SOUTHWEST AIRLINES CO quarterly report, Q2 FY2019

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Southwest Airlines Co. — Q2 2019 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2019. Southwest operates scheduled passenger air service in the United States and near-international markets. Financial amounts below are in U.S. dollars; “H1” refers to the six months ended June 30.

Financial performance

MetricQ2 2019Q2 2018H1 2019H1 2018
Operating revenue$5.909B$5.742B$11.059B$10.686B
Operating income$968M$972M$1.473B$1.588B
Net income$741M$733M$1.128B$1.195B
Diluted EPS$1.37$1.27$2.06$2.05
Cash from operations$966M$1.631B$2.071B$2.632B

Q2 revenue rose 2.9%; operating income was nearly flat, while net income increased 1.1%. H1 revenue grew 3.5%, but operating income fell 7.2% and net income fell 5.6%. Q2 load factor increased 1.7 percentage points to 86.4%, passenger yield rose 4.2%, and operating revenue per available seat mile (RASM) increased 6.8%. Capacity (ASMs) declined 3.6% in Q2; operating expense per ASM increased 7.5%, or 10.9% excluding fuel, special items, and profitsharing.

Q2 operating margin was approximately 16.4%, versus 16.9% a year earlier; H1 operating margin was approximately 13.3%, versus 14.9%. These are calculated from reported revenue and operating income.

Cash, debt, and liquidity

  • At June 30, cash and cash equivalents were $2.446B and short-term investments were $1.540B, totaling about $4.0B in unrestricted cash and short-term investments.
  • Reported current and long-term debt totaled $3.103B, including finance-lease amounts. Operating-lease liabilities were another $1.422B; total lease liabilities, including finance leases, were $2.116B.
  • Current assets were $5.554B and current liabilities were $8.611B. The company said its working-capital deficit is typical for airlines and largely reflects advance ticket sales and loyalty obligations.
  • H1 capital expenditures were $390M. The company repaid $175M of debt and finance-lease obligations, repurchased $950M of stock, and paid $276M in dividends.
  • A $1.0B unsecured revolving credit facility, expiring August 2022, was undrawn; Southwest reported compliance with its financial covenant.

Material changes and operating drivers

  • The FAA grounding of Southwest’s 34 Boeing 737 MAX 8 aircraft began March 13, 2019. Management estimated the grounding reduced operating income by about $175M in Q2 and $225M in H1. Approximately 20,000 flights were canceled in Q2, and delayed aircraft deliveries reduced capital spending.
  • Higher fares and yield, improved load factor, and growth in co-branded card and loyalty-related revenue supported revenue. Management noted Q2 comparisons also benefited from the prior-year Flight 1380 accident’s estimated $100M passenger-revenue impact and from lower capacity.
  • H1 operating expenses increased 5.4% despite a 1.3% capacity reduction. Salary and benefit costs, maintenance, and other operating costs increased; lower market fuel prices reduced fuel expense.
  • Southwest adopted the new lease standard on January 1, 2019. It recorded operating right-of-use assets and lease liabilities; management said the adoption’s effect on results and cash flows was not significant. Prior-year periods were not restated.

Outlook, risks, and contingencies

  • Management expected Q3 2019 ASMs to decline 2%–3% year over year and full-year 2019 ASMs to decline 1%–2%, reflecting MAX-related schedule reductions. MAX flights were removed from the schedule through January 5, 2020; a Q4 return-to-service assumption depended on Boeing and FAA actions.
  • Based on bookings and trends, management expected Q3 RASM growth of 3%–5%. It expected Q3 unit costs excluding fuel and profitsharing to rise 9%–11%, partly because cancellations reduce capacity while many costs remain fixed.
  • Management estimated 2019 capital expenditures of $1.2B–$1.3B, assuming MAX return to service in Q4. It expected $500M–$600M of scheduled 2019 aircraft spending to shift into 2020; further delays could change the estimate. The company’s estimated full-year effective tax rate was approximately 23.5%.
  • MAX delivery timing and compensation remain uncertain. Boeing announced a $4.9B after-tax charge for potential customer concessions and other considerations, but Southwest had not reached conclusions on compensation and included no expected Boeing compensation in Q2 results.
  • Fuel-hedging coverage, instrument values, and hedge-accounting treatment expose results to commodity-price and accounting volatility. As of June 30, fuel derivatives had a reported fair-value asset of $187M; management cautioned that hedge coverage varies with market prices.
  • The company disclosed a $15M settlement of U.S. consumer capacity litigation, finally approved in May 2019, with appeals filed by three objectors. A separate MAX-related class action filed in July 2019 named Southwest and Boeing; Southwest denied the allegations and intended to defend itself. Management did not expect ongoing legal proceedings or IRS matters to have a material adverse effect.
  • Other risks cited include economic and competitive conditions, severe weather, fuel-price volatility, technology execution, and dependence on Boeing and FAA decisions. The MAX grounding was identified as a new material risk factor.

Most important facts for investors to verify

  • Whether and when the FAA authorizes MAX service and deliveries, and the resulting effects on capacity, costs, earnings, and capital spending.
  • Whether Southwest secures Boeing compensation, its amount and timing, and whether any amount is recognized in future periods.
  • Whether forecast Q3 revenue and unit-cost trends materialize, particularly given lower capacity and fixed operating costs.
  • Cash generation and liquidity after continued share repurchases and dividends; distinguish operating-lease obligations from funded debt.
  • Developments in the MAX-related lawsuit and appeals concerning the consumer litigation settlement.