus. And there are a lot of corporate customers out there, I guarantee you, who want access to Southwest's content, and they'll be able to get it through those 2. So where things go with Sabre, I do not know. We've got a good plan and a good set of partners in place right now. So...

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Hunter Kent Keay, Wolfe Research, LLC - MD and Senior Analyst of Airlines, Aerospace & Defense [19]

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Okay. Tom, and to that, you said there's a lot of corporates that want your product that have TMCs that book through Sabre. But what about the TMCs themselves? And how willing are you to play in the commission game if the TMCs are not going to be swayed simply by your product alone?

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Thomas M. Nealon, Southwest Airlines Co. - President [20]

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Well, TMC -- thank you for the question, Hunter. I think the -- first of all, we will be paying our segment fees as we should expect in a GDS, and we're competitive there. Our pricing, I think, is competitive. I don't think it's best in industry, but I think it does what we need it to do. I think that part of the play with the TMCs is on the customer side, the customers are going to be asking for that content. So I think the strength is not just what we think of our product, but I think the strength is what the travel managers think of our product and what the travelers think of the product. I think that's going to be a pull to get the TMCs showing the Southwest content.

And by the way, to be honest with you, historically, we have not spent a lot of time with TMCs. We just haven't had to. We didn't. So we are out there right now with our sales team and we just -- in fact, we had a pretty big group in this past week or 2 weeks ago. And we're starting to work with, with the TMCs and with the travel managers, and there's a real pull for the Southwest content. I guess that's what I can tell you.

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Operator [21]

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The next question comes from Jamie Baker with JPMorgan.

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Jamie Nathaniel Baker, JP Morgan Chase & Co, Research Division - U.S. Airline and Aircraft Leasing Equity Analyst [22]

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So Tammy, given the current return to service assumption, the 5 to 10 aircraft a week, getting back to sort of hitting your fleet stride by midyear, it sounds like ex-fuel CASM challenges are going to persist fairly materially in the first half of next year. How confident should we be that those pressures don't subsequently bleed into the second half as well?

It just feels like -- RASM takes a hit as soon as the additional capacity picks up, but cost relief is stickier. And the market's assumption is that you're going to experience material ex-fuel costs relief next year. But given what you've said about the first quarter, the return to service guidance, I'm not convinced that ex-fuel CASM really improves that much. Thoughts?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [23]

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Yes, sure. Well, we're obviously going to work really hard to mitigate any costs as we return the MAX to service here, and we'll just have to remain nimble and adjust as we need to. What -- as you said and what we do know at this point is that we do expect to have a ramp-up unit cost penalty in the first half of 2020. And while we do -- while we'll do what we can to mitigate the financial impact, the penalties are significant and certainly grow as the fleet deficit grows.

Of course, our discussions with Boeing are ongoing in that regard. But our long-term unit cost target remains unchanged, and that's to keep our annual unit cost growth, excluding fuel and oil expense and profit sharing, to below 2%. So we haven't lost sight of that goal. And while there likely to be some inefficiencies as we focus on the safe return of the MAX to service in the short term, we'll be laser-focused on achieving our long-term cost goals.

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Jamie Nathaniel Baker, JP Morgan Chase & Co, Research Division - U.S. Airline and Aircraft Leasing Equity Analyst [24]

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Can you put any numbers on first half or second half ex-fuel CASM?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [25]

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It is, honestly, just too early to do that. We don't even have a return to service plan. So I just think it's just premature to do that. Obviously, once we have more certainty around return to service, we'll come back and walk you through and give you as much guidance as we can. But as we've all said, we want to have a measured approach to bring the MAX into service, and we've got a lot of objectives that we're balancing here. And certainly, hitting our financial targets is one of those objectives.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [26]

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Jamie, I think the issue is the timing of achieving the spirit of what you're asking. So I think we're all reluctant to say, yes, third quarter is going to be really clean. We just don't know. But I think once we get to the point where we are clean, that yes, I think that the parameters that you're thinking about, without getting specific, yet, it makes sense to us. We just don't know when that's going to be.

