LUV

Business Context and Reporting Period

Company: Southwest Airlines Co.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2004
Overview: Southwest reported its 53rd consecutive quarterly profit despite a challenging revenue environment and record-high energy prices. The airline expanded its fleet to 405 aircraft and added service to Philadelphia, its 59th city. Management highlighted strong load factors, reaching a record 76.3% in the second quarter.

Key Financial Metrics

Note: Q2 2003 Net Income included a $271 million government grant from the Emergency Wartime Supplemental Appropriations Act, which significantly inflated prior-year comparisons.

Material Changes vs. Prior Period

• Revenue Growth: Operating revenues increased 13.3% in Q2 2004 compared to Q2 2003, driven by a 14.1% increase in Revenue Passenger Miles (RPMs) and a 4.9% increase in capacity (Available Seat Miles).
• Profitability Adjustment: While reported Net Income decreased 54% year-over-year due to the absence of the 2003 government grant, adjusted Net Income (excluding the grant) increased 9.7% to $113 million.
• Cost Pressures: Operating expenses per Available Seat Mile (CASM) increased 5.3% year-over-year. This was driven by higher fuel costs (up 21.3% per ASM), higher maintenance, and labor costs, partially offset by fuel hedging gains and the elimination of travel agency commissions.
• Operational Efficiency: Load factor improved significantly to 76.3% in Q2 2004, up 6.2 points from the prior year, representing a company record.

Guidance, Outlook, and Risks

• Outlook: Management expects third-quarter 2004 earnings to exceed third-quarter 2003 earnings due to improved revenues offsetting higher labor and fuel costs. Full-year 2004 CASM is expected to exceed 2003 levels (excluding the grant) due to lower-than-estimated capacity growth in the second half.
• Fuel Hedging: The company has hedged over 80% of its 2004 fuel requirements at prices under $24 per barrel and 80% of 2005 requirements at approximately $25 per barrel. As of June 30, 2004, fuel hedge contracts held a net asset fair value of $548 million.
• Capital Allocation: The company repurchased $136 million of common stock in the first half of 2004 under a $300 million authorization. Capital expenditures for the first half totaled $870 million, primarily for new 737-700 aircraft.
• Risks: Key risks include volatile jet fuel prices, labor contract negotiations, competitive fare sales, and potential disruptions from security directives or adverse weather. The company noted that government war-risk insurance coverage expires August 31, 2004.
• Unusual Items: Q2 2004 included $11 million in charges for a voluntary early-out employee program and a $12 million charge related to a tentative flight attendant labor agreement. Q1 2004 included $18 million in costs for consolidating reservations centers.

Investor Verification Checklist

• Adjusted Earnings: Verify the reconciliation of GAAP Net Income to Non-GAAP Net Income excluding the 2003 government grant to assess true operational performance trends.
• Fuel Hedge Effectiveness: Monitor the realization of the $548 million unrealized gain on fuel hedges and the impact of rising spot fuel prices on future quarters.
• Labor Costs: Track the ratification of the tentative Flight Attendant contract and the long-term impact of the voluntary early-out program on labor costs.
• Capacity Growth: Confirm the delivery schedule of the 25 remaining 737-700 aircraft for 2004 and the impact on unit costs (CASM) in the second half of the year.
• Stock Repurchases: Review the remaining balance of the $300 million share repurchase program and the timing of future buybacks.