15 (Elliott Management Update #2, Casey Murray, Hank Ketchum, Erich Schnitzler)

Today's SWAPA Number is 15. That is the size of the expanded Southwest Airlines Board of Directors, Now that Rakesh Gangwal, a familiar name to those in our ranks with US Air history was added to the board.

Two weeks ago, we released a SWAPA Number podcast about Elliot Investment Management's initial 12% equity position in Southwest. But it's been a busy couple of weeks with several headlines, so today, we're back in the studio with SWAPA President Casey Murray, 2nd Vice President, Hank Ketchum, as well as Economic and Financial Analysis Committee Chair, Erich Schnitzler to continue our discussions on the latest developments. 

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Transcript

Tony Mulhare (00:03):

Today's SWAPA number is 15. That is the size of the expanded Southwest Airlines Board of Directors now that Rakesh Gangwal, a familiar name to those in our ranks with US Air History, was added to the board.

Matt McCants (00:16):

Two weeks ago, we released a SWAPA Number podcast about Elliott Investment Management's initial 12% equity position in Southwest. But it's been a busy couple of weeks with several headlines, so today we're back in the studio with SWAPA President Casey Murray, 2nd Vice President, Hank Ketchum, as well as Economic and Financial Analysis Committee Chair Erich Schnitzler to continue our discussions on the latest developments.

Tony Mulhare (00:53):

I'm Tony Mulhare.

Matt McCants (00:54):

And I'm Matt McCants.

Tony Mulhare (00:56):

And here's our conversation with Case, Hank and Erich.

(01:04):

Case, let's start with a quick status check. Can you update the membership on our interactions with the company and with EIM lately?

Casey Murray (01:11):

Yeah. So last week Southwest announced a new board member and several days prior to that, they announced the poison pill. Elliott did reach out and gave us a foreshadowing of their letter that they were going to post, which they did in response to both of those actions by the company. So that was good to have the interaction. We have a meeting coming up later today on Monday, July 15th with Elliott in Dallas. They're bringing their team and we'll have our core team in Dallas with them as well. So that's kind of where we're at and the continuing dialogue is good and so we're looking forward to the meeting and see where we go from there.

Tony Mulhare (01:47):

And how would you characterize those interactions? Have they been collaborative? Are they just telling us what they're doing or are they just providing real general broad brush information?

Casey Murray (01:56):

No, they've been very forthcoming to our questions, which is refreshing and I've said it before that they aren't a friend of labor and that's okay. It's not their job. And I've said that exact statement on the last podcast. But they are deeply involved in the analysis of Southwest, which we drilled down on in our first meeting with them and they had done their homework. So it is collaborative as far as they're asking for some input as well. They're also laying out their plans a little bit more in depth and in each time we meet with them, we get a little more information. And so it's good to continue the dialogue. That's something that they've committed to and they've been very forthcoming and actually very prompt in reaching out anytime there is a development

Tony Mulhare (02:40):

Case, what is communication with Southwest Management like at this point? Are they open to hearing solutions and ideas from SWAPA? Is there any collaboration there or are they continuing to treat SWAPA as just a junior partner?

Casey Murray (02:54):

I think Southwest has made it clear that we are a junior partner at best, and I've used the word before, but disdain at the worst. And let me give you a couple examples. We have highly NDAed Section One compliance meetings. We also have our schedule analytics team meets with network planning and coming out of those, and they're all highly NDAed. But coming out of those, we have seen time and time again where we will have a meeting, they won't be open with us about where they're at, and they literally on multiple occasions have made announcements the very next day. So coming out of a network planning meeting, and we're not told about schedule reductions, we're not told about closing cities. And so it's very hard to really feel that there is any type of collaboration.

(03:43):

So I wanted to give specific examples as to why they treat us at times not as a partner. They have an airline to run and we have an airline to analyze. We're not running the airline nor do we want to. But through the calls and the numerous alarm bells that have gone off over the past numerous years, whether it's infrastructure, whether it's IT, whether it's processes, whether it's the revenue issue, there has been just little taking of our input and they're actually at where they're at today and Elliott is here for a specific reason.

Tony Mulhare (04:16):

Okay, gentlemen, let's review. We watched the media take off with the announcement of a poison pill two weeks ago. As the SWA Board of Directors begins to maneuver to protect itself, what can you tell us about the specifics of a poison pill and in this case, how does that work?