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Jamie Nathaniel Baker, JP Morgan Chase & Co, Research Division - U.S. Airline and Aircraft Leasing Equity Analyst [27]

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Got it. And Gary, for my second question, I saw the headline story on CNBC before, Board looking at a second fleet type. You can obviously achieve that in 1 of 2 ways. You can go get in line for deliveries and start from scratch, or you can buy an existing fleet and immediately get scale with the aircraft albeit with some other baggage that inherently accompanies consolidation.

So is it safe to assume that if the Board is debating a second fleet type, as you've said today, it's also debating consolidation? Or is it somehow possible to divorce those 2 topics? Because in my mind, they're highly intertwined.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [28]

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Well, you're a brilliant mind. So I do think that they are potentially intertwined, but they can also be disaggregated. I think it just depends on how one wants to think about it, but I'll just give you a straight answer. We're -- as I did say earlier, we are focused on 2 fundamental things. We're focused on settling up with Boeing, and we're focused on getting the MAX back into service. The comment that I made about evaluating the question in a single fleet type is -- that's not new news. I've shared that before. And we've done it, and then they also asked me, "Well, what would Herb do?" And I know what Herb did do because we did this. We looked at it very carefully on several occasions.

Mike led that effort as late as 2011 when we agreed to launch the MAX. We gave a very serious look to an alternative. So I was simply sharing that if -- and people do -- there are people that do have this question, is it time for us to look at the question? Yes. Not now, but next year, maybe the following year. It is time to look at that question yet again. I wouldn't prejudge the answer at all. We've been extremely successful for 48 years with a single fleet type. I know that our Vice President of Flight Operations would agree it certainly makes for a more reliable and arguably safer operation when we have the expertise that we do in this airplane. So there are plenty of good arguments for just -- I really feel like it's just acknowledging the obvious, and I feel like we have a duty to look at the question and especially in light of what's going on right now.

So hopefully, that answers part of the question. As -- to say today, understanding that -- we're not entertaining this question today. So to say today, does that make us enthused about consolidation for that reason? Absolutely not. It's irrelevant. It's -- because that is -- in that sense, they are 2 different questions. If we got to the point where we said we want a second fleet type, then I would admit, you would -- you might want to think that through in terms of that is a means to get to a second fleet type.

But I would quickly add -- and that all I'm doing is repeating our AirTran experience. Just because we buy another airplane doesn't mean that Southwest instantly has the capability to operate it. So regardless of the path that we do -- that we go through with that hypothetical, we would still, in Mike's shop, with technology support have to construct the capability to operate a second fleet type. And that would all have to be factored into whether we think that's the right priority. So those are all really complex questions and not anything that we are thinking about or talking about at this point in time.

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Jamie Nathaniel Baker, JP Morgan Chase & Co, Research Division - U.S. Airline and Aircraft Leasing Equity Analyst [29]

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Okay. That's very, very helpful. And thank you for the kind words by the way. I hope that means I'm off the hook for having misspelled Southwest a couple quarters ago.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [30]

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No, we -- Herb always said he had Irish Alzheimer's, which means he always carried the grudge. So...

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Operator [31]

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The next question comes from Michael Linenberg with Deutsche Bank.

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Michael John Linenberg, Deutsche Bank AG, Research Division - MD and Senior Company Research Analyst [32]

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Question here on I think, Tom, you mentioned about some of the growth you would be focused on: Denver, Baltimore and Houston. And it does seem like on one hand, you're maybe targeting the markets of a particular competitor, but I suspect that those markets or those airports are a focus because you can get gates there. And I'm just curious if that is what's driving that decision on one hand. And then as we look out, are there other airports that are key to Southwest where you do see additional gates coming on maybe over the next 12 to 18 months.

