Business context and reporting period
Southwest Airlines Co. operates scheduled passenger air service in the United States and near-international markets. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2018. Comparative 2017 figures were recast for accounting-standard changes, including revenue recognition, hedging, and pension-cost presentation.
Financial performance and position
Amounts are in millions of dollars except per-share data and where noted.
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Operating revenue | $5,575 | $5,303 | $16,261 | $15,888 |
| Operating income | $798 | $845 | $2,386 | $2,667 |
| Net income | $615 | $528 | $1,811 | $1,610 |
| Diluted EPS | $1.08 | $0.88 | $3.13 | $2.66 |
| Operating cash flow | $1,271 | $996 | $3,904 | $3,366 |
| Capital expenditures | $454 | $638 | $1,384 | $1,603 |
- Q3 revenue grew 5.1%; operating income fell 5.6%, while net income rose 16.5%. Nine-month revenue increased about 2.3%, operating income declined 10.5%, and net income increased 12.5%.
- Calculated operating margin was approximately 14.3% in Q3 2018 versus 15.9% in Q3 2017; nine-month margin was approximately 14.7% versus 16.8%. Net margin was approximately 11.0% versus 10.0% in Q3.
- Q3 passenger revenue increased 5.1%, but operating expenses rose 7.2%. Fuel expense increased 16.2%; fuel cost per gallon including tax rose 13.1%. Salaries and benefits rose 6.8%, primarily due to contractual wage increases.
- Q3 capacity (ASMs) increased 3.9%; load factor declined 0.9 percentage points to 83.9%. Passenger yield increased 2.3%, and average fare increased 2.5%. For the first nine months, passenger yield declined 1.0% and average fare declined 2.1%.
- Cash and cash equivalents were $2.104 billion; short-term investments were $1.716 billion, for combined cash and short-term investments of $3.820 billion. Long-term debt, including current maturities, was $3.446 billion. Stockholders’ equity was $10.153 billion.
- Current liabilities exceeded current assets by $2.242 billion, largely reflecting advance ticket sales and loyalty-program obligations. Management said this working-capital deficit is customary for the airline and expects liquidity and operating cash generation to cover ordinary obligations.
- Nine-month investing cash use was $1.370 billion and financing cash use was $1.925 billion. Financing included $1.5 billion of share repurchases, $332 million of dividends, and $255 million of debt and capital-lease payments. Operating cash flow less capital expenditures was approximately $2.520 billion, a simple derived measure.
Material changes, outlook, and risks
- Management attributed higher Q3 net income chiefly to the lower federal corporate tax rate under the Tax Cuts and Jobs Act (Q3 effective rate 21.7% versus 36.5%); higher fuel and labor costs partly offset the benefit. Nine-month effective tax rates were 22.8% and 36.3%, respectively.
- Q3 2017 passenger revenue was reduced by about $100 million due to natural disasters. Management said nine-month passenger unit revenue was also affected by the April 2018 Flight 1380 accident, which resulted in a customer fatality.
- Q3 fuel hedge settlements were $52 million received, versus $163 million paid in Q3 2017; reported fuel expense included $54 million of net hedging gains versus $117 million of net hedging losses in the prior-year quarter. Fuel-hedge fair value was a $698 million asset at September 30, including Level 3 valuation inputs; results remain exposed to fuel prices, hedge performance, and counterparty risk.
- Management forecast Q4 2018 operating unit revenue growth of 1%–2% year over year; ASMs up 6%–6.5%; and unit costs excluding fuel and profitsharing flat to up 1%. Full-year 2018 ASMs were expected to increase about 4%, capital expenditures to be $2.0–$2.1 billion, and the effective tax rate to be about 23%. 2019 ASMs were expected to increase no more than 5%.
- At October 19 market assumptions, Q4 economic fuel cost was estimated at $2.30–$2.35 per gallon, including hedge premiums; this estimate is sensitive to market prices and hedge outcomes. The company reported maximum economic hedge coverage of 63% for 2019, 38% for 2020, 20% for 2021, and less than 5% for 2022, varying by price level.
- Southwest ended Q3 with 742 aircraft and expected 751 by year-end. It planned to begin selling Hawaii tickets in Q4, subject to governmental and FAA approvals. A tentative mechanics’ labor agreement was not ratified.
- The company had an undrawn $1.0 billion revolving credit facility expiring August 2022 and was in compliance with its financial covenant. It had $1.85 billion remaining under its May 2018 $2.0 billion repurchase authorization as of September 30, and launched an additional $500 million accelerated repurchase program on October 29.
- Material commitments include aircraft orders and estimated related capital commitments of $304 million for the remainder of 2018, $900 million in 2019, $1.4 billion in 2020, $1.7 billion in 2021, $1.2 billion in 2022, and $5.1 billion thereafter. The company also guaranteed $220 million of remaining LAX project borrowing and $424 million of Dallas Love Field modernization bonds.
- A proposed $15 million settlement of domestic airline capacity antitrust class actions awaited a March 22, 2019 fairness hearing. Southwest denied wrongdoing. Management did not expect ongoing legal proceedings or IRS matters to materially adversely affect financial condition, results, or cash flow. The filing reported no material changes to previously disclosed risk factors.
- Accounting estimates warrant attention: the frequent-flyer liability was approximately $2.9 billion, and a one-percentage-point change in estimated point spoilage would have changed passenger revenue by about $26 million for Q3 and $87 million for the nine-month period. Adoption of the new lease standard was expected to significantly increase reported assets and liabilities, including from aircraft operating leases.
Most important facts for investors to verify
- Whether projected Q4 unit-revenue growth and cost control materialized, particularly amid fuel-price volatility and weather-related disruption.
- How the Flight 1380 accident, customer demand, and competitive pricing affected passenger yield and bookings.
- Fuel-hedge coverage, settlement cash flows, valuation assumptions, and counterparty exposures as market prices change.
- Actual capital spending, aircraft deliveries, liquidity, and the pace and price of share repurchases relative to cash generation.
- Frequent-flyer redemption and spoilage assumptions, the resulting revenue recognition, and the balance-sheet impact of lease-standard adoption.
- FAA and other approvals for Hawaii service, labor negotiations, and the outcome of the proposed antitrust settlement.