12 (Elliott Management Update, Casey Murray, Tom Nekouei, Hank Ketchum, Erich Schnitzler)

Today's SWAPA Number is 12. That's the approximate percentage of Southwest Airlines shares that Elliott Investment Management took hold of in early June, challenging the leadership landscape of the company and bringing some uncertainty as to what the future of the airline holds.

Today we're sitting down with your SWAPA executive officers, along with economics and financial analysis chair, Erich Schnitzler, to discuss what's transpired since then, address some of the questions from the membership, and set some expectations for the future given this unprecedented event.

If you have any feedback for us at all, please drop us a line at comm@swapa.org
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Transcript

Matt McCants (00:04):
Today's SWAPA Number is 12. That's the approximate percentage of Southwest Airlines shares that Elliott Investment Management took hold of in early June, challenging the leadership landscape of the company and bringing some uncertainty as to what the future of the airline holds.

Mike Panebianco (00:19):
Today we're sitting down with your SWAPA executive officers, along with economics and financial analysis chair, Erich Schnitzler, to discuss what's transpired since then, address some of the questions from the membership, and set some expectations for the future given this unprecedented event.

Matt McCants (00:50):
I'm Matt McCants.

Mike Panebianco (00:51):
And I'm Mike Panebianco, and this is our conversation with Casey, Tom, Hank, and Erich. So, Case, it's been a game changing few weeks with the announcement that Elliott Investment Management has entered the chat on the future of Southwest Airlines, and while our membership is spinning on the internet and discussing the events and the possible outcomes of what comes next, what would you and the execs like to open the conversation today with to level set our position and give them membership, a little bit of a roadmap for where we can go from here?

Casey Murray (01:25):
Yeah, Mike, it's been an interesting 17 days since Elliott dropped their slide deck on Sunday, but I want to go back several months. SWAPA has been writing about this for years, whether it's the revenue issues, the operational issues, just a plethora of unforced errors they've continued to make. We were concerned several months ago that Southwest was getting backed into a corner and we were concerned that they were going to really do only what was left to them, which was be forced into an M&A. So we hired our M&A attorneys both on the equity side and on the seniority list integration side, and really it was just us mitigating risk but concerned that they were going to be forced to do something. And sure enough, now they are.

(02:10):
And I think we have to look at the why is Elliott here, and they're here because of the underperformance, the real lack of a plan, and if we look at the timing of Elliott being here, Southwest just downgraded their forecast for the eighth time in 18 months with an 8K last week. And so I think Elliott and most of Wall Street saw that coming and it's just a continual slide down and something has to be done, and that's kind of been SWAPA's message for a while now is how long are we going to tolerate lagging performance, lagging financials before, number one, something gets done, or number two, we end up in a place that we really can't dig ourselves out of?

Tom Nekouei (02:55):
We've certainly written about it as recent as in April and then May. I wrote in April, Hank wrote in May, about the performance. Not only that, going back to 2016 when we started the EFA. Again, at the time, Hank and Greg and Erich here have written about, it's not a surprise to us because we hear about it, we see the numbers not just every quarter when we have the board meeting here, but we know where the trajectory has been. Then actually when we meet with Bob Jordan and Andrew Watterson, we bring these concerns up. Very, again, analytical and data-driven because of the numbers that Greg and Erich provide for us.

(03:31):
The issue is that to us, there was no surprise that this happened. We actually specifically talked about it maybe in joking or in the hallways a few months ago, about the fact that there is a possibility that some activist investors are going to come in and take advantage of the stock price and do kind of a predatory takeover of Southwest Airlines. We quite literally talked about that a few months ago.

(03:53):
But what I'd like to stress on too is that we hadn't heard from leadership until last week, and as we wrote in the comm, the meeting that took place virtually with labor on Wednesday, which was a call about nothing, as we wrote about it in the blast, very underwhelming and no details, no plans. Jody Reven actually was on the call and he tried to prompt Bob about these initiatives that you're saying are going to get us out of this trajectory. It would be nice for your employees, for your people to hear, to at least give him some glimmer of hope, and that was completely missed by Bob, what Jody had said. And was there a surprise? No, but we're not going to speculate too much as to where this thing is going to land, how successful the Elliott group will be, or if it's not the Elliott group, the next group, but it is absolutely unsustainable to stay on this trajectory in terms of revenue and operationally, even with or without the Elliott group.