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Thomas M. Nealon, Southwest Airlines Co. - President [33]

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I think that your comment about we're going after the airports where the competition is, like I said, I think we're looking at this strictly from when you look at the proximity of where Denver is, where Baltimore is, where Houston is and how they fit with our network, our intent is to really begin to use these as cornerstones, if you will, and drive more connectivity and tighten up the spider web of our point-to-point network. And that's what's driving it. Now there is a competitive response in all those, by the way, so that's part of it as well. But this is really primarily about strengthening the core of the network.

And I do think that there's value to us in adding in more medium and short-haul flying. In conjunction, we're not moving away from long haul at all. In fact, the MAX 8 is a great long-haul aircraft. But with more medium flying in and out of Denver, Houston, Baltimore, it really does give you much greater number of itineraries. It gives you greater operational reliability and recovery, and it's just a really efficient network structure for us. So I think we're just building out our core point-to-point network is what you're seeing. Nashville is another one that you see us growing quite a bit. So that's kind of how I'm thinking about it.

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Michael John Linenberg, Deutsche Bank AG, Research Division - MD and Senior Company Research Analyst [34]

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Okay. And then anything on as it relates to infrastructure as we look out maybe over the next 12 to 18 months, airports that you do that are key to you where you do see gates coming on where you're currently constrained?

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Thomas M. Nealon, Southwest Airlines Co. - President [35]

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Well, there seems to be -- we're -- we seem to be constrained in many places. In California, we have many constraints obviously. Denver, we have capacity coming on. It's a ways out. Mike or Gary, you guys want to jump in here?

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [36]

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Well, Mike, yes, I think you probably know what the culprits are. So I don't know that we have anything new to share on that point today but -- except to agree with you that they are constraints. Fortunately, we have a vast enough array of opportunities to grow that we can work around them. And then in the cases where at least the constraint can be remediated, we're working on those. But LAX is a prime topic, and we're very desirous of adding 9 more gates through what is envisioned as Terminal 1E and we just don't have a time line with LAWA yet. So that's one that's well underway but still could be out there before there's a solution. I hope not. Obviously, we'd love to have that capacity.

And the only thing I was going to quickly just underscore what Tom's answer is we're seeing a return of demand in short-haul markets which obviously we have a real strength in. We have limited aircraft resources, and right now we have more of a focus, both in 2019 and in 2020, in addressing that. So it's -- and you see evidence of that with the fact that we trimmed a lot of long-haul flights because of the MAX here. So it's not to say that we don't like long-haul flights. It's more to say that we -- we're short of capacity and will be for quite some time. And we can at least address those O&D city payers on a one-stop basis. But if we don't put the flights into the short-haul markets, you're -- it's the obvious. You're not serving that market. So good news is we've got a lot of opportunities and -- the not as good news is we don't have enough airplanes, but hope to remedy that here soon.

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Operator [37]

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The next question comes from Savi Syth with Raymond James.

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Savanthi Nipunika Syth, Raymond James & Associates, Inc., Research Division - Airlines Analyst [38]

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Just, Tammy, I was wondering if you could help us understand -- I appreciate just how difficult next year's planning is right now. But I was wondering if you could help us understand just some of the bigger cost items that were pressures this year ex-MAX. How do those trend into next year? Should we be thinking about like the airport cost, the maintenance cost? Just generally, how do you think they should be trending into next year?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [39]

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Yes, sure, Savi. I'll give you a little bit of color here. Just really going into next year, the biggest penalty here starting at least in January and that will continue until we get the MAX return to service is related to the grounding of the MAX. Outside of that, I feel pretty good about our cost structure. We do have ongoing maintenance cost pressures and just our normal inflationary cost pressures with salary, wages and benefits. And outside of that, we are always looking to balance our technology spend and make sure that any spend or investments that we make obviously have benefits to come along with that.

So as we kind of think past the MAX, we -- we've got a lot of initiatives underway, and I feel really good about the efforts that we have. One obviously is our fleet modernization plans, and that's been halted here obviously with the MAX grounding. But certainly, once we get the MAX back on track, we'll be able to see the benefits there and certainly on the fuel efficiency side as I noted earlier. So just looking past the MAX, I really feel good about where we are. But as always, that always takes hard work and -- but our people are up to that, so I'm confident we'll deliver there. So -- and again, I'll just kind of point you back to our long-term goal is to maintain inflation CASM-Ex sub-2%.

