8 (EFA, Elliott, and Q3 Update, Erich Schnitzler, Greg Auld, Hank Ketchum)

Today's SWAPA Number is 8. That's the number of new faces that have joined the Southwest Airlines Board of Directors since Elliot announced its investment in June with five Elliot nominees being seated as part of a comprehensive agreement between the Company and Elliot Investment Management. This was the final announcement in a slew of headlines over the last several weeks that included the Company's third quarter financials as well as the investor day in late September. 

So on today's show we spoke with Greg Auld and Eric Schnitzler from the Economic and Financial Analysis Committee and second VP Hank Ketchum about these events and to take a look at what's on the horizon for the industry as well as what all this means for the membership. 

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

Tony Mulhare:

Today's SWAPA Number is 8. That's the number of new faces that have joined the Southwest Airlines Board of Directors since Elliott announced its investment in June with five Elliott nominees being seated as part of a comprehensive agreement between the Company and Elliott Investment Management. This was the final announcement in a slew of headlines over the last several weeks that included the Company's third quarter financials as well as the Investor Day in late September.

Amy Robinson:

So on today's show we spoke with Greg Auld and Erich Schnitzler from the Economic and Financial Analysis Committee, and second VP Hank Ketchum about these events and to take a look at what's on the horizon for the industry, as well as what all this means for the membership.

Tony Mulhare:

I am Tony Mulhare.

Amy Robinson:

And I'm Amy Robinson.

Tony Mulhare:

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

Let's start with the situation with Elliott Investment Management and try to put a bow on that situation. So the big news is they and Southwest Airlines reached an agreement to avoid the proxy fight for the board, but I was listening to an episode of The Air Show Podcast about a week ago, and they described this more as a temporary ceasefire than an end to this war. Can you walk us through what that means and what the situation is now?

Greg Auld:

Yeah, sure. I understand the characterization of the ceasefire. For the moment, Elliott's activist event in Southwest is concluded. Now they do have an agreement in place. Erich, it was, what, till February of '26?

Erich Schnitzler:

Right, they're calling it a cooperation agreement.

Greg Auld:

As we sit here today, Elliott has succeeded in moving Gary Kelly off the board of directors. That happened on the 1st of November. And they've placed five of their original slate of 10 directors on the board. So the activist intervention right now in the governance of the company is done for the moment.

Tony Mulhare:

And so I think the big takeaway, and you guys can tell me if I'm right or wrong here, is that the fight for the board, the potential for this proxy vote, all of those things have been put to bed for now, correct?

Erich Schnitzler:

That's correct. And one important takeaway from this cooperation agreement, as you mentioned earlier, it being somewhat of a ceasefire, is that in February of 2026 Elliott could re-engage.

Amy Robinson:

I'm sorry. Did you say February of '26 or '25?

Erich Schnitzler:

February of 2026.

Amy Robinson:

Oh, okay. So this is in effect for over a year?

Erich Schnitzler:

Correct, and one of the points of this agreement was that Elliott would agree to not publicly disparage the company, and obviously that goes back to their public relations campaign to make big changes, have Bob Jordan step down. So they are prevented from doing any of that until after this cooperation agreement is over. So at that point they could potentially reengage.

Tony Mulhare:

And so what would that decision tree look like for them a year and a couple of months from now? Is that just based on the revenue that the company's been able to produce, whether the new board members have been able to push some change? What would reignite a fire then, or do you see this just going away?

Greg Auld:

You would have to imagine it would be essentially the financial performance of the company and its progress on the initiatives that they've announced. So if that's going well, then you would not expect this fight to reignite. But if things are going poorly and maybe there's a reason that the activists would want to seek some sort of more significant change, then you could see that at the end of that agreement there could be some more action.

Erich Schnitzler:

And if you look at the product changes that the company has publicly discussed, most of those, many of the big ones are not going to take effect until 2026. So if you look at that window of where Elliott could reengage in February of '26, I mean there's a chance that those initiatives, the big ones, have just started. So it'll be difficult to measure obviously the progress of things like extra legroom and assigned seating if we've only had two months. So to Greg's point, it would be more of what is the rate of change and the progress, what does it look like, the buildup to that? At least that's how we're thinking about it.

