Southwest Airlines Co. — Q2 2014 Form 10-Q
Reporting period: Three and six months ended June 30, 2014. Southwest operates a major domestic airline and continued integrating AirTran; international Southwest service began July 1, 2014. Financial amounts are in U.S. dollars.
Financial performance
| Metric | Q2 2014 | Q2 2013 | First half 2014 | First half 2013 |
|---|---|---|---|---|
| Operating revenue | $5.011B | $4.643B | $9.178B | $8.727B |
| Operating income | $775M | $433M | $991M | $503M |
| Net income | $465M | $224M | $617M | $283M |
| Diluted EPS | $0.67 | $0.31 | $0.88 | $0.39 |
| Operating cash flow | $1.338B | $778M | $2.458B | $1.760B |
Q2 GAAP operating and net margins were approximately 15.5% and 9.3%, respectively, versus 9.3% and 4.8% a year earlier. First-half margins were approximately 10.8% and 6.7%, versus 5.8% and 3.2%. Management cited strong travel demand, strategic initiatives, relatively stable fuel prices, and largely flat operating expenses as drivers of the improvement.
- Revenue and operating trends: Q2 passenger revenue rose 8.5%; passenger yield increased 6.0% and load factor rose 2.3 percentage points to 83.9%. Operating revenue per available seat mile (RASM) rose 8.4%. Capacity (ASMs) declined 0.4% and trips flown declined 4.7%.
- Costs: Q2 operating expenses rose 0.6% despite slightly lower capacity. Fuel expense fell 4.3%; salaries, wages and benefits rose 8.3%, partly from higher profitsharing. Unit costs excluding fuel and special items increased 3.4%. First-half operating expenses fell 0.4%, while unit costs excluding fuel and special items rose 3.6%.
- Cash and liquidity: At June 30, cash and cash equivalents were $1.882B and short-term investments were $2.112B, totaling approximately $4.0B. Operating cash flow was offset in part by $907M of capital expenditures in the first half. The company had a fully available $1B revolving credit facility, no borrowings under it, and was in compliance with its covenant.
- Debt and capital returns: Long-term debt including current maturities totaled approximately $2.758B. First-half debt and capital-lease payments were $119M; remaining 2014 maturities and capital-lease obligations were approximately $440M. The company repurchased $555M of shares and paid $97M of dividends in the first half. The quarterly dividend was raised from $0.04 to $0.06 per share; a new $1B repurchase authorization was approved.
Material changes and unusual items
- Q2 passenger revenue included a $47M favorable revision to estimated ticket-spoilage revenue. The estimated net-income benefit was $25M, or $0.04 per diluted share, for both Q2 and the first half. This estimate change was linked in part to revised assumptions following the No Show policy.
- Q2 GAAP net income increased 107.6% year over year; first-half net income increased 118.0%. Non-GAAP diluted EPS, which excludes specified hedge effects and special items, was $0.70 in Q2 and $0.87 for the first half. These non-GAAP measures are not directly comparable across all companies.
- AirTran acquisition and integration costs were $38M in Q2 and $56M in the first half. Management expected approximately $550M in total integration costs, of which $466M had been incurred through June 30.
- The company recorded a $17M Q2 expense adjustment for estimated costs to convert AirTran 717 aircraft for Delta. As of June 30, 36 of 88 aircraft had been delivered to Delta; Southwest expected to end 717 service around year-end 2014.
Outlook, risks and contingencies
- Management expected Q3 2014 ASMs to increase approximately 2% year over year and full-year 2014 ASMs to be relatively flat. July passenger unit revenue was projected to rise 3%–4% year over year; July trends and bookings were described as strong. Management expected Q3 unit-cost growth excluding fuel, profitsharing and special items to be comparable to Q2’s increase.
- Management projected a 37%–38% full-year effective tax rate. It expected Q3 freight revenue to be comparable to Q2; Q3 other revenue was expected to decline more year over year than in Q2.
- Fuel hedges covered approximately 33% of Q2 fuel consumption; coverage for the remainder of 2014 was up to 41% as of June 30, depending on market prices. Management cautioned that hedge settlements could make fuel costs exceed unhedged market prices in some future periods. WTI-based derivatives no longer qualified for hedge accounting prospectively, creating earnings volatility; a 25% fall in relevant commodity prices could require substantial additional collateral under the company’s sensitivity scenario.
- Key execution and business risks include fuel-price and hedge volatility, demand and competition, AirTran integration, technology implementation, fleet and capacity changes, and substantial aircraft commitments. The company had $535M of aircraft commitments remaining in 2014 and $827M in 2015, with larger commitments thereafter.
- Airport projects create material commitments and potential exposures: the company guarantees principal and interest on $456M of Love Field modernization bonds; it had recorded $470M of Love Field construction assets and a $468M construction obligation. Houston Hobby expansion was estimated at $156M. A roughly $500M Los Angeles airport modernization project was planned, with funding arrangements still under consideration and a possible guarantee contemplated under one option.
- A federal antitrust class action involving AirTran and Delta remained pending; proceedings were stayed while a special master considered a discovery-sanctions dispute. Management did not expect currently ongoing legal matters or IRS adjustments to have a material adverse effect. The filing reported no material change to previously disclosed risk factors and stated disclosure controls were effective.
Important facts for investors to verify
- How much of reported revenue and EPS growth reflects the $47M ticket-spoilage estimate revision, and how future ticket-spoilage estimates may change.
- Whether revenue strength and unit-cost trends persist as capacity, network and fleet plans evolve.
- Fuel-hedge coverage, settlements, hedge-accounting volatility and potential collateral needs under changing commodity prices.
- Cash generation relative to aircraft purchases, integration spending, debt maturities, airport-project obligations and shareholder returns.
- Progress and final costs of AirTran integration and the 717 transition, as well as outcomes of the antitrust case and airport-project financing.