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Savanthi Nipunika Syth, Raymond James & Associates, Inc., Research Division - Airlines Analyst [40]

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That's helpful, Tammy. Is that kind of sub-2%, does that include kind of any kind of upcoming labor deals as well where you'd kind of target that, again, excluding the MAX.

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [41]

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Yes, thanks for asking that, Savi. Yes, we incorporate labor cost into that in all of our cost pressures. And one cost pressure I didn't mention simply because we, I think, we alluded to that earlier is airport cost pressures. So that's one cost pressure that we'll continue to have to work hard over the longer term to control.

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Savanthi Nipunika Syth, Raymond James & Associates, Inc., Research Division - Airlines Analyst [42]

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Great. And if I might just ask a quick clarification question on the growth if I think about next year. Is Hawaii still kind of a large part of kind of next year's growth assuming you can grow as you want to grow? Or how should we think about kind of the composition if you can do what you want to do?

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Thomas M. Nealon, Southwest Airlines Co. - President [43]

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Well, just to keep in perspective, Hawaii, there's a lot of hoopla around Hawaii. We're pretty excited about Hawaii. It's a very, very modest portion of our network. It's like less -- it's about a point of our network. So yes, we're going to continue to invest, and we're off to a great start. We want to continue to build on momentum. But even if we were to -- I'm not sure exactly given what our status of our plan for next year is, but it's not going to be a massive portion of our capacity. It's just not -- you will see focus on California. As I said, California, Denver, Baltimore, Houston. Hawaii, we're going to stay committed to. We're absolutely committed to Hawaii, by the way. If anyone wants to know if we're going to back off Hawaii, absolutely not. We've opened 5 stations in Hawaii. They're performing really well. So we're not backing off it. We may have to pace it a little bit depending upon the MAX. But Hawaii is going to be a focus, but it's going to be a relatively modest piece of our capacity I think.

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Operator [44]

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The next question comes from Catie O'Brien with Goldman Sachs.

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Catherine Maureen O'Brien, Goldman Sachs Group Inc., Research Division - Equity Analyst [45]

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So not to keep harping on the cost outlook here, but I guess just if I think about your 2% to 3% capacity forecast for the first quarter and then just think about -- if I assume that CASM growth is just linear with cost growth, that would get me to -- based on what you're planning to do in the fourth quarter here, that would get me to a first quarter CASM-Ex of around 3% all else equal. I guess just starting there, what are the puts and takes that would -- that I should be thinking about to get me away from that number?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [46]

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Yes. So just looking ahead to the first -- kind of going into the first quarter?

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Catherine Maureen O'Brien, Goldman Sachs Group Inc., Research Division - Equity Analyst [47]

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That's correct.

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [48]

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Yes. So just to make a few points on the first quarter, and I think this will help address your question. So excuse me if I'm a little bit redundant. But keep in mind, we've got the schedules out through first quarter 2020. And at this point, the MAX is canceled through February 8. So I just want to point out that we do have some conservatism built into our February schedule. We -- and again, all this is contingent upon the deliveries of how those resume from Boeing.

But based on what they've indicated, they are targeting here in the fourth quarter, we would expect to have around 50 MAX aircraft in our fleet at the beginning of February. And that, of course, includes the 34 MAX 8s that are currently grounded. Yet, we'll only have 30 MAX aircraft worth flying for sale in our February 2020 schedule. And that ramps to 65 aircraft in our March schedule. And as you all know, there's strong demand, and we have pent-up demand here at Southwest. So we'll want to ramp up prudently, but we certainly want to ramp up as quickly as we can to utilize our assets and to absorb some of the cost pressure that we're obviously experiencing here in the fourth quarter.