Amy Robinson:

You said that Elliott did secure five seats on the board. What would you say is the takeaway for that? Is that a positive thing, a negative thing?

Hank Ketchum:

I see it as a positive thing. The five directors are coming on. The airline experience, both with Saretsky and David Cush, they'll bring to the board with their experience at WestJet and then also at Virgin America, so I think that's an added benefit. We also have the individual with the background at Marriott that'll be coming onto the board. And then the other people that round out the Elliott picks should be influential in helping lead the company forward.

As we look at the implementation challenges that will be presented by the changes that are going to be made in 2025, and Erich and Greg just talked about it, the Elliott cooperation agreement expiring in 2026 will give them visibility as to how well these plans are implemented and they'll see the pace of that implementation through 2025 as we start to see the benefits accruing in the 2026 financial performance.

Amy Robinson:

One of the things that comes to mind for me is you're talking about the changeover over the board, but a lot of these things that you're talking about implementing in '25 and '26 are things that they already announced at their Investor Day and stuff. Are we expecting anything bigger or more shaken up with this new board or anything that would be not currently on the slate of changes or expectations?

Greg Auld:

I would think in the short term, no. I mean, you're going to now, since the company has made this announcement at Investor Day in September, and so they've got quite a lot of changes in front of them, a lot of plans in front of them, I would not expect any more major news from Elliott or from corporate change over the next few months. There could be some personnel changes. There could be some things like that, but I would expect things to quiet down on the news front, which would be a good thing so they can get busy.

There's been a lot of discussion on the analyst side and in the media. In fact, this came up at a conference that Erich and I were at yesterday. Was Elliott the agent of change? Was there change because of Elliott? The company has been pretty adamant saying, "Hey, we were looking at these changes before Elliott arrived in June." I'm sure that that's true, but I think it's beyond doubt that Elliott catalyzed the change, put a lot more urgency.

If you just think of the timeline, Elliott showed up on June 10th. The company made some announcements in July at their second quarter earnings call teasing some changes. And then, of course, in the end of September on their Investor Day they put some meat behind those changes and put some numbers on it.

So there's been a fair bit of news and announcements made here in the summer. I think we'll see things quiet down and you'll see the company just get busy on some of that effort.

Erich Schnitzler:

I mean, we have things like the revenue management system, the red eyes coming next year, certainly some points that the company will be able to use, some actions that the company will be able to use to get better, so to speak, to get on that road to financial recovery before the big changes that are coming in 2026.

Greg Auld:

The company's put out a scorecard with a relatively low hurdle to get to, so a 3 to 5% operating margin in 2025. So as we see progress toward that, and Erich's exactly right, using the things like the red eyes, the network efficiencies that they're already starting to take effect, the better management of a revenue management system, hopefully load factors will begin to improve.

Hank Ketchum:

And in that 3 to 5% guide, the lower end of the guide is based on not taking the benefit from the fleet strategy, and then the higher end of the guide is having the benefit of fleet strategy. And as you said, it's really a majority of the impact in 2025 is going to be driven by the red eye and turn time improvements and more of those revenue initiatives coming in '26.

Amy Robinson:

So you talked a little bit about Investor Day, but Hank, can you go into a little bit more specifics about what all was announced at Investor Day and where the products are coming from, that kind of thing?

Hank Ketchum:

Yeah, so as we look forward and you look at '25 and '26, those are building up to '27. '27 is really the show me year, and they're guiding to 15% after tax ROIC exceeding the weighted average cost of capital 9%, and it's really being driven by four core areas. So the 4 billion of incremental EBIT, or what we call operating profit, that drives the results or derived from core product, which includes assigned seating and extended legroom, that's 1.5 billion of annual EBIT benefit.

Other revenue initiatives like network optimization, revenue management, marketing and distribution enhancements, all those things are partnerships. They announced Icelandair vacation packages and then some other revenue contributors. They're forecasting to provide another $1.5 billion of EBIT benefits.

