Southwest Airlines Co. — Q2 2017 Form 10-Q
Business context and reporting period. Southwest operates scheduled passenger air service in the United States and near-international markets. This unaudited quarterly report covers the three and six months ended June 30, 2017, compared with the same 2016 periods. Dollar figures below are in millions unless noted.
Financial and operating performance
| Metric | Q2 2017 | Q2 2016 | H1 2017 | H1 2016 |
|---|---|---|---|---|
| Operating revenue | $5,744 | $5,384 | $10,627 | $10,210 |
| Operating income | $1,250 | $1,276 | $1,908 | $2,220 |
| Net income | $746 | $820 | $1,097 | $1,333 |
| Diluted EPS | $1.23 | $1.28 | $1.80 | $2.07 |
| Operating cash flow | $746 | $1,112 | $2,370 | $2,728 |
- Q2 revenue increased 6.7%; operating income fell 2.0% and net income fell 9.0%. Operating and net margins were approximately 21.8% and 13.0%, respectively, versus 23.7% and 15.2% in Q2 2016.
- For H1, revenue increased 4.1%, while operating income declined 14.1% and net income declined 17.7%. Operating and net margins were approximately 18.0% and 10.3%, compared with 21.7% and 13.1%.
- Non-GAAP diluted EPS, excluding special items, was $1.24 in Q2, up 4.2%, despite non-GAAP net income decreasing 1.2%; the company attributed the per-share increase partly to share repurchases. H1 non-GAAP diluted EPS was $1.84, down 10.7%.
- Q2 passenger revenue rose 6.7%, supported by 5.1% capacity growth and 1.6% higher passenger revenue per available seat mile (ASM). Load factor was 85.6%, unchanged year over year. H1 capacity grew 4.6%, but load factor fell 0.3 percentage point to 82.9% and passenger revenue per ASM declined 0.8%.
- Q2 operating expenses rose 9.4%, faster than capacity growth; operating expense per ASM increased 4.1%. Wage and benefit expense rose 13.9% in Q2 and fuel expense rose 9.6%. Management cited amended union agreements and higher market fuel prices.
- At June 30, cash and cash equivalents were $1,537 and short-term investments were $1,615. Current assets were $4,343 versus current liabilities of $7,097, reflecting the company’s customary working-capital deficit, principally from advance ticket sales recorded as air traffic liability.
- Total debt, including current maturities, was approximately $3,095, down from $3,387 at year-end 2016. The company had no borrowings under its $1.0 billion revolving facility and was in compliance with its covenant. H1 capital expenditures were $965; debt and lease repayments were $428, share repurchases were $950, and dividends paid were $199.
- H1 operating cash flow declined to $2,370 from $2,728. Management noted that the $897 increase in air traffic liability from advance bookings and frequent-flyer point sales supported H1 cash flow. Cash and equivalents declined by $143 from year-end.
Material changes, outlook and commentary
- Management attributed earnings pressure primarily to higher labor and fuel costs, partly offset by passenger revenue growth. The company recognized fuel-hedge losses of $123 in Q2 and $229 in H1 within fuel expense; hedge-related mark-to-market items also affected other gains and losses.
- Management forecast Q3 2017 ASM growth of 4%–5% and Q4 growth of 1%–2%. It expected Q3 operating unit revenue to rise approximately 1% year over year, including an estimated one-point adverse impact from the reservation-system transition. It expected Q3 unit costs excluding fuel, profitsharing and special items to increase 2%–3%.
- The Amadeus Altéa reservation-