So currently, the largest step-up of aircraft coming back into service is from the seasonally off-peak February time period into March. And that's how we met to the current first quarter capacity number that you mentioned, which is up 2% to 3% year-over-year. And -- but most importantly, we'll want to be measured and deliberate in the way we introduce that MAX aircraft safely back into service. But all of these planning assumptions change if we have to extend our flight cancellations further. So hopefully, you can appreciate how difficult it is to announce -- nail down a solid plan and cost guidance for even this environment.

But all that said, we're focused on delivering solid results and focused on mitigating those cost pressures as much as we can. And of course, as always, our goal would be to have positive RASM in the first quarter. So we're looking to balance all of that.

So we'll have to manage our flight cancellation impacts of the schedule very carefully as each time period has its own set of unique challenges. But again, based on the current environment, I feel pretty good that we can do that.

So we expect the year-over-year unit cost penalty to continue, and we'll face those headwinds as we ramp back up. But we'll -- as we get past the MAX, the penalties that we've shared to you throughout the year, we would expect those to reverse and turn into a tailwind next year once we get past the return to service and we're back up to our normal capacity plans. So that was a long-winded answer, but that's -- I just wanted to give you a little bit of color so that you can appreciate how difficult it is for us to nail down cost guidance.

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Catherine Maureen O'Brien, Goldman Sachs Group Inc., Research Division - Equity Analyst [49]

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Yes. No, definitely, a lot of moving pieces here and it seems like an ever moving target on this return date. So really appreciate all the work you guys and the employees there have had to do.

I guess just maybe one quick follow-up to that question and then one more. So I guess is there -- and again, as I just said, I really appreciate all the moving pieces here, but I guess, is there anything that we should think about as we go into the first quarter that would either prevent costs from improving on a linear basis or help costs improve even more than that, just in terms of -- I know there are return to service costs or some good guys maybe we're forgetting about from earlier this year that will create a tailwind? And then just on non-aircraft CapEx, how should we think about that next year and going forward? I know you got a lot of irons in the fire on the technology front.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [50]

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Tammy, let me jump in here. I think there's way too much focus on the first quarter with your question. The cost performance here in the third and the fourth quarter looks really good to me. And so I feel like we'll be able to continue managing as best we can. The issue is a numerator and a denominator. There is unabsorbed overhead. And until we get the airplanes flying, you're going to have that cost penalty rolling forward, and especially compared to a year ago. That's number one.

Number two, is it is not linear. So what Mike has to do if we're going to ramp up our flying, he has to hire in advance. So it is actually front-loaded. And now the question becomes a judgment on our part about how much we front-load. And to be honest with you, we don't know yet. We don't know how many pipes -- people we're going to hire at what point in the first quarter. What Mike is trying to do is, he's got 2 chances here, he can hit the peak for spring break or we'll miss that and then we'll try to hit the peak, and I'm talking about flying, and then we'll try to hit the peak flying for, say, June. And so we just don't know how it will ramp up yet. I think we'll get much more visibility over the next 30 days. But we'll still have to continue to make a judgment about whether we're even going to hit this February 8 date.

So I think -- I know you want a number. I think basically, what we're trying to do is make sure that we don't waste money here until we get back to something that is more manageable. But until we get there, and this is just the honest truth, it will be messy, and we don't -- and we're not in total control. We're not in control of what Boeing can do. We're not in control of what the FAA can do to support our return to service. That's all assuming that we do -- we're on a path returning to service at that point.

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Catherine Maureen O'Brien, Goldman Sachs Group Inc., Research Division - Equity Analyst [51]

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Understood. Apologize for the short-term nature of that question. And then just maybe, Tammy, on the non-aircraft CapEx, any comments there?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [52]

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Yes. Sure. And just to add one more comment on the cost, because I can't help myself, is we are tallying up all those damages, and obviously, have ongoing discussions with Boeing. Yes. And on the non-CapEx, aircraft CapEx, 2019 is roughly in the $800 million range and -- so that -- I'm not expecting a significant departure from that for next year. But as we've said many times, we just have it wrapped up, our plan, for all the obvious reasons. And once we do, we'll come back and give you more precision around what we're doing next year.

