Business Context and Reporting Period
Company: Southwest Airlines Co.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2004
Business Overview: Southwest is a major domestic airline providing point-to-point, low-fare service. As of year-end 2004, it operated 417 Boeing 737 aircraft serving 60 airports in 59 cities across 31 states. The company maintained its position as the largest U.S. carrier based on originating domestic passengers boarded and scheduled domestic departures. Key competitive strengths include a single aircraft type, high asset utilization, and a low-cost structure.
Key Financial Metrics
| Metric | 2004 | 2003 |
|---|---|---|
| Operating Revenues | $6,530 million | $5,937 million |
| Operating Expenses | $5,976 million | $5,454 million |
| Operating Income | $554 million | $483 million |
| Net Income | $313 million | $442 million |
| Diluted EPS | $0.38 | $0.54 |
| Operating Cash Flow | $1,157 million | $1,336 million |
| Total Assets | $11,337 million | $9,878 million |
| Long-term Debt | $1,700 million | $1,332 million |
| Stockholders' Equity | $5,524 million | $5,052 million |
| Cash and Equivalents | $1,305 million | $1,865 million |
Operational Highlights:
- Load Factor: 69.5% (up 2.7 points from 2003).
- Fleet Size: 417 aircraft (net addition of 29 aircraft).
- Fuel Cost: Average cost of $0.83 per gallon (net of hedging gains), representing 16.7% of operating expenses.
- Employees: 31,011 at year-end.
Material Changes vs. Prior Period
Revenue and Profitability:
- Operating revenues increased 10.0% to $6.53 billion, driven by an 11.4% increase in revenue passenger miles (RPMs) and a higher load factor. However, passenger yields declined 1.8% due to industry-wide fare discounting.
- Reported Net Income decreased 29.2% to $313 million. This decline is largely attributable to the absence of a $271 million government grant received in 2003 under the Emergency Wartime Supplemental Appropriations Act. Excluding this grant, 2004 net income increased 5.0% compared to 2003.
- Operating Income increased 14.7% to $554 million.
Expenses:
- Operating expenses increased 9.6%. Fuel and oil expenses rose 12.1% per available seat mile (ASM) due to higher jet fuel prices, partially offset by hedging gains of $455 million.
- Salaries, wages, and benefits increased 2.6% per ASM, driven by higher wage rates and benefits costs, though productivity improvements (headcount per aircraft dropped from 85 to 74) mitigated some costs.
- Agency commissions were eliminated, saving approximately $50 million in 2004.
Liquidity and Capital:
- Cash and cash equivalents decreased to $1.3 billion from $1.865 billion, primarily due to significant capital expenditures ($1.9 billion) for new aircraft and a $40 million debtor-in-possession loan to ATA Airlines.
- Long-term debt increased to $1.7 billion following the issuance of $350 million in senior unsecured notes and $112 million in floating-rate financing.
Guidance, Outlook, and Risks
Outlook and Strategy:
- 2005 Capacity: Expected to grow approximately 10% with the net addition of 29 aircraft.
- Cost Outlook: Management expects unit costs excluding fuel to be lower in 2005 than in 2004, driven by productivity gains and the absence of one-time severance costs incurred in Q1 2004.
- Fuel Hedging: Approximately 85% of 2005 fuel consumption is hedged at an effective price of roughly $26 per barrel. Management forecasts Q1 2005 fuel costs to exceed Q4 2004 levels.
- Expansion: New service to Pittsburgh began in May 2005. A codeshare agreement with ATA Airlines is expected to generate $25–$50 million in annual revenue.
Risks and Contingencies:
- Fuel Prices: Significant exposure to jet fuel price volatility, though mitigated by an extensive hedging program.
- ATA Acquisition: Risks associated with the acquisition of ATA assets and the collectibility of loans made to ATA.
- Regulatory: Potential changes in the Wright Amendment (Dallas Love Field restrictions) and ongoing security costs.
- Accounting Changes: Adoption of SFAS 123R (Share-Based Payment) in 2005 is expected to reduce net earnings by approximately $10 million per quarter.
Investor Verification Checklist
- Government Grant Impact: Verify the exclusion of the 2003 $271 million wartime grant when analyzing year-over-year profitability trends.
- Fuel Hedge Effectiveness: Review Note 10 for details on the $796 million fair value of fuel derivative assets and the extent of hedging coverage for 2005.
- ATA Transaction: Assess the risks and potential returns of the $40 million loan and asset purchase from ATA Airlines, Inc.
- Stock Repurchases: Note the $246 million spent on share repurchases in 2004 and the remaining authorization under the $300 million program.
- Debt Structure: Confirm the mix of fixed vs. floating rate debt, noting the conversion of $350 million in notes to floating rates via interest rate swaps.