Southwest Airlines Co. — Q3 2017 Form 10-Q
Business context and period. Southwest operates scheduled passenger air service in the U.S. and near-international markets. This unaudited filing covers the quarter and nine months ended September 30, 2017; financial figures below are in millions of dollars except per-share and operating statistics. The company notes that airline results are seasonal and interim results are not necessarily indicative of full-year performance.
Financial performance and position
| Metric | Q3 2017 | Q3 2016 | Change | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|---|
| Operating revenue | $5,271 | $5,139 | +2.6% | $15,897 | $15,350 |
| Operating income | $834 | $695 | +20.0% | $2,742 | $2,915 |
| Net income | $503 | $388 | +29.6% | $1,600 | $1,722 |
| Diluted EPS | $0.84 | $0.62 | +35.5% | $2.64 | $2.70 |
| Operating cash flow | $996 | $856 | +$140 | $3,366 | $3,584 |
- Margins: GAAP operating margin was approximately 15.8% in Q3 2017 versus 13.5% a year earlier; for the nine-month period, approximately 17.2% versus 19.0%.
- Revenue mix: Q3 passenger revenue was $4,745 (+1.6%); freight was $42 (flat); other revenue was $484 (+13.1%). Nine-month passenger revenue rose 3.1% and other revenue rose 9.3%; freight was relatively flat.
- Cash and liquidity: At September 30, cash and cash equivalents were $1,460 and short-term investments were $1,580, totaling $3,040. The company also had an undrawn $1.0 billion revolving facility, extended to August 2022. Current assets of $4,280 were below current liabilities of $6,965, primarily reflecting advance ticket and frequent-flyer obligations; management says these obligations largely do not require cash settlement.
- Debt and equity: Long-term debt including current maturities was $3,079 ($316 current and $2,763 noncurrent). Stockholders’ equity was $8,800. The company repaid $534 of debt and capital lease obligations in the first nine months.
- Capital returns and investment: Nine-month capital expenditures were $1,603. The company repurchased $1,250 of stock and paid $274 in dividends. It declared $0.125 per share in Q3 dividends.
Changes versus the prior comparable period
- Q3 GAAP income improved, but comparison benefited from $356 of contract ratification bonuses accrued in Q3 2016. Excluding special items, Q3 2017 net income was $528, down 9.3% from $582; diluted EPS was $0.88 versus $0.93. Nine-month non-GAAP net income fell 13.6%, to $1,648 from $1,907.
- Nine-month operating expenses increased 5.8%, faster than capacity growth of 4.1%; operating expenses per available seat mile (ASM) rose 1.6%. Wage increases under amended union agreements and higher fuel prices were key factors. Fuel and oil expense increased 8.1% for the nine-month period.
- Q3 passenger capacity grew 3.1%, while passenger revenue per ASM declined 1.4%; passenger yield fell 0.9% and load factor eased to 84.8% from 85.3%. The company attributed pressure to a competitive fare environment.
- Hurricanes and earthquakes led to approximately 5,000 flight cancellations and an estimated $100 reduction in Q3 passenger revenue.
- Q3 operating cash flow increased year over year, but nine-month operating cash flow declined to $3,366 from $3,584. The 2017 period included an $817 increase in air traffic liability and $286 of net cash collateral inflows from fuel-derivative counterparties.
Outlook, commentary, risks and unusual items
- Near-term outlook: Management expected Q4 2017 operating unit revenue to rise from slightly positive to 1.5% year over year; ASMs were expected to increase 1%–2%. Q4 unit costs excluding fuel, special items and profitsharing were expected to be flat to up 1.5%. The company projected a full-year 2017 effective tax rate of approximately 36%–37%.
- Capacity and fleet: The remaining 69 leased Boeing 737-300 (“Classic”) aircraft were retired in Q3. The company expected its fleet to reach 707 aircraft by year-end 2017 and 750 by year-end 2018; it expected 2018 ASM growth below 5.7%, with first-half growth of 3%–4%. Management expected Classic fleet retirement to generate at least $200 of cumulative pretax savings by the end of 2020.
- Operational initiatives: The new reservation system was expected to deliver an estimated $200 of incremental pretax benefit in 2018. Route additions and schedule optimization were ongoing. Planned Hawaii service remained subject to government and FAA approvals.
- Unusual costs: Classic aircraft retirements resulted in $83 of Q3 charges: a $63 grounding charge and $20 of lease termination expense. Nine-month related charges totaled $96. Natural-disaster disruption and fuel-hedge effects also affected results.
- Fuel exposure: Fuel-derivative fair value was a net liability of $10 at September 30, excluding collateral. The company reported economic hedge coverage at varying price levels of up to 79% of estimated 2018 fuel consumption and 63% for 2019. Hedge outcomes, fuel prices, and collateral requirements remain volatile; a 25% commodity-price decline was estimated to require an additional $45 of cash collateral under the then-current portfolio.
- Accounting changes: The company planned to adopt the revenue standard in 2018 and estimated frequent-flyer liabilities could increase approximately 20–25 times the existing $64 balance, depending on assumptions. The new lease standard was expected to significantly increase reported assets and liabilities; contractual rents for 53 leased aircraft and 76 aircraft subleased to another airline had a stated net present value of about $1.0 billion, excluding other measurement factors and sublease income. Management did not expect the lease standard to affect existing debt covenants.
- Contingencies and risks: Airline capacity and pricing antitrust claims and government inquiries were ongoing; management did not expect current proceedings or IRS matters to materially adversely affect financial condition, results or cash flow. The filing reported no material change to previously disclosed risk factors. Other key risks include competition, fuel-price and hedge-accounting volatility, natural disasters, regulation, and timely delivery of aircraft and technology initiatives.
- Credit and controls: S&P upgraded the company to BBB+ in August 2017; Moody’s rated it A3 and Fitch BBB+. The company reported compliance with its revolving-credit covenant and effective disclosure controls as of September 30, 2017.
Important facts for investors to verify
- Assess underlying profitability using both GAAP and non-GAAP results, particularly the effect of 2016 ratification bonuses and 2017 aircraft-retirement charges.
- Track fare yield, unit revenue, load factor and capacity growth against management’s Q4 outlook, including any continued competitive pricing pressure.
- Monitor fuel prices, hedge settlements, derivative fair values and collateral needs, and distinguish economic fuel costs from GAAP expense.
- Review execution of fleet, route and reservation-system plans, including the timing and realization of projected savings and benefits.
- Evaluate the prospective balance-sheet effects of the revenue and lease accounting standards and follow developments in antitrust matters and other contingencies.