Southwest Airlines Co. Q1 2008 Filing Summary
Business Context and Reporting Period
This Form 10-Q covers the quarterly period ended March 31, 2008. Southwest Airlines Co. reported its 68th consecutive quarterly profit. The airline operates a low-cost business model and maintains a significant fuel hedging program to mitigate jet fuel price volatility. The quarter was impacted by high fuel prices, a proposed FAA fine, and the bankruptcy of codeshare partner ATA Airlines.
Key Financial Metrics
| Metric | Q1 2008 | Q1 2007 |
|---|---|---|
| Total Operating Revenues | $2,530 million | $2,198 million |
| Operating Income | $88 million | $84 million |
| Net Income | $34 million | $93 million |
| Diluted EPS | $0.05 | $0.12 |
| Operating Cash Flow | $964 million | $617 million |
| Cash and Equivalents (End of Period) | $2,982 million | $1,618 million |
| Total Debt (Current + Long-term) | $2,119 million | $2,091 million |
| Fuel Cost per Gallon (Hedged) | $2.01 | $1.60 |
Material Changes vs. Prior Period
- Revenue Growth: Operating revenues increased 15.1% ($332 million) driven by a 14.3% increase in passenger revenue, higher yields (4.7% increase), and a record load factor of 69.8%.
- Profit Decline: Net income decreased 63.4% to $34 million. This decline was primarily due to a $23 million net loss recorded in "Other (gains) losses, net" related to fuel derivative ineffectiveness and mark-to-market adjustments, contrasting with an $83 million gain in Q1 2007.
- Expense Increases: Total operating expenses rose 15.5%. Fuel and oil expenses increased $189 million (25.6% per ASM) despite hedging benefits. Other operating expenses increased $55 million, largely due to a $10 million accrued FAA fine and higher advertising costs.
- Liquidity: Cash and cash equivalents increased by $769 million, bolstered by strong operating cash flows and an increase in counterparty collateral deposits related to fuel hedges.
Guidance, Outlook, and Risks
- Capacity and Fleet: Management reduced 2008 capacity growth guidance to approximately 3.5% (down from 4-5%) due to economic slowdowns and high fuel costs. The company is reviewing plans to retire 22 aircraft.
- Fuel Hedging: Southwest has hedged over 70% of its 2008 fuel needs at an average crude oil equivalent price of ~$51/barrel. Q2 2008 fuel costs are estimated at $2.35/gallon.
- Legal Contingencies: The FAA proposed a $10 million fine regarding airworthiness directive compliance. The company has accrued this amount and is in an informal conference with the FAA. Two putative class-action lawsuits related to this incident are pending.
- Subsequent Event: ATA Airlines, Southwest's sole codeshare partner, declared bankruptcy in April 2008. Southwest expects a $5 million cost to accommodate affected passengers, to be recognized in Q2 2008.
- Investment Risk: The company holds $320 million in auction rate securities. Due to market liquidity issues, these were reclassified to Level 3 fair value measurements, with a $10 million unrealized loss recorded in other comprehensive income.
Investor Verification Checklist
- Fuel Hedge Effectiveness: Verify the impact of derivative ineffectiveness on future earnings, as unrealized losses in Q1 significantly reduced net income despite strong operating performance.
- FAA Fine Resolution: Monitor the outcome of the informal conference with the FAA regarding the $10 million proposed fine and potential additional penalties.
- Auction Rate Securities: Assess the liquidity risk and potential for further valuation adjustments on the $320 million portfolio of auction rate securities.
- Capacity Adjustments: Confirm the final number of aircraft retirements and the impact on 2008 unit cost targets.
- ATA Bankruptcy Costs: Track the actual costs incurred in Q2 2008 related to the ATA codeshare termination.