Mike Panebianco (04:52):
We have a bunch of questions for you, but before we move on, I want to ask one very pointed question. Is SWAPA taking sides?

Casey Murray (05:00):
No, we're not going to, at least initially. Our issue is Southwest has done zero engagement with us. As we said, last week's call, way underwhelming, zero plan. Very disappointed in that. The flip side is Elliott has been very engaged with us and they're no friend of labor, and I don't mind saying that. That's not their job. Our number one job is to defend our CBA and we're going to make sure that we have a seat at the table. We have a separate outside council that is very involved in Wall Street and in the investment community and is providing guidance as well. We've taken every opportunity to do case studies on Elliott and we're really mitigating risk as much as we can, and again, having a seat at the table is critical.

Tom Nekouei (05:48):
To reinforce what Casey said, for our members that are apprehensive about us talking to Elliot, I can tell you that as not as a SWAPA exec, as a due paying member, as a line pilot, I would much rather my union be close to the Elliott group and have those conversations rather than being on the outside.

Casey Murray (06:08):
I'll take it one step further. As an employee of Southwest Airlines and someone who came here to be a part of Southwest Airlines, I would much rather put the entire weight in support of SWAPA and our pilots behind our company. Unfortunately, we can't do that. We haven't been asked to. We have years of disdain from leadership and that's how labor has been treated, and it is absolutely unconscionable to me that we haven't been spoken to. We haven't been asked to participate in anything that Southwest has planned. We haven't even been part of a call to action, which should have been the first thing that this leadership team should have done is leverage your employees. Herb had an absolute knack for getting everyone behind him even when there weren't battles, and this leadership team has not done that.

(07:00):
And again, I want to be clear, it would be much better for all of us to be behind Southwest Airlines, but unfortunately right now, that's a very difficult proposition when they don't want us behind them, that's truly how I feel, and we don't know what the plan is.

Matt McCants (07:17):
Okay. Erich, let's start in with some of the mechanics of what's happening here. We know that Elliott has acquired roughly 12% of the company. What is the significance of that number and can you walk us through some of the corporate steps that most of us might have some trouble understanding?

Erich Schnitzler (07:34):
Sure. As Casey mentioned earlier, we first became aware of this that Sunday evening, and our feeling is that Elliott has been building a position in Southwest for a little while. And as many people may know, once a public company has more than a 5% ownership, it has to be publicly disclosed. We're thinking that that's the reason that Elliott finally came out with their announcement is now it's over that limit, and that's when they've launched their activist campaign for Southwest.

(08:06):
From here, basically, there are usually several steps. Usually starts with a public relations campaign. As we know, they released a slide deck with their plans and what they'd like to see happen with the company. Really, this is kind of step two of five or six different steps that they could potentially use. Right now with an over 10% ownership by the Southwest bylaws, they could actually call for a special board meeting, which could involve, at this point, even leading up to a proxy fight. And I want to stress that we're not absolutely sure of their economic ownership, but over 10% means that they would have the ability to call for a special board meeting and then that could lead to a number of different steps down the road. We're very early in process though.

Matt McCants (08:56):
Did the company see this coming? Could they have?

Erich Schnitzler (08:59):
As we mentioned earlier, it's something we here at SWAPA had been talking about for quite a while. They don't appear as if they've seen it coming just by their public reaction, but again, it's here now and it's got to be dealt with.

Matt McCants (09:15):
Erich, you mentioned something there that we've seen in some public circles, and I think the members are curious about too, what is the possibility of a proxy fight and what does that look like exactly?

Erich Schnitzler (09:27):
Typically what happens in these is that after a public relations campaign, you need to get a special board meeting going and then obtain votes from the board to literally a proxy fight where you would end up replacing some of the board members. And then, of course, the board oversees the CEO of a company, so then the board would be responsible for removing, if it came to that, the CEO. It's been done at numerous other companies.