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Operator [53]

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We have time for one more question. We'll take our last question from Joe Caiado with Credit Suisse.

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Jose Caiado De Sousa, Crédit Suisse AG, Research Division - Research Analyst [54]

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Gary and Tom, you've teased us with some new revenue initiatives that you have in the pipe for 2020. It sounds like summer are getting ready for prime time like the corporate travel initiative that Tom walked through in great detail. Appreciate that. Are there any other of these revenue initiatives for 2020 that are getting ready for prime time that you might kind of share with us today?

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [55]

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Well, no, not today. I think that GDS is the big one that's in the pipe for 2020. There's lots of work going on right now for -- there's a pretty rich revenue initiative pipeline, and we're just not going to take you through it. So -- I wish I could, as I'm pretty excited about it, but we're just going to pace it out. These are all -- they are kind of sequenced in such a way one builds upon the other in terms of the technology foundation. So it's not you can just throw these all up there at one time. They are very -- it's a very additive kind of process. But GDS is a big foundational piece for us, and we're going to put that in, and then we have more that follows subsequent to that. But I think we have really great pipeline, just not going to talk about it today.

The other thing is, what's interesting for us next year is there's a lot of capacity that's on the sideline that's going to return at some point. And so I think we've made clear that we're not just going to put back in what we took out. So there's an opportunity there to optimize. And Tom answered a question earlier about Hawaii. I -- Tom, I don't think with what we're going to add back next year, there's that much development flying. I think it's -- and that's sort of the -- to reemphasize, it sounds boring perhaps to you all, but adding to Denver, adding to BWI, adding to Houston should generate strong returns quickly. And that's part of our strategy for next year. It is a great revenue idea. It's not new, but it is what is -- what I wouldn't discount too much is the fact that we've taken the network. We've taken some capacity out. Now we're going to reoptimize that network, we're forced to, but we're trying to do it in a way that it produces a superior product. And I'm really excited about that.

So whether -- we'll just have to get out and play the game and see how good that turns out. But I'm -- the emphasis on the short-haul markets, which are very core for Southwest, emphasis on still retaining a presence in longer haul O&D markets and maybe on a one-stop basis, I'm pretty excited about all of that.

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Jose Caiado De Sousa, Crédit Suisse AG, Research Division - Research Analyst [56]

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Okay. Great. And maybe just a very quick follow-up for Tammy. Clarification question, really. The incremental cost sort of associated with the return to service, explicitly associated with the return to service, are you going to include those in your 2020 CASM-Ex guidance when you do provide that? Or are you going to exclude them and adjust them out?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [57]

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We would include that.

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Ryan Martinez, Southwest Airlines Co. - MD of IR [58]

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Okay. Great. Well, that wraps up the analyst portion of our call. And as always, if you have any follow-up questions, please feel free to give me a ring. So thank you all for joining.

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Operator [59]

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Thank you. Ladies and gentlemen, we will now begin our media portion of today's call. I'd like to first introduce Ms. Linda Rutherford, Senior Vice President and Chief Communications Officer.

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Linda B. Rutherford, Southwest Airlines Co. - Senior VP & Chief Communications Officer [60]

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Thank you, Chad. I would like to welcome members of the media to our call today. And we can go ahead and get started with our Q&A session. Chad, if you'll just give them instructions on how to queue up.

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Operator [61]

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(Operator Instructions) Our first question will come from Alison Sider with The Wall Street Journal.

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Alison Sider;The Wall Street Journal, [62]

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Just to ask quickly about the fleet diversification review. And this sounds a little bit like more of a formal process than the ongoing kind of kicking the tires that you described in the past. Is that right? And what kind of factors or metrics we'll be looking at as part of this review?

