SOUTHWEST AIRLINES CO quarterly report, Q1 FY2016

Southwest Airlines Co. — Q1 2016 Form 10-Q

Reporting period: Three months ended March 31, 2016; filed April 28, 2016. Southwest operates scheduled passenger air service in the United States and near-international markets. Unless otherwise stated, amounts are in U.S. dollars.

Financial performance

Metric	Q1 2016	Q1 2015	Change
Operating revenue	$4.826 billion	$4.414 billion	+9.3%
Operating income	$944 million	$780 million	+21.0%
Operating margin	19.6%	17.7%	+1.9 percentage points
Net income	$511 million	$453 million	+12.8%
Diluted EPS	$0.79	$0.66	+19.7%
Operating cash flow	$1.616 billion	$1.452 billion	+$164 million

Passenger revenue rose 5.3% to $4.398 billion; freight revenue fell 4.5% to $42 million; other revenue doubled to $386 million. The passenger-revenue increase reflected capacity growth and demand, while passenger unit revenue per ASM declined 3.6%. Net margin was approximately 10.6%, versus 10.3% a year earlier.

Management’s non-GAAP results were operating income of $952 million and net income of $567 million, compared with $770 million and $451 million, respectively. These measures adjust for fuel-hedge timing and other items and are not GAAP substitutes.

Cash, debt and liquidity

• Cash and cash equivalents were $2.388 billion at March 31, 2016, up from $1.583 billion at year-end. Short-term investments were $1.194 billion; cash plus short-term investments totaled $3.582 billion.
• Operating cash flow was $1.616 billion. Capital expenditures were $438 million; cash used in investing activities was $175 million. Financing activities used $636 million, including $500 million of share repurchases and $96 million of dividends.
• Long-term debt, including current maturities, totaled $3.308 billion ($953 million current and $2.355 billion long-term), versus $3.178 billion at December 31, 2015.
• The company reported a $1 billion unsecured revolving credit facility, undrawn at quarter-end and expiring April 2018. It was in compliance with the facility’s covenant. Management stated liquidity was sufficient to meet known obligations.
• Current liabilities were $8.253 billion and current assets were $4.574 billion. Air traffic liability, largely reflecting tickets and travel sold for future trips, was $3.675 billion.

Material changes and operating trends

• Available seat miles increased 9.2%; revenue passenger miles increased 9.9%; load factor rose to 80.5% from 80.1%. Passenger count increased 8.2%.
• Average passenger fare declined 2.7% and passenger yield fell 4.2%. The yield comparison includes the effect of the revised Chase co-branded credit-card agreement.
• Fuel and oil expense declined 2.9% to $852 million despite an 8.8% increase in fuel consumed. Economic fuel cost was $1.78 per gallon, down from $2.00. Reported fuel expense included $275 million of hedge losses, versus $47 million a year earlier.
• Operating expenses rose 6.8%, less than capacity growth. Expenses per ASM fell 2.1%, primarily due to lower fuel prices; excluding fuel and profitsharing, unit costs were approximately flat on the company’s stated basis.
• Depreciation and amortization increased 18.9% to $290 million, including $28 million of accelerated depreciation from the decision to retire the 737-300 fleet earlier. The company estimated about $88 million of additional depreciation expense for the remainder of 2016.
• Chase agreement accounting change: Q1 2016 revenue was increased by an estimated net $115 million ($169 million more other revenue and $54 million less passenger revenue); estimated net income increased $62 million, or $0.09 per diluted share. This prospective accounting change materially affects year-over-year revenue and earnings comparisons.

Outlook, management commentary and risks

• For 2016, Southwest planned ASM growth of 5%–6% and a fleet of approximately 720 aircraft. It expected Q2 ASMs to increase 4%–5% year over year.
• Management expected a modest Q2 increase in operating unit revenue, including an estimated approximately $125 million Q2 effect from the co-branded card agreements and accounting change. It noted some yield softness into April while describing low-fare demand as strong.
• Expected unit costs excluding fuel, profitsharing and special items were forecast to rise approximately 2% in Q2 and 1% for full-year 2016, largely because of accelerated depreciation. The projected full-year effective tax rate was 37%–38%.
• Fuel hedges covered up to approximately 60% of estimated remaining 2016 consumption at varying price levels; maximum coverage was 62% for 2017 and 35% for 2018 as of April 18. At March 31, outstanding fuel derivatives had a net fair-value liability of $1.4 billion, and Southwest had provided $1.1 billion in cash collateral. A 25% decline in relevant market prices was estimated to require another $287 million of collateral, subject to the company’s ability to use aircraft or letters of credit.
• Management cautioned that hedge accounting, commodity-price movements, demand, competition, consumer behavior, vendor performance and information-technology execution could affect results. The filing says fuel-hedge outcomes may differ from the protection intended and that low prices can make hedging costs disadvantageous.
• Southwest accelerated retirement of its 737-300 fleet to no later than Q3 2017, compared with a prior schedule extending to 2021, to simplify operations and address pilot-training requirements. Aircraft commitments include $850 million remaining for 2016 and substantial future purchase obligations.
• Antitrust matters include a legacy AirTran/Delta baggage-fee case and investigations and class actions alleging airline capacity coordination. The company denies wrongdoing and intends to defend itself; management did not expect ongoing legal proceedings or IRS matters to materially adversely affect financial condition, results or cash flow.
• No material changes to previously disclosed risk factors were reported. Management concluded disclosure controls were effective as of March 31, 2016; no material change in internal control over financial reporting was reported.

Key facts for investors to verify

• How much of reported growth reflects underlying passenger demand and capacity versus the Chase agreement’s $115 million revenue and $62 million net-income accounting benefit.
• Whether passenger yield and unit revenue trends improved, and how subsequent periods compare after separating the Chase accounting effect.
• Actual fuel-hedge settlements, fair values, collateral requirements and the sensitivity of cash and earnings to fuel-price movements.
• Realized accelerated depreciation and fleet-retirement timing, alongside aircraft deliveries, capital commitments and related financing needs.
• Progress and outcomes in the antitrust investigations and litigation, and any resulting financial or operational consequences.