(09:57):
But I want to mention also that typically, at least in our research with Elliott, it doesn't usually get to that point. A lot of times the companies will kind of go along with their suggestions, or even if they see they've made an investment, they'll start making the changes even before any of the Elliott-induced actions occur. So the proxy fight from what we have seen is relatively rare, at least with Elliott, from what we've seen.

Mike Panebianco (10:26):
Erich, to follow up on Matt's question on mechanics and the comments that we've had so far, we mentioned history and we look at past history, mentioned flying the line, flying the line too. You look at the Lorenzos and the Carl Icahns for parallels to this situation. How does this compare?

Erich Schnitzler (10:42):
Well, I think since then laws have changed. It's a totally different atmosphere right now. When you look back at what happened in the 1980s at Continental with Frank Lorenzo or TWA with Carl Icahn, there was a point there with Continental where he took the company to bankruptcy and two days later emerged literally over the weekend and told the pilots, you're welcome to come back, but you're going to take 50% pay cut. And we don't believe that that's possible in this environment today. Certainly, we could go into pilot demand and things like that, but just in general since then the laws have changed.

(11:23):
Those were the true corporate raiders. Not to say that that's not happening in today's corporate world, but it's just a different scenario in today's airline industry. At least that's our feeling as it stands for right now.
Matt McCants (11:36):
So the company keeps pointing towards this investor day in September. What is investor day and how does this new situation with Elliott play into that?

Hank Ketchum (11:45):
In terms of investor days, those are really a marketing platform for an executive leadership team. It doesn't have anything to do with a shareholder meeting or it's not a place where proxy fights are battled out, and the purpose of an investor day is for an executive team to come out and lay their plan, their strategy for the future, and show investors how they're going to grow the top line in terms of revenue, what those specific initiatives are, how they're going to contribute to revenue. They get pretty granular in explaining that.

(12:21):
And then on the cost side, how they're going to reduce OpEx or how they're going to control costs going forward, and then what that means to the operating income line and as you go down to the net income line. And then what's left over, an investor is always concerned with free cash flow. So how much is the company going to spend on capital expenditures, investing in aircraft, technology, facilities and netting that out. And then how much is left for investors or to pay down debt? And that's what investors care about. They're really looking for the shareholder return in terms of a higher dividend or a share repo, and then, obviously, they want to see earnings growing in terms of EPS, so the company's perceived as more valuable, and that increases the share price going forward.
(13:13):
So that's the purpose of an investor day is to really tell the story for where the company's headed and market the company as, hey, this is a great investment and you should buy our stock.

Mike Panebianco (13:25):
So Elliott came out with a comprehensive plan publicly stating that their vision for management changes, revenue enhancements, return to best-in-class performance, and profitability. When you met with Elliott, did they expand further on that plan? Some of our pilots may not have seen that slide deck. What do you think their capability is to launch?

Hank Ketchum (13:43):
Yeah, there's five pillars to the Elliott plan: commercial strategy, unit cost performance, network performance and optimization, capital allocation and fleet, and then investing in technology. I'll kind of take each one of those separately. So commercial strategy, what is that? That's how am I going to generate revenue? So let's look at the cabin. Can I segment the cabin? Can I look at a base economy, economy, premium economy product? How can I upsell that? Assigned seating. Do I charge for bags? Do I charge for a second bag, a first bag? Those are all things that are part of the commercial strategy.

(14:18):
Unit cost performances, how do I control the OpEx piece, operating expenses? And in Southwest case, there is a perception on Wall Street that our head count is running ahead of where it should be in terms of productivity. A full-time employee's an FTE, that's what they reference it as. And they'll look at a metric, they'll compare that to ASM's flown, and then they'll project that out and look at efficiencies over time. They think there's an opportunity probably to make Southwest more productive and increase productivity for each employee. So an opportunity maybe have an impact on lowering unit cost there.

(15:00):
Network performance and optimization would be underperforming routes. So in the Elliott deck, they have a view that 12% of our capacity is underperforming and they used a load factor metric to measure that.

(15:17):
Capital allocation and fleet plans, that is specifically how do I deploy the cash that's left over in terms of free cash flow, do I invest back into the company? And that's going to reduce free cash flow because that's a capital expenditure. So that's buying airplanes, that's the fleet plan. That's, again, investing in technology and facilities. So as an airline and pilots, we obviously want to see somebody in terms of management that is going to be invested in growing the airline, so they're going to be continuing to want to buy new aircraft.