On the revenue side, $3 billion of benefit. Cost savings, they're looking at run rate cost savings of $500 million as we better optimize the staff that we have as the airline will only be growing 1 to 2% going out to '27. And then obviously getting turn times taken down by that five minutes and then the increase in red-eye flying, all those things drive towards better aircraft utilization, better asset utilization and help on the cost savings front. So again, that's a $500 million run rate in cost savings.

Amy Robinson:

And Hank, didn't you say there were potential benefits from the announced fleet strategy?

Hank Ketchum:

They're looking at driving $500 million of potential benefit there. As you break down the numbers, at least that's what it appears to be. It's a savings of 1.6 billion in average annual aircraft capital outlay from $2.1 billion going down to $500 million with the fleet strategy, so that helps on the free cash flow front. So those are the main initiatives that were outlined at Investor Day.

Tony Mulhare:

So let me just back up one second to the Elliott situation because as I look at this as an outsider and a non-analyst or a non-investor, if Elliott had the votes to win the proxy fight, why did they settle for five seats? What do they get out of that without controlling the board?

Hank Ketchum:

Well, normally you don't want to take these things to a proxy fight. It's very unusual for an activist investor to actually have to go all the way to a proxy fight. They always look for a negotiated settlement. And I think the way Elliott probably approached this and looking at the settlement, the board has now four airline CEOs on the board, not including Bob. So you've got Rakesh, you've got Fornaro, you've got Saretsky, you've got Cush, and all of them have a variety of experiences, international experience, domestic experience, experience with different products, networks, aircraft types, so a pretty well-rounded board.

And then they bring in technological expertise, government expertise, again hospitality. And then you look at some of the other, the board additions and then who left the board, and Elliott probably looked at it just assuming that their view would be this is a well-rounded board and we'll give them the opportunity to go out and execute.

Erich Schnitzler:

And to Hank's point, I mean even though they only got five, I mean they will exert a big influence.

Amy Robinson:

The next question is then why do you think Gary Kelly chose to leave the board? What was his reason for departing?

Hank Ketchum:

Well, I think as Elliott looked at it, they want a change. And if you look at how Southwest got to where we are today from an outsider investor's perspective, they're looking at the failure to innovate, the failure to advance with technological initiatives and to keep up with the rest of the industry. So I think they wanted to see a new mix of fresh ideas and a new group in there. And I would imagine that that led to the negotiated settlement where Gary would retire. He did keep his title as Chairman Emeritus.

Tony Mulhare:

So on that theme of leadership change, one of Elliott's initial demands was that Bob Jordan would step down, but that isn't happening. What do our listeners take away from that? Is this a change in heart by EIM on their views of the existing leadership there or what's going on here? Why would they not continue with that demand?

Greg Auld:

I think the best way to characterize this is everything's a negotiation. So both sides will take positions that they can then compromise from. So for Elliott to suggest early on that there had to be significant leadership change and for them then to compromise with some leadership change like Gary Kelly leaving the board as executive chairman, getting five of their initial 10 directors, that makes sense in the larger context of negotiation. Also, I think you can read into it is that while they were initially seeking the CEO change and while Bob will stay as CEO, he clearly is going to be under some pressure over the next couple of years to perform.

Hank Ketchum:

Absolutely correct. You look at four former airline CEOs on there that are going to be looking over Bob's shoulder, and there's going to be a lot of pressure on this executive team to make sure that they execute the plan that they laid out at Investor Day, and I don't think there will be a lot of extra time given if there are any stumbles along the way.

Amy Robinson:

So what would you say is probably the largest takeaway from this change with Elliott and all of the lead up to this?

Greg Auld:

The one good takeaway I would say, just for the listeners, is SWAPA cultivated a very good relationship with Elliott and they promised that we will stay in contact with them. They've assured us we'll have access to the new board members. We've already met them. So this is actually a good takeaway going forward.

Tony Mulhare:

So around the same time as the board agreement, Southwest released its third quarter earnings report. What are the big takeaways from this quarter?

