SOUTHWEST AIRLINES CO quarterly report, Q1 FY2019

Southwest Airlines Co. — Q1 2019 Form 10-Q

Reporting period: Three months ended March 31, 2019; unaudited. Southwest operates scheduled passenger air service in the United States and near-international markets. Comparisons are with Q1 2018 unless noted.

Financial performance and position

Metric	Q1 2019	Q1 2018	Change
Operating revenue	$5.149 billion	$4.944 billion	+4.1%
Operating income	$505 million	$616 million	-18.0%
Net income	$387 million	$463 million	-16.4%
Diluted EPS	$0.70	$0.79	-11.4%
Operating cash flow	$1.105 billion	$1.002 billion	+$103 million

• Passenger revenue rose 3.5% to $4.745 billion; freight revenue was flat at $42 million; other revenue increased 14.2% to $362 million. Passenger yield rose 2.6%, while load factor fell 0.5 percentage points to 81.0%.
• Operating expenses increased 7.3% to $4.644 billion, faster than the 1.4% increase in capacity. Operating expenses per available seat mile (ASM) rose 5.9%; excluding fuel, profitsharing, and special items, the company reported an 8.1% increase.
• Salaries, wages, and benefits increased 8.5% to $1.976 billion; other operating expenses rose 16.8% to $730 million. Fuel and oil expense was nearly flat at $1.015 billion. Economic fuel cost was $2.05 per gallon, down 1.9%.
• Cash and cash equivalents were $2.344 billion and short-term investments were $1.517 billion at March 31, totaling $3.861 billion. Operating cash flow benefited from a $944 million increase in air traffic liability, partly offset by lower accounts payable and accrued liabilities.
• Capital expenditures were $160 million. Investing activities provided $164 million, while financing activities used $779 million, including $500 million of share repurchases, $178 million of dividends, and $99 million of debt and finance-lease payments. Cash increased $490 million to $2.344 billion.
• Long-term debt, including current maturities, totaled $3.173 billion. Separately reported operating lease liabilities totaled $1.511 billion; finance lease liabilities were included in debt. No amounts were outstanding on the $1.0 billion revolving credit facility, and Southwest was in compliance with its covenant.
• Current assets of $5.483 billion were below current liabilities of $8.723 billion, largely reflecting advance ticket sales and loyalty-related air traffic liabilities. Management said this working-capital deficit is common in the airline industry and cited $3.9 billion of cash and short-term investments and available credit as supporting liquidity.

Material changes and notable items

• The FAA grounded all 34 Southwest 737 MAX 8 aircraft on March 13, 2019. Southwest canceled more than 10,000 flights in the quarter amid the grounding, unscheduled maintenance disruptions, and severe winter weather. Management estimated these events, the federal government shutdown, and softer leisure revenue trends reduced Q1 net income by approximately $150 million; the combined unexpected events reduced revenue by more than $200 million.
• The MAX grounding, weather, and maintenance disruptions affected revenue and costs; fixed operating costs and lower aircraft utilization pressured unit costs. Other operating expense comparisons were also affected by a $25 million gain on retired 737-300 aircraft recorded in Q1 2018 and insurance recoveries received in that prior-year quarter.
• Southwest adopted the new lease accounting standard on January 1, 2019. It recorded operating lease right-of-use assets of $1.508 billion and operating lease liabilities of $1.511 billion at March 31. Adoption changed balance-sheet presentation; management said the impact on operating results and cash flows was not significant.
• The company repurchased $500 million of stock in Q1 and paid dividends of $178 million. The Q1 accelerated repurchase program was completed in April, for 9.4 million shares in total. As of March 31, $850 million remained under the existing $2.0 billion authorization; additional repurchases totaling $450 million followed quarter-end.

Outlook, management commentary, and risks

• For Q2 2019, Southwest expected operating unit revenue to increase 5.5%–7.5% year over year. It expected ASMs to decrease 2%–3% versus Q2 2018 due to schedule adjustments for the MAX grounding.
• For full-year 2019, the company expected ASMs to increase 2%–3% year over year and capital expenditures of $1.9–$2.0 billion, assuming no prolonged MAX grounding that affects aircraft spending. It expected to end the year with approximately 775 aircraft, subject to the grounding and delivery schedule.
• For Q2, management expected unit costs excluding fuel and profitsharing to increase 10.5%–12.5%, citing fleet underutilization, Hawaii start-up costs, and cancellations. It projected a full-year 2019 effective tax rate of approximately 23.5%.
• Southwest began service to Hawaii in March and described Hawaii as a key expansion focus for 2019 and 2020. It had removed MAX flights from schedules through August 5, 2019, seeking to protect schedule reliability.
• The duration and conditions for ending the MAX grounding were unknown. A prolonged grounding could cause cancellations, lost revenue, underused aircraft and fixed-cost pressure, disrupt aircraft deliveries and retirements, affect customer confidence, and require more costly fleet alternatives. Southwest identified Boeing as its sole aircraft supplier.
• Fuel-price volatility and hedge effectiveness, severe weather, economic and demand changes, labor costs, technology execution, and third-party performance are also risks. Fuel derivatives had a $254 million fair-value asset at March 31; hedge outcomes and accounting treatment can vary with market prices and other factors.
• Southwest reported ongoing U.S. and Canadian capacity-related antitrust proceedings. The U.S. proposed class settlement included a $15 million payment; after a March 2019 fairness hearing, the court had not yet issued its written approval decision. Management did not expect ongoing legal matters or IRS adjustments to materially adversely affect financial condition, results, or cash flow.
• Fitch upgraded Southwest to A- in February 2019; Moody’s rated it A3 and S&P BBB+. Management reported effective disclosure controls at quarter-end. Lease-accounting system and process changes materially changed one component of internal control over financial reporting, with operating effectiveness to be evaluated as part of the annual assessment.

Investor verification priorities

• Track the FAA’s MAX grounding decisions, aircraft return-to-service timing, Boeing deliveries, cancellations, capacity, and related compensation or cost effects.
• Compare subsequent revenue, load factor, unit costs, and earnings with management’s Q2 and full-year assumptions, particularly the anticipated MAX-related capacity and cost effects.
• Monitor operating cash conversion and the composition of air traffic liabilities, as well as liquidity, debt, lease obligations, and planned capital spending.
• Assess fuel prices, hedge coverage, derivative fair values, and any resulting volatility in cash costs or reported earnings.
• Follow the U.S. antitrust settlement approval and other material litigation developments.