Hank Ketchum (04:32):

Well, a poison pill is designed to stop a hostile takeover, really something that was used and developed back in the 1980s. We haven't seen poison pills deployed recently, or at least Elliott hasn't in the last 10 years in one of their campaigns. The poison pill that Southwest developed has a few elements to it. So on July 15th, they'll issue a special dividend, which contains one right for every shareholder that owns one share of Southwest stock. With that one right, if there was ever a triggering event, the triggering event being 12.5%. So if an investor or group were to acquire 12.5% or more of the common shares, then that trigger would be in place. And then if you have a right, you will have the ability to buy one share of Southwest stock at basically half the price of the current market value of the shares. So what that does is it's dilutive, it obviously floods the market with additional shares of Southwest stock, and then it makes it very expensive for the acquiring entity to continue on that path. So we've never seen though a poison pill actually triggered in corporate America.

Tony Mulhare (05:44):

We know that EIM had a negative reaction to that, the letter that they put out. What else have we seen across Wall Street and amongst shareholders?

Erich Schnitzler (05:52):

Well, Wall Street generally frowns on these type of strategies just because they give the perception of a management that doesn't want to change. And they've used the term insular management, that's not open to change. And it just gives the idea that they're not welcome to other ideas or outside influences.

Tony Mulhare (06:15):

And how does an activist investor respond to one of these poison pills? What moves or counters are they likely to make and do they even need to?

Hank Ketchum (06:22):

The move that they'll likely make, and really the only one that's in the playbook because they can't acquire more shares above that 12.5% without being costly, very prohibitive. Once they get over 10% in place, which they say they have the 11%, they can then call a special shareholder meeting and engage in a proxy fight. So that's the way you can actually overturn a poison pill is if you successfully execute a proxy fight, you achieve your goal of overturning the current board of directors, putting a new board in place, that new board can then throw out the poison pill.

(07:00):

The other option that they have of course, would be to negotiate directly with the board of directors and be able to come to an agreement as to what changes they could make through those negotiations.

Erich Schnitzler (07:13):

I do want to point out we don't know what economic interest Elliott holds right now. We know that they've stated they have 10% or greater, but we're not sure at this point if it's common shares or other various combinations of financial instruments. But we assume that as you spoke of, if we get to that point where there's some sort of a proxy fight or a determination for a special board meeting, at that point, we would know that they have 10% or more of the actual common shares.

Casey Murray (07:43):

I think it's interesting that I think everybody is now on the same page, whether you're Elliott, whether you're the company, whether you're Wall Street, whether you're SWAPA, that change is needed and Southwest has acknowledged the revenue issues, some of our technological issues, infrastructure, and that's a good thing. There is going to be change. There's a difference I think, of opinion amongst all parties, whether you're an analyst on Wall Street, whether you're Elliott, whether you're the company, whether you're us on how that actually takes place. But it is good to see that Southwest has been prodded a little bit into making some fundamental changes to address our lagging revenue and our lagging initiatives.

Matt McCants (08:24):

So we mentioned in our blast last week that back in '22, Twitter adopted a shareholder rights plan as well as an attempt to fend off Elon Musk. That attempt failed. Is there any parallel to draw in our situation with EIM right now?

Erich Schnitzler (08:38):

Well, just looking at that particular acquisition, Elon Musk announced the acquisition, they instituted a poison pill, which then he kind of went around by negotiating directly with the board. They accepted his offer. There was some legal maneuvering actually when he tried to get out of the deal. But eventually later on that year in 2022, the fall of 2022, he ended up making the purchase. So in that respect, the poison pill didn't have any effect on the eventual outcome of his purchasing Twitter.

Matt McCants (09:12):

So shortly after the poison pill positioning came about the follow-Up news this past week was that Southwest was adding Rakesh Gangwal to its board of directors. What do we know about his background and history?

Erich Schnitzler (09:23):

Well, he has a long history in the airline industry. He started in the 1980s. He was actually a protege of Stephen Wolfe. He followed Stephen Wolfe to all the companies there in the 80s and 90s that he worked at. Started at United, went to Air France and ended up at US Airways in the late 1990s. He was there from '98 to 2001 as the CEO and President and then left shortly after 9/11 in November of 2001.

Matt McCants (09:53):

And what is he doing now?

Erich Schnitzler (09:55):

After US Air, he went to a company called Worldspan, CEO. It's a technology company. And then from there, co-founded Indigo in 2006 where he has been all the way up until just recently where he most recently he disengaged himself from the active participation at Indigo. But Indigo is now one of the largest airlines in India and patterned somewhat after Southwest.

Matt McCants (10:22):

Now, a lot of the membership might not be too familiar with Indigo. How are they doing operationally

Erich Schnitzler (10:27):

Pretty well from all accounts. Again, they're the largest airline in India and fourth largest I think in market cap of all the airlines in the world right now. So done well financially and again, have surpassed all other airlines in India in terms of size and passengers carried.