(15:52):
It's also critical that management teams that are running airlines continue to invest in airplanes even if they're not growing the fleet because you want a modern piece of equipment that's more fuel efficient. You look at a MAX, it's 15% more fuel efficient than an NG, so that helps reduce your unit cost chasm. So that's very favorable. So you want to invest in aircraft, and also, consumers would prefer to, obviously, sit in a newer seat or a newer aircraft than they would in an older aircraft. So there's a lot of advantage. Lower maintenance costs, you look at depreciation, amortization, all the other factors that go into that.

(16:33):
And the other end of that is, okay, when I net out the CapEx piece, how am I allocating the rest of the cash? Well, Southwest has a fortress balance sheet, superior balance sheet to any airline in the industry, investment grade rating by all three credit agencies. So as an activist investor in Elliott looking at Southwest, there's an advantage to a carrier that doesn't have a lot of debt obligations. So when that debt matures comes due, if I'm looking at free cash flow, I don't have to commit or allocate capital to pay off debt, so that leaves more money to return to shareholders. So again, the shareholder returns dividends and potentially share repurchases. So that's a big piece and why investors focus on capital allocation.

(17:25):
And then technology is the other piece. So they recognize that Southwest has underinvested in technology. Obviously, the meltdown wouldn't have occurred. The company's trying to play catch now and rolling out a lot of technological initiatives and trying to course correct, if you will. And Elliott sees an opportunity there to use technology to help increase productivity.

(17:51):
So those are the main pillars. Their main focus is to increase unit revenues, lower unit costs, and return Southwest to where it used to be. If you look at pre-pandemic, Southwest was putting up numbers like in 2018, according to their slide deck, 21% EBITR. Their plan and their revenue initiatives, costs initiatives, they're guiding through their slide deck to a 19% EBITR, which is best-in-class performance, and restoring Southwest to a highly profitable carrier, and they're using a $49 price target in terms of what they think they could achieve if they were to get back to 19% EBITR performance in terms of EBITR margin. And that's what they're focusing on. That's how they're trying to get investors to join their camp and buy into their plan going forward.

Casey Murray (18:54):
I want to talk for a moment about the FTEs, the full-time employees you were talking about. We all know, through VPTO and some of those discussions, that we are a little bit overstaffed on the pilot side, and that's something that this management team has to own. But we talked to Elliot about this and their issues were the fixed costs at the corporate level and more of the bloat that's occurred, and they were very aware of it, that's occurred at the general office. So we did have the ability to talk through this with them, and while there are assurances of no furloughs, we don't have a contract with them, we have a contract with the company. But again, that is our job to address, but they were very specific in the fixed costs at the corporate level have to be addressed and that's where they're going to focus.

Tom Nekouei (19:39):
One of the things that I took away from that meeting was that they are pretty darn confident that they can get this done. So that's something that I wanted to see coming out of that meeting, what their mindset was and how they approached it, but they are pretty confident in doing what they say they will do. I'll go back and touch on some that Casey said about the de-inflation of the headquarters staffing. I think that that number is out there. If you look at the increased number of staffing at headquarters at Southwest since 2018, that number has grown by 3000 employees, while at the same time, same period, Delta and United have cut their headquarters staff drastically, and that's something that they absolutely touched on and that's part of their focus.

Mike Panebianco (20:25):
What's your best estimate on a timeline if they have to go through the hard way? We talked about the easy way, and their definition of the easy way was Bob and Gary and management folks step down and they roll in with their picks and they put people in place. I think we've heard that Bob said publicly they're not going anywhere.

Erich Schnitzler (20:47):
Just taking a look at some of our case studies that we've been researching here over the last couple of weeks. This process could play out six months, nine months, maybe sooner, could go as long as a year. But as we mentioned before, there's a lot of steps that have to happen before we get to that stage. And it really just depends on the reaction of the company. As you just mentioned, our senior leadership has said they have no plans to go anywhere. So if it does go down the more difficult road and they gain shareholder support for a change, then yeah, it could last a little bit. I would think at least into the fall, possibly longer. Again, we mentioned looking at some other companies anywhere from three months to a year.

