Southwest Airlines Co. — Q2 2012 Form 10-Q
Reporting period: Three and six months ended June 30, 2012. The filing is dated July 26, 2012. Southwest acquired AirTran on May 2, 2011, so year-over-year comparisons include a longer period of AirTran operations in 2012; this affects comparability.
Financial performance
| Metric | Q2 2012 | Q2 2011 | First half 2012 | First half 2011 |
|---|---|---|---|---|
| Operating revenue | $4.616B | $4.136B | $8.606B | $7.238B |
| Operating income | $460M | $207M | $481M | $321M |
| Net income | $228M | $161M | $327M | $166M |
| Diluted EPS | $0.30 | $0.21 | $0.43 | $0.22 |
| Operating margin, approximate | 10.0% | 5.0% | 5.6% | 4.4% |
Q2 revenue rose 11.6% and operating income rose 122.2%; first-half revenue rose 18.9% and operating income rose 49.8%. Management attributed improved results principally to higher passenger yields from fare increases and revenue management, lower year-over-year Q2 fuel cost per gallon, lower interest expense, and operating efficiency. Non-GAAP Q2 net income was $273M ($0.36 diluted EPS), versus $121M ($0.15); first-half non-GAAP net income was $255M ($0.33), versus $142M ($0.19). These measures exclude specified fuel-hedge accounting effects and acquisition/integration costs and are not GAAP measures.
- Revenue and traffic: Q2 passenger revenue was $4.338B, up from $3.892B. Passenger yield increased 6.0%, while load factor slipped 0.4 percentage points to 81.9%. First-half passenger yield rose 4.7%; load factor declined 0.9 points to 79.7%.
- Costs and margins: Q2 operating expenses rose 5.8%, versus 5.6% capacity growth; reported operating expense per available seat mile (ASM) rose 0.2%. Excluding fuel and special items, Q2 unit costs rose 3.8%. First-half unit costs increased 2.9%, reflecting higher fuel prices and other costs.
- Fuel and hedging: Q2 reported fuel expense was $1.577B; fuel cost per gallon including tax was $3.25, down 1.5% year over year. First-half fuel cost per gallon was $3.32, up 6.1%. Fuel derivatives produced a $33M Q2 loss in fuel expense versus a $6M gain in Q2 2011; first-half impact was a $64M loss versus a $12M gain.
- Cash flow: Operating cash flow was $145M in Q2 versus $237M; first-half operating cash flow was $1.370B versus $1.202B. First-half investing cash use was $368M and financing cash use was $748M. Financing included $469M of debt and capital-lease repayments and $275M of stock repurchases.
- Liquidity and debt: At June 30, cash and cash equivalents were $1.083B and short-term investments were $2.173B, totaling approximately $3.256B. Management described unrestricted cash and short-term investments as $3.3B and cited an available $800M unsecured revolving credit facility, expiring April 2016. Current and long-term debt totaled approximately $3.276B, down from $3.751B at year-end 2011. Current liabilities were $5.080B; current assets were $4.691B.
- Capital returns: The quarterly dividend increased from $0.0045 to $0.01 per share. Southwest repurchased about 26.1M shares in Q2 for approximately $225M; about $500M of the $1B total authorization had been used by quarter-end.
Material changes and outlook
- AirTran integration costs were $11M in Q2 and $24M in the first half, down from $58M and $75M, respectively. Southwest expects total acquisition and integration costs of approximately $550M and targets $400M in annual pretax net synergies in 2013, excluding integration expenses.
- Management expected a solid increase in Q3 passenger unit revenue. Q3 unit costs excluding fuel, profitsharing, and special items were forecast to rise in the mid-to-high single digits year over year. The company projected a full-year 2012 effective tax rate of approximately 38%–40% and expected 2012 ASMs to approximate the combined 2011 Southwest and AirTran level; it did not plan to grow total fleet size in 2012.
- Southwest deferred 30 Boeing deliveries from 2013–2014 to 2017–2018, reducing expected capital expenditures by approximately $1B over 2012–2014 without reducing total purchase commitments. It planned to retire about 40 older 737-300 and 737-500 aircraft in 2012.
- After quarter-end, Southwest agreed to lease or sublease all 88 AirTran Boeing 717s to Delta, with transfers expected to begin in August 2013. The company expected to record an approximately $140M charge when the lease arrangements commence, anticipated in Q3 2012; additional vendor termination costs may arise.
- The company expected to begin international service in 2014, subject to plans and approvals. It agreed to fund an estimated $100M expansion at Houston Hobby Airport, expected to be available in 2015, and planned two daily Washington Reagan–St. Louis roundtrips subject to approvals.
Risks, contingencies, and unusual items
- Fuel hedging is exposed to commodity-price volatility, hedge ineffectiveness, and accounting-driven earnings swings. At June 30, outstanding fuel derivatives had an estimated net fair-value liability of $140M before collateral. Southwest had posted $265M of cash collateral, including $98M classified as excess deposits; a 25% fall in relevant commodity prices could require additional cash, aircraft, and letter-of-credit collateral.
- Management noted that the widening spread between WTI crude and jet fuel had reduced hedge effectiveness; further divergence could leave fuel costs inadequately hedged. Fuel prices, demand, the economy, competition, integration execution, technology projects, regulation, and third-party dependencies are key forward-looking risks.
- Southwest guaranteed principal and interest on $456M of Love Field modernization bonds issued by June 2012. The project was expected to cost about $519M; $268M of costs had been recorded as an asset and corresponding obligation at quarter-end.
- A putative class-action antitrust case involving Delta and AirTran remained pending. Class certification and summary-judgment briefing were scheduled for later in 2012. Management did not expect current legal proceedings or IRS matters to materially affect financial condition, results, or cash flow. The filing reported no material change to the risk factors in the 2011 Form 10-K.
- Q2 comprehensive loss was $35M despite $228M net income, primarily reflecting a $251M after-tax unrealized fuel-derivative loss. First-half comprehensive income was $231M, below net income of $327M.
Important facts for investors to verify
- How much of reported growth and margin improvement reflects underlying Southwest performance versus the changing AirTran consolidation comparison.
- Whether passenger revenue momentum and fare increases can persist without further load-factor deterioration, and whether Q3 cost guidance is achieved.
- Realized fuel-hedge cash flows, future hedge settlements, hedge effectiveness, and collateral or liquidity requirements under adverse fuel-price movements.
- Timing and final cost of the expected $140M Boeing 717 transition charge, additional AirTran integration spending, and progress toward the $400M synergy target.
- Aircraft spending and obligations after the delivery deferrals, Love Field bond guarantees, and funding commitments for Houston Hobby.
- Developments in the antitrust class action and any required approvals for the Boeing 717 leases and planned route changes.