Tony Mulhare (10:46):

So what might be the strategy from the board of directors to add someone with that background?

Erich Schnitzler (10:52):

Well, he brings a long history of airline experience, particularly the United States, and he agrees with the strategic direction of Southwest and what they've planned going forward.

Hank Ketchum (11:02):

They also cited his expertise in travel technology and that being valuable to Southwest Airlines.

Tony Mulhare (11:08):

What was EIM's evaluation of that move?

Hank Ketchum (11:12):

EIM's approach and what it's been from their initial slide deck that they put up on the internet and then their follow on letter, they are looking to make a large change at Southwest in terms of the board members in that composition. So EIM and how they would look to a selection like that is that's a board member that's going to continue to support the current strategic direction of Southwest Airlines, which EIM believes Southwest should be on a different path.

Tony Mulhare (11:43):

Are we watching a proxy fight being teed up here?

Hank Ketchum (11:47):

The proxy fight would likely occur based on the poison pill action. So you look at EIM's letter and what they're trying to accomplish. And the next step, the next logical step would be to engage in a proxy fight. They talk about the shareholder base being supportive of their call for change. So the next step would be to show that they have over 10% of votable shares and call for a special shareholder meeting and then engage in a proxy fight and put their picks forward for the board of director seats and enlist the support of other institutional investors.

Erich Schnitzler (12:26):

And we're thinking this could probably be sometime in the fall by the time all of this occurs?

Hank Ketchum (12:31):

Yeah, I think that's a likely timeline. We don't know, of course, but yeah, it could happen in the fall.

Matt McCants (12:39):

So that's a recap of the last several plays between the managerial parties, if you will. Let's do a deeper dive into Southwest financials and get into the why of the situation at hand. Give a profit and loss management 101 class to our members and listeners on how we went down this slow road to being targeted by Elliott.

Hank Ketchum (12:56):

Well, basically if you go back to 2018 and you look at our unit revenue performance through 2023 and unit cost performance, and then you compare that to inflation, inflation's up 21.4% over that period of time. We've seen unit costs outpace the rate of inflation. So we've seen unit costs go up 29.9% over that period in terms of core unit costs, CASM X, and we've seen RASM unit revenue underperform. So unit revenue is only up 11.4% compared to inflation up 21.4% over that time. So that's led to some pretty severe margin compression with Southwest just generating a 3.4% operating margin in 2023.

Tony Mulhare (13:40):

Okay Hank, so let's start with RASM. So explain what RASM is and why RASM hasn't kept up with inflation.

Hank Ketchum (13:47):

Okay, so RASM is revenue per available seat mile. And what that is the amount of revenue that I take in to fly one seat one mile. And it's critically important to make sure that unit revenues keep pace with inflation because you want to make sure that as you're looking at your cost structure, that your unit revenues keep pace of inflation to maintain your margins over time.

Tony Mulhare (14:14):

Okay, so here at Southwest that's primarily driven by the number of seats we sell and the price that we sell those seats at. What are other people doing that we aren't doing to increase their RASM?

Hank Ketchum (14:24):

Well, what we're seeing at the successful carriers in this post pandemic world, you look at Delta. Delta's engaged in cabin segmentation. So has Alaska, American, United in terms of a basic economy, economy, premium economy, and then a first class offering. So they have a lot of different levers to pull that are able to attract varied levels of consumers from somebody on maybe middle income to higher income consumers. They have a product that meets the demand for each one of those segments. So they've been very successful in upselling. So you look at also the GDS platforms, global distribution system, they're able to offer a very low basic economy fare that drives traffic to their website and then they're able to upsell all these other travel experiences. So that's been very successful for those carriers compared to Southwest, which kind of has a one size fits all product.

Tony Mulhare (15:19):

And so we're hopeful in the next couple of weeks as we lead into this investor day that we might hear some things from the company about some of those other revenue streams. Now let's switch gears and talk about CASM. What is that and why has that outpaced inflation?

Hank Ketchum (15:33):

Okay, so CASM is cost per available seat mile, and that's what we call unit cost, but we strip that down to another level, we call it CASM-Ex. Well, what is CASM-Ex. It's cost per available seat mile, excluding two main components: fuel and profit sharing. We exclude fuel because fuel costs are vary widely with the market and we want to make comparisons to how our operating cost structure compares to other carriers. So we strip out fuel. Like we have a hedging program that allows some variability and some protection for us. Profit sharing-wise, some carriers offer profit sharing, others don't so we strip that out as well. So we look at the core unit costs. What is that in the operating expense piece? It's salary, wages and benefits. So we've seen a lot of inflation in labor agreements and in costs for salaried employees in this inflationary environment that's been seen across the entire US economy.