Matt McCants (21:35):
That's a pretty good recap of what's been publicly said and what we can all see on Elliott's website, strongersouthwest.com. Let's step back into the financial play-be-play and talk about what the next step is an event like this, and I think something everyone wants to know, is this going to be mostly closed door or will the membership see this play out?

Erich Schnitzler (21:56):
We might all have an opportunity, a front row seat, if you will, on how this plays out. And again, many of their cases is very public. The activist investor will go to the public with their campaign and also in an attempt to influence the board and the shareholders and will continually, for lack of a better word, hammer on the points they want to get across to affect change at the particular company. It could play out publicly. Absolutely.

(22:24):
What we've seen so far is one other company, Artisan Partners, has taken a public position saying they support what Elliott is trying to do. I don't think it's any wild guess to think that they have probably lined up other major institutional investors to at least take a look at what they're attempting to do here in affecting change at Southwest. So it would not surprise us at all to see other large shareholders come out at some point in support of this.

Mike Panebianco (22:55):
Erich, you spent a lot of time up on Wall Street building these relationships. I know the execs go up there and meet with these people, and we've heard a lot from them. You've looked at some case studies in history of what's happened when Elliott has moved into a company. What have you found? I think that's something that would be of interest to our membership and our listeners.

Erich Schnitzler (23:17):
They were founded in 1977 and they've been around a long time. They're one of the major players on Wall Street when it comes to activist investing, one of the top three firms for sure, and they've been pretty successful. And their outcomes range, they have longer term investments and they have some shorter term. You look at some longer term companies that they've held for a while, a company like a Suncor Energy or a Marathon Petroleum. And then you have some shorter term investments on the tech side, companies like Salesforce, Twitter, and so it kind of varies. It's all over the map. I think the overriding theme to take away is when they come to a company, they're very well-prepared, they've done their homework, they spend a lot of time doing research on that particular company, and they're pretty confident about the outcome or they wouldn't be there. They have too much credibility at stake when they come to firms looking to shake things up.

Mike Panebianco (24:16):
Erich, when you looked at the case studies, because we've all been studying for the last few weeks, you went in and you did some case studies, and what I saw was there are two ways they go about doing business. They either get really hands-on or they're somewhat hands-off. What does hands-on look like?

Erich Schnitzler (24:34):
What we found, hands-on is affecting board change, replacing board of directors, a lot of times, replacing senior leadership, CEO and maybe some other senior leadership. Then taking a strategic look at the business plan, selling off non-performing business units, adding shareholder returns, making an emphasis on repurchasing stock or adding a dividend, those kind of things. A more passive type of investment would be just like any other type of investment where you just put money in and you kind of sit back and see how the process plays out. That's what we found with a lot of these tech companies. They started off on the activist side, maybe try and replace the CEO, but ended up just with more of just a quiet investment in the firm without doing much more.

Matt McCants (25:26):
So that begs the question as to what does a SWAPA pilot to make of all this? Casey, can you walk the membership through where our priorities lay at present? What is our role in all this?

Casey Murray (25:38):
I think that the most important thing to understand is that, again, as I began the podcast, we've been looking at various possibilities for a long time now. We've been trying to provide input to Southwest, but we saw with the start of the revenue slide and Boeing's issues and just kind of the entire enterprise failures that something was going to happen. And so we invested a lot of time, as Erich's talked about these case studies, as we now know the name of the activist investor involved, but all the possibilities, again, I'll go back to the M&A side who were afraid, like I said, that they were going to be forced to do something. And now they are forced to do something and it's at the hands of Elliot. And so our job is to defend our CBA.

(26:31):
But all along, and one of our core statements is to move our profession forward, and that includes our company. And I've always said that they have airline to run and we have an airline to analyze, and that's what we do. And I mentioned the word disdain before, and I'm going to say it again because that's the only way that really we can describe how labor has been treated, and SWAPA and our data-driven analysis has been treated. It has been disregarded. And here we are with an activist investor basically saying everything that we've said. So having a seat at the table, having some input into if there is a CEO change, if there's a board change, if there's other C-suite changes, that we have a voice in that so that the downline effects are minimized.