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [63]

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Alison, I'd say yes and no. In terms of the literal looking at different airplane -- it's no different than what we've ever done. The only thing that we will -- that we're -- I feel we are obligated to do is just debate the wisdom strategically of having a sole source vendor in one fleet type. That is different. I don't know that we've ever focused on it with that kind of intensity. And I don't want to prejudge the answer to that. They are -- but they are 2 different questions. You can say we'd love to have a separate fleet type, but when we look at it, it just may be economically and operationally infeasible. And vice versa, we may find that even without the strategic necessity of having 2, we may discover, I doubt it, but we may discover that it is better to have 2 airplanes economically and operationally. So all of that will need to be thought through. But again, it just addresses the question of -- the obvious question, and we post it and our Board agrees with it, and we'll study it at the right time. I've said next year, and I don't feel that, that is a deadline, by the way. But it's mainly to make clear that with the questions that we've had so far on that topic, we've made clear we are not thinking about that right now. We're not working on it. It is not an issue. We have 2 things (inaudible) that's settling up with Boeing and getting the MAX return to service. That is our focus.

And as you can tell from listening, there's a tremendous amount of work involved running the airline in the meantime with the uncertainty of when it comes back. So at the right point in time, we'll take a look at that. And as I tried to make clear this morning, that's not new news. We've said that months ago that we would maintain these things as our priority and that we would look at that question later.

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Alison Sider;The Wall Street Journal, [64]

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And if I could ask one more. One of your employees, Mark Forkner's focus of the DOJ and congressional investigation for his role in developing the MAX. And some messages from when he was at Boeing suggesting he may have detected some issues with MCAS or unintentionally misled regulators. Do you have any concerns about those messages or concerns with him working at FAA or MAX issues now that he is at Southwest?

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [65]

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Well, those are clearly issues unrelated to his Southwest employment. And so that -- all of that investigation will have to run its course. And so it has nothing to do as far as I am aware with his employment at Southwest. By all accounts, he's a very fine man and does a fine job for us.

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Operator [66]

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The next question comes from Tracy Rucinski with Reuters.

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Tracy Rucinski;Reuters, [67]

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I was wondering what your internal research and bookings past February 8 are telling you about customers' willingness to fly the MAX? And to what extent that sentiment is playing into your planning for putting the aircraft back into your network?

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Thomas M. Nealon, Southwest Airlines Co. - President [68]

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Okay, this is Tom. I'll be glad to take that question. It's a good question. Yes, obviously, this is something that's getting media nearly every day, so the consumers are very, very aware obviously. I think what I'd say is we do expect there to be some uneasiness in the early days of the aircraft's return to service. It's very natural, and you expect that it's natural given the nature of the situation, just how much attention has been focused on by the media. Having said that, though, we've been doing research every -- very frequently, since this thing has come -- has happened in March, rolling bands of research, if you will. And what we're finding is that there's very little difference originally versus what we're hearing today, so what we're arguing is this, Southwest has a very, very strong reputation of being a safe flying to -- a safe airline to fly. They have confidence in Southwest and they trust us, number one.

We're also very consistently hearing that a majority of customers, not just our customers, but travelers do not expect to change their flying behavior based on aircraft type, and that's an interesting learning, which has also been very consistent. There are some travelers, though, who are saying, and it is a minority, who are saying that they'll have -- they'll be looking for a different aircraft when they fly and they may try and avoid the MAX for a month or 3 months or 6 months, but that is a minority. But based on what we're listening to and hearing from our customers, we feel like we have a pretty good understanding and we have to figure out how do you begin to insert that into what do you plan financially from a business standpoint in terms of a book away phenomenon? So we're still working through that, but we are sensing as that the customers really are -- they will come back. Our core customers are very confident and loyal to Southwest. So we feel pretty good about that.

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Tracy Rucinski;Reuters, [69]

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And can you give us a little sense, so when you said that there isn't much difference from originally versus today, can you -- and you talked about a minority, can you give us a little bit more color on what that looks like in percentage terms?