(16:28):

The other factor, we're excluding fuel, so we'll put that aside. But we have higher maintenance expenses. Those higher maintenance costs are driven by aircraft as they age and into higher engine expenses, higher expenses as aircraft go to heavy checks. We're not getting aircraft from Boeing, aircraft that were slated for retirement and we weren't going to have to pay for that heavy check. Now we're not getting that aircraft from Boeing, so we're having to keep these old aircraft. So that drives higher maintenance costs. Then you have higher landing fees and you have higher airport facility rental fees, and that's driven by inflation and local government jurisdictions trying to raise more revenue. And then you have other. You have technology and other areas of spend. So those are all things that have caused unit cost to increase.

Tony Mulhare (17:21):

Okay, so now let's wrap this up. Connect the dots for me between RASM, CASM, our stock price and why Elliott's on the door.

Hank Ketchum (17:31):

So we had the meltdown in December of 2022, and coming out of the meltdown we saw traffic that migrated elsewhere and we've been trying to recapture that traffic. We saw 5% drop in load factor in 2023 versus Delta. We used to be at 83%, we're at 78%. So that volume isn't there to help generate more revenue at the top line. And then the operational reliability issues, technology issues that go back to under-performance and what led to the meltdown in the first place. And there was a lot of market cap that was destroyed, a lot of shareholder values. So we saw $5.2 billion of shareholder value wiped out from the period of the meltdown through June of this year. And Elliott, according to their slide deck, started looking at Southwest, really coming right out of the meltdown. They said they were looking at Southwest for an 18-month period.

Matt McCants (18:27):

So Hank, you mentioned back there that there are some new collective bargaining agreements with the other airlines, Delta, United, and American, which have increased their costs, they have lucrative pilot contracts like our own. What are they doing differently that's resulted in increased profits in those companies while we're trailing?

Hank Ketchum (18:43):

Those carriers have done a great job of really growing the top line and focusing on top line initiatives. They're going to grow revenue. So they've realized they've had the higher fixed cost base and higher operating expenses and they've looked strategically forward and continuing to evolve the cabin experience and to be able to drive additional revenue streams and pulling additional levers. And consumers are willing to step up and pay for those experiences as we've seen coming out of the pandemic, what consumers really value spending their discretionary dollars on travel experiences.

Matt McCants (19:20):

So do we have a labor cost problem here at Southwest or is there another answer?

Hank Ketchum (19:25):

No, I mean we have to go out and pay what the market is demanding in terms of wages. So we are a Big 4 carrier. We have to make sure that we're compensating our pilots and other work groups at least to the same level as those other carriers that we're competing with. So we can continue to attract the best and brightest and most talented and retain those individuals. As you're looking forward and you're a management group and you realize that reality is absolutely imperative that you're looking to the top line and those top line revenue initiatives to help maintain margins going forward.

Matt McCants (20:01):

To that point about market realities, we still have a long-term pilot shortage on our hands, and that's a piece of this equation management has to keep in mind as well, correct?

Erich Schnitzler (20:09):

Yes, that's true. I mean, while right now hiring is slowed somewhat this year, but long-term, we definitely expect it'll pick up again and there's no question that there's going to be increased pilot demand and a shortage as we head toward the end of the decade.

Matt McCants (20:26):

All right, we talked about a lot of problems with the company. Is there an opening for something to go right for Southwest Airlines that might change the game that's afoot here?

Casey Murray (20:34):

So let me be clear. We want to see Southwest succeed. Southwest success is our pilots' success, is all employees' success. And really through our analytics, everything that we do is supporting Southwest Airlines, is making sure that we're the strongest, most profitable, most aggressive carrier that we have been in the past and we want to see that carry on in the future. So that is the most important thing in protecting our CBA. SWAPA will protect our CBA and we'll fight going down and we'll fight going up, but again, Southwest has to succeed and really that is where we are at as far as an analytical organization.

Hank Ketchum (21:21):

And a couple of points there Case that I'll add on. If you look at the really core strengths of Southwest and what makes us such a great airline, first it's our network. We're number 1 in 22 of the top 50 O&D markets in the United States. That generates a lot of nonstop itineraries. No other carrier can say that, not even the big three, Delta American, United, they're number one in their fortress hubs. We're number 1 in 22 markets. That's huge. And those nonstop itineraries generate higher yield.

(21:54):

The other piece is the balance sheet. We have the strongest balance sheet in the airline industry. We have a two and a half billion dollars net cash position. All of that cash is generating interest today. Net interest income to Southwest Airlines will likely be $332 million in 2024. No other carrier can say that, not Delta, American, United that have balance sheets that are levered. And at Delta and United, they're doing a great job of generating income to pay that down. But at Southwest, that is a huge tailwind for us if we can just focus on these top line initiatives and get RASM headed in the right direction.

Erich Schnitzler (22:34):

And certainly Boeing, fixing their issues would also be a great help as well, raising their delivery schedules to get back to where they were previously. Also, the certification of the MAX 7. We can also hope that that is expedited as well. That should fix a lot of the problems on the aircraft side.

Hank Ketchum (22:54):

Absolutely. And one of the things we talked about before, and Erich, you and I talk about a lot, is it's not just net aircraft deliveries, it's just getting airplanes from Boeing. So we don't even need to grow the fleet, it's just getting those airplanes because that MAX is 15% more fuel efficient than an NG that we can retire, drives lower fuel expense, and then also lower maintenance costs as we get kind of a honeymoon with new engines and other things that new aircraft brings along. And then of course with the MAX 7, if we can get it certified, that increases productivity on a unit basis for the employee groups because we're going to a higher gauge, 150 seats versus 143 seats in an NG 700. So a lot of advantages to getting that airplane once Boeing can deliver.

Erich Schnitzler (23:40):

Right. Boeing is slowly getting their delivery rate up to 38, which is where they were previously, and that is an FAA imposed limit for now. But hopefully we get to there and then if they get their issues fixed, they can go up to their own goal, which is in the mid 50s.

Hank Ketchum (23:56):

And that'll be good. And as you look at this year, it's almost in a way, obviously the efficiency of the new airplane would be great, but also in terms of capital expenditures and CapEx spending, Southwest is fixing the product going forward. And as we look at free cashflow, we've actually run negative free cashflow the last two years. So getting a little breather on CapEx spending might not be a bad thing, and as we manage some capacity going forward.

Tony Mulhare (24:24):

Is there any chance that Southwest could bring a strong action plan to the September investor day, one that EIM can get behind and back off its calls for a leadership change? Or are they too far down that runway to stop now?

Hank Ketchum (24:37):

Well, of course, management come out with a great plan and investors will then have to decide is the current management team the one that they're going to get behind to go out and execute that plan? Or do they want a new management team in place to do that? EIM's position is they want a new management team in place to execute a new revised strategy going forward. If you look at EIM's points in their letter that they just issued, number one is board change. Number two is change in leadership in terms of executive leadership. And then number three is a comprehensive business review. And they've been pretty detailed in how they've laid that out publicly to shareholders and the public.

Casey Murray (25:22):

I think Elliott feels that this management team can't do what Hank just kind of elaborated on. They can make changes in September, but this management team is really being forced into what they're doing. They had plans for investor day, but I think they're going to accelerate and expedite, but ultimately can they execute on it? And I think that's Elliott's sort of issue. What we've seen over the past two weeks probably strengthens Elliott's position as far as the problem with Southwest leadership. And again, I'm making some guesses here on how Elliott feels, but there is further entrenchment, which we've seen over the last two weeks with the poison pill as well as the latest board edition. I've written about this before and I feel fairly strongly about it, that Herb warned against what he called institutional worship, which is a reluctance to affect change because there's an admission of being wrong and he likened it to a rock and now you're just carrying that rock around with you. And I think that Elliott feels that Southwest is just running around with a rock, big one, and it just gets bigger.

(26:29):

But there is a reason, as we've said many times, why we have an activist investor here. It's not just someone that's interested in Southwest, it's someone who's identified failures and continued failures in everything that Hank went through on the analytics of our finances and where our peers are and where Southwest is. All of it really speaks to why Elliott is here. We do want to see the change. We've been calling for this change for years as far as the business model and changing and adapting and innovating a business model that evolves with where the industry has gone. We are going to see a change. As I said earlier, there is an agreement amongst all parties that change is needed as far as our revenue model and our business model. And we're going to see that change come. Ultimately though, we will be involved and we will defend our CBA. That's what we do.

Matt McCants (27:30):

We'd like to thank Case, Hank and Erich for the update as the membership continues to watch the developing situation between Elliott and Southwest management. We'll undoubtedly hear from them again as this continues to take shape. If you have any feedback or questions, please drop us a line at comm@swapa.org. You can also find an Elliott Resource Center on the SWAPA website under the Resources tab. This will contain all articles, podcasts, and press releases across the channels on this issue.

Tony Mulhare (27:56):

Today's bonus number is 47. That's the number of consecutive years of profitability we had at Southwest Airlines prior to 2020. Regardless of the management lineup, the 74,000 employees here at Southwest hope to return to this level of prosperity.