(27:19):
And this is kind of where our concern lies is not so much in the near future, but where are we at in one, three, and five years? And the airline has to be hitting on all cylinders, and that's the best way to protect all of us. And so having a seat at the table has been critical to us. Elliot has been very receptive to that, and, unfortunately, our company has not.

Mike Panebianco (27:41):
Can we influence an outcome here?

Casey Murray (27:44):
It's a very dangerous position to be in because what are those downline effects and what effect did we have on choosing A CEO? What input did we have? And then where are we in one, three, and five years? And that's something that we're very, very conscious of. And so again, having a seat at the table allows us to provide input but also learn motivations and where they're headed, and that's very important for where we're at.

Matt McCants (28:13):
So maybe even if much of this is out of our control, it should also be stressed that safety and productivity should still be at the forefront of a pilot's mind right now, yes?

Casey Murray (28:22):
100%. All of our jobs is to go out there and do the 100% best that we can at doing what we do, which is being the best 737 pilots in the world, and there's a lot of distractions right now. Our company is in distress. We are a distressed carrier by every definition of the word, and we have to focus on what we're doing and how we're doing it and make sure that we are representative of the Southwest Airlines that we want to portray, and let this battle go on. Let SWAPA represents you, but focus on what you're doing.

Mike Panebianco (28:56):
We waited a long time to hear from the company and they really didn't say much. I know the pilots are asking, what can the membership expect from SWAPA as we move into this process, which Erich laid out very well that it could be months, it could be late in the fall, and it could go further. What can the membership expect from SWAPA in terms of updates in communication?

Casey Murray (29:19):
Our pilots have heard zero from the company. The rank and file, the 70,000 employees that are out there moving revenue and that are responsible for this airline every day, have not heard the first thing from leadership. What we will do and continue to do is to make sure that while we're not a voice for everybody, we are a voice for our pilots, we're a very strong voice, and we will continue with the company. And on last week's call, I was very vocal with Bob about communication and about a plan and about where we need to go and what we need to do. But again, as I said, we would love to get behind the company on this. More than anything, it is who we are as Southwest, but right now we just can't do it because we're, again, disdained and there's very little concern right now at C-suite outside of their jobs. There's not a concern for the employees, and that's something that we can never forget and really won't.

(30:18):
So we'll continue to fight. We'll continue to take our seat at the table, provide input where we can, provide protections where we can, and continue to keep the dialogue open. Our pilots can expect to hear from us constantly. We've put something out every week. We've got podcasts, we've got a blog. There's even more on the horizon.

Hank Ketchum (30:35):
Even if Elliott's not successful, it's going to drive Southwest to focus on fixing these problems maybe even sooner than they would've had Elliott not been here. And at that investor, they're going to be laying out their own set of initiatives. It might be a different direction, but they've hinted at changes the cabin and doing things with seating. So there are probably revenue initiatives on the forefront.

Tom Nekouei (31:00):
We're going to do what we do best, and that's to be here for our membership, protect our careers, enforce the contract. We also have to run the organization and make sure that the ink is even dry on the CBA, and we have to make sure that's implemented correctly and all the protections are there and it's enforced. Outside of that, everything that we've done from negotiations to everything else, external threats, internal threats, we've been extremely transparent with the membership and they can absolutely expect that we will continue to be transparent with every step of the way depending on which way this quest is going to go for the Elliott group, and we'll be there as soon as we have updates, we'll share this with the board. And the board, obviously, being their first conduits are going to share that with their constituents. And we're always here 24/7.

(31:49):
But the reason why we're here is to protect our members and their careers and protect their families, and that we're going to continue to do that as the strongest independent pilot unit in the world.

Mike Panebianco (32:08):
We'd like to thank Casey, Tom, Hank, and Erich for stopping by today. Give the membership an update on all things Elliott Investment Management. As always, SWAPA will continue to meet the expectations of our membership and communicate any changes along the way. If you have anything that you'd like us to cover, please drop us a line at comm@swapa.org.

Matt McCants (32:27):
Today's bonus number is eight. That's the number of revenue guidance reductions in the last 18 months at Southwest Airlines, a figure Elliott pointed out in a statement on June 26th.