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Thomas M. Nealon, Southwest Airlines Co. - President [70]

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Well, now I'm not sure I have all the specific facts in my head. But I think the majority -- I think it's kind of a super majority, actually, all right? So I'm not going to give you a precise number, but it is a super majority who are saying this is not that big of an issue for me, I'm not going to change my flying behavior. I think it's in the high 60s, 70s, very significant. So I'm not going to do justice by trying to give you all these little factoids. But it is a minority. It's a real minority as opposed to almost 50-50.

But we feel good. Our customers feel very -- yes, they're uneasy just like everyone else. They want to see the aircraft fly, they want to be sure it's safe, but they really do have confidence in the way we're going to bring this back into service.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [71]

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And Tom may have mentioned this, but the other thing to note or maybe repeat is that when we survey our customers, do you trust Southwest? The trust factor is extremely high, and higher than our competitors, quite frankly. So I think that all of this -- all of the research we've done suggests that time will address this. So the airplane comes back into service, it performs well, and I think most people answered the question by saying, well, I won't fly it for 6 months for those who deselect flying it, or I might not fly it for 12 months. And so I think we feel that the research supports and our history supports and our judgment would say that, that will be short-lived.

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Thomas M. Nealon, Southwest Airlines Co. - President [72]

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Now, one just a little factoid that kind of helps validate what Gary's last comment was, was our customers do have the ability to see what aircraft they're flying. And you might think that given all the news on the MAX and all this stuff going on, that there would be a higher propensity to be checking, am I on one of those aircraft or not, and it's like less than a single-digit. It's actually less than 1%. So I just don't think people are really as focused on it as we are being in the industry. I think this is going to -- this will take care of itself, I think.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [73]

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Right. In other words, we're taking bookings for the MAX now. It's in our schedule. It's in our schedule as of February the 8th, and there's nothing abnormal. We're seeing no booking patterns.

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Thomas M. Nealon, Southwest Airlines Co. - President [74]

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We see no [book away].

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Operator [75]

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At this time, we'll take the last question that we have, and that is from Dawn Gilbertson with the USA Today.

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Dawn Gilbertson;USA Today, [76]

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Two questions, unrelated. The first on the MAX. Gary or Tammy or somebody, can you give us an update on where you are in the negotiations with Boeing for -- is there any timetable there for recovering damages?

And my second question has to do with fees. I'm wondering if you can give us an update on year-to-date EarlyBird revenue and Upgraded Boarding and whether you might be considering any changes there to the fees.

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Gary C. Kelly, Southwest Airlines Co. - Chairman & CEO [77]

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Well, Tammy is leading the -- she'll be working on your second question. She's leading a couple of negotiations for us, but she's working -- and she and Mike are working together with Boeing, but Tammy has got the lead on it. And yes, I'm impatient on that. I'm anxious for that to get wrapped up. So no, I can't give you a time line other than to say it's a major objective of ours -- of mine, and I want that wrapped up quickly.

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [78]

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And on EarlyBird, I have the fourth quarter numbers, which would be helpful kind of as you think about annualizing that maybe going forward. We had very strong EarlyBird performance in the fourth quarter. And in the fourth quarter alone, that was probably $112 million, $113 million. And our Upgraded Boarding was about $20 million, both is up significantly from the prior year. And our third quarter was up about 19%. So we're running on well over $100 million with respect to EarlyBird. So it's been a tremendous success and, obviously, a very popular product for our customers.

And I have a year-to-date number for you, it just took us a minute to pull it, it was $342 million year-to-date.

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Dawn Gilbertson;USA Today, [79]

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For EarlyBird or both of those?

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Tammy Romo, Southwest Airlines Co. - Executive VP & CFO [80]

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It's for EarlyBird.

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Operator [81]

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All right. This includes our question-and-answer session. I would like to turn the conference back over to Ms. Rutherford for any closing remarks.

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Linda B. Rutherford, Southwest Airlines Co. - Senior VP & Chief Communications Officer [82]

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Thank you very much. If you all have any other questions or inquiries, you can contact our communications group, (214) 792-4847 or you can send an inquiry through our online newsroom at www.swamedia.com. Thank you.

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Operator [83]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.