Greg Auld:

I think the big takeaway for the third quarter is it was a disappointing quarter for Southwest. I mean, third quarter should be a strong quarter. If we look back historically, Southwest, we should be somewhere in the double-digit operating margins. Our average pre-pandemic was 15.1% on an operating margin, and in the third quarter this year was 0.5%, so that's clearly a case where the company is not performing financially. So it was a disappointing quarter, universally acknowledged. But I think as Erich and I were talking about, and even the Street feels this way too, it does feel like a bottom.

Erich Schnitzler:

Yeah, it feels like we've bottomed out here and we're definitely trending upwards. At one point we were expecting to possibly lose money three quarters in a row, in the third quarter, the fourth quarter and the first quarter, and we squeaked out a profit here in the third quarter. But trends are looking better with our network being optimized and capacity cuts taking effect, fourth quarter looks better and into next year is definitely on an upwards path.

Greg Auld:

I was going to say just for a company that is used to double-digit margins, that's what we've lived with for years and years, to have these continual either losing money, which was from the pandemic and have losing quarters or to have these very meager financial performances, it's hard to stomach. It's hard to read. But so the company's on a glide path to try to improve these margins for the next two or three years, but you can't ignore the fact that this was a poor financial quarter for Southwest.

Hank Ketchum:

And one of the things we're always watching is free cash flow, and Southwest continues to produce negative free cash flow. And Q3 was more of the same, over $400 million of negative free cash flow. And as we look forward, part of the fleet optimization strategy that they've laid out is an effort to reduce CapEx spending, which should help improve free cash flow along with improving profitability at the EBIT line. But as we look forward, it's going to be important for them to turn the corner, not having net cash continuing to be reduced quarter after quarter, and then move towards that $1 billion free cash flow goal that they have for 2027 and beyond.

Tony Mulhare:

So there were lots of questions in the earnings call about the aircraft sale leaseback plan. Is Wall Street's skeptical that that's going to be an improvement for our bottom line or what's going on there?

Erich Schnitzler:

Well, it'll definitely help the bottom line. I mean it's interesting because the only other carrier that we're aware of that've seen do this so far is Frontier, has done this for the last couple of quarters. So it's definitely surprising to see Southwest step into this arena, but it's going to be accretive. I mean, we will make money from this. To me, it feels more like a temporary fix.

Greg Auld:

This is where the skepticism comes from because it's not the core business of the airline. So as we talked earlier about some of the margin expectations for '25, '6 and '7, probably about two points of margin will likely come from some sort of fleet monetization. And that could either be outright sales of airplanes or sale leasebacks where they sell an airplane to a lessor and then just essentially rent the aircraft back.

Hank Ketchum:

Obviously, we don't want to hang our hat on a strategy of selling airplanes. That's just very short term in thinking. That's not something that will be beneficial long term.

One of the benefits that I see from this strategy though is if they're able to reduce the net cap expense, we don't need all those airplanes, we have 694 aircraft on order to be delivered from Boeing through 2030. And then Bob stated at Investor Day, the goal is to drive us towards a hundred percent max fleet, there are a lot of benefits that we can see from that, especially as we push aircraft utilization by flying more red-eye flights and the cost savings that would come down the road from 2030 and beyond in making us more efficient and driving unit costs lower with an all MAX fleet could be fairly significant.

Amy Robinson:

You're all at the International Conference of Pilot Unions where we had the virtual panel with some of the Wall Street analysts. Was there any takeaways from that that we'd want to with our listeners, anything that was surprising, maybe not surprising, but anything that you'd want for them to know that was said?

Erich Schnitzler:

The overriding theme was they're glad that the drama with Elliott is over with and then now the airline can get back to its core focus, which is improving the business. They knew there would be a negotiation. I don't think there was any great surprise on how this turned out. They knew that Elliott would get at least most of what they wanted, but I think now it's just focus on the airline, and they're happy to see some of these early initiatives that we've discussed bear fruit here in 2025.

Greg Auld:

So we host this conference every year, and one of the highlights of the conference has been is we get a number of the Wall Street sell-side analysts. So if any of you are listen to any of the quarterly earnings calls, some of the names that ask questions in the end, we here at SWAP have a really good relationship with those folks and so it's great. They come to this conference and they really talk freely about their thoughts of the industry.

So the macro themes of the industry is the current dominance of, and maybe surprisingly if you look back over 10 years, is the current dominance of the legacy carriers, particularly United, Delta, and to a lesser extent American, and also the complete reversal of fortune of the ULCC. That was a discussion there as well.

Relating to Southwest, it was really a discussion, Erich hit it with relief that the Elliott drama is over and that Southwest is definitely, to the eyes of the Street, is in a show-me mode, the okay, you've announced what you want to do, now how many times did we hear the word execution during that panel? So that was clearly where their heads are.

Tony Mulhare:

So Southwest isn't the only airline facing challenges right now. Frontier just reported a loss in the quarter. Spirit just announced more pilot furloughs and downgrades. Boeing just came out of a major worker strike that's going to impact its ability to deliver aircraft for a long time. Our own Investor Day announcements of assigned seating and increased leg group options, we're not going to see the impact of that revenue for another year to a year and a half. Let's wrap up today's discussion with an outlook for 2025. Where do you see Southwest going and what opportunities do you see there, or do you see an outlook that's just beset with challenges right now?

Hank Ketchum:

2025 is going to be a year of obviously implementation and making sure these technological initiatives are executed and executed well to enhance the revenue production that's been forecast for 2026. Also, the capacity grows for the airline. You're looking at 1 to 2%, very muted, really driven by red-eye flying. And then cost savings being driven by not only the red-eye flying but reducing the turn times.

So it's just going to be more of a churning year, 3 to 5% operating margins, which as a guidance is not anything stellar in this industry, especially for Southwest when you look at us historically producing 15% in our banner glory years, if you go back to last decade.

So certainly a lot of challenges, and towards the end of the year, Southwest will be retrofitting the aircraft and retrofitting 50 to 100 airplanes in the new seating configuration. We'll start with larger aircraft first and then look at the 700s, but there's a lot of work to be done and 2025 will be a year full of challenges.

Erich Schnitzler:

And I think as you look at the industry as a whole, I mean it's pretty interesting that Alaska with their 13% margin led the industry here in the third quarter, but we have the issue with Spirit. They're potentially looking at a bankruptcy, I mean a terrible situation there, pilot furloughs. You have a Frontier that's trying to reinvent their product. You have JetBlue with their JetForward plan. Underneath the surface you have a lot of other airlines, including us obviously, as we've just discussed, that have a lot of challenges in 2025.

Greg Auld:

I agree with all that. I mean, we hear this a lot in the company that I think Gary Kelly used to say, it's going to be a blocking and tackling year. It's a back to basics year. How many times did we hear that? But this year is, as I mentioned on the analyst panel from the conference, is all about execution.

So to what Hank was talking about, internally they'll be getting this product ready, they'll be getting the assigned seating, the technology, all the tech touches there to get that out the door. They'll be reconfiguring these airplanes. I mean, I think we'll bide our time over the next two to three quarters and hope that some of these network improvements and as they re-optimize things, and what does that look like? That's like some of the drawdown in Atlanta, so with the increase in places like Phoenix and Nashville, higher yielding markets, we're going to hope that those changes manifest into an improving financial performance.

Tony Mulhare:

We'd like to thank Hank, Greg and Erich for taking the time to give our listeners their view on theCompany landscape and what's to come. As a reminder, if you have any feedback, comments or suggestions, please drop us a line at comm@swapa.org. We really do love hearing from our listeners.

Amy Robinson:

Finally, today's bonus number is 18 million, which is the amount of money that was paid into profit sharing for the third quarter. That's a modest number compared to previous years, but the good news is that we expect another small profit sharing contribution in the fourth quarter. There was a lot of talk about execution being the big question about the company's strategic plan. It will certainly have to pan out if we want to see numbers higher than this in the future. In the meantime, SWAPA pilots will continue to do their part remaining the most productive pilots in the industry. They will certainly hold up their end of the bargain.