Business context and reporting period
Southwest Airlines Co. operates scheduled passenger air service in the United States and near-international markets. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2016; comparisons are with the corresponding 2015 periods. Amounts are in U.S. dollars.
Financial and operating performance
| Metric | Q3 2016 | First nine months 2016 |
|---|---|---|
| Operating revenue | $5.139 billion, down 3.4% | $15.350 billion, up 3.4% |
| Operating income | $695 million, down 43.3%; 13.5% margin | $2.915 billion, down 5.7%; 19.0% margin |
| Net income | $388 million, down 33.6% | $1.722 billion, up 4.7% |
| Diluted EPS | $0.62, down 29.5% | $2.70, up 10.2% |
| Operating cash flow | $856 million | $3.584 billion, versus $2.914 billion |
| Capital expenditures | $464 million | $1.364 billion |
Management’s non-GAAP results, which exclude specified special items and adjust fuel-hedge accounting effects, were Q3 operating income of $972 million and net income of $582 million ($0.93 diluted EPS); nine-month operating income of $3.190 billion and net income of $1.907 billion ($3.00 diluted EPS). These measures are supplemental, not GAAP substitutes.
- Q3 passenger revenue was $4.669 billion, down 1.0%; passenger unit revenue (PRASM) fell 5.0%. Capacity rose 4.2%, traffic rose 4.1%, and load factor was 85.3%.
- Q3 salaries, wages and benefits rose 12.4%, in large part reflecting accruals for proposed union-contract signing bonuses. Depreciation and amortization rose 22.1%, including accelerated depreciation on the Classic fleet.
- Q3 fuel and oil expense increased slightly in dollars, despite lower market fuel prices, as fuel-hedge losses offset much of the benefit. Economic fuel cost per gallon declined 8.2% year over year.
- For the first nine months, fuel and oil expense decreased 4.3%; labor expense increased 7.7% and depreciation and amortization increased 20.2%.
Balance sheet, debt and liquidity
At September 30, 2016, cash and cash equivalents were $1.966 billion and short-term investments were $1.480 billion, totaling $3.446 billion. Total debt, including current maturities, was $3.295 billion; stockholders’ equity was $8.047 billion. Current assets were $4.839 billion and current liabilities were $7.816 billion, including $3.677 billion of air traffic liability. The company reported no borrowings under its new $1 billion unsecured revolving credit facility, which expires in August 2021, and said it was in compliance with the facility covenant.
Nine-month financing cash outflows included $1.450 billion of share repurchases, $222 million of dividends, and $171 million of debt and capital-lease payments. In October, the company completed a $250 million accelerated share repurchase, bringing total shares repurchased under it to 6.7 million. A subsequent October 31 term loan provided $215 million, secured by seven 737-800 aircraft.
Changes, outlook and notable items
- Q3 GAAP revenue and profit declined, while nine-month revenue and net income increased. The prior-year comparison included a one-time $172 million special revenue adjustment in Q3 2015. Separately, a change in Chase co-branded card revenue accounting increased nine-month 2016 revenue by an estimated net $261 million and net income by $139 million; it shifted amounts between passenger and other revenue.
- A July 2016 technology outage led to more than 2,000 canceled flights and contributed to lower Q3 passenger revenue and higher other operating expense.
- Southwest accelerated retirement of its 737-300 Classic aircraft, now planned no later than Q3 2017 rather than 2021. The change added $94 million to nine-month depreciation expense; management estimated a further $29 million increase in Q4 2016.
- Management expected Q4 2016 operating unit revenue to decline 4%–5% year over year, with holiday timing estimated to account for about 1.5 percentage points. It expected Q4 capacity growth of about 5%, and Q4 unit costs excluding fuel, special items and profitsharing to rise 4%–5%. Planned 2017 capacity growth was about 3.5%. Management projected a 37%–38% full-year 2016 effective tax rate.
- Fuel hedges: the reported fair value of outstanding fuel derivatives was a net liability of $722 million, excluding collateral. The company had provided $605 million in cash collateral and disclosed potential additional collateral needs if commodity prices fell. It expected approximately $401 million of net-of-tax fuel-hedge losses in AOCI to be recognized in earnings over the next 12 months.
- Labor negotiations and tentative agreements generated substantial bonus accruals; ratification outcomes remained pending for some groups. The company continued reservation-system replacement work, with foundational releases then scheduled for December 2016 and May 2017.
- Commitments include substantial future aircraft purchases: capital commitments were $281 million for Q4 2016, $1.1 billion for 2017, and $6.1 billion thereafter. The company also guaranteed $439 million of outstanding Dallas Love Field modernization bonds and guaranteed obligations associated with the Los Angeles airport project credit facility.
- Antitrust matters include class litigation related to alleged capacity restrictions and a separate AirTran baggage-fee case. The company denied wrongdoing and said it intended to defend the cases; management did not expect ongoing legal proceedings, individually or collectively, to have a material adverse effect.
Important facts for investors to verify
- Whether falling fares and unit revenue persist, and how planned capacity growth affects load factors and margins.
- The final cost and effect of labor agreements, including bonus accruals and ongoing negotiations.
- Fuel-hedge settlements, future fuel costs, collateral requirements and the timing of losses deferred in AOCI.
- Execution and costs of the reservation-system transition following the July outage.
- Aircraft delivery, retirement and capital-spending plans, and the outcome and potential exposure of antitrust litigation.
- How reported GAAP results compare with management’s non-GAAP measures and the accounting impact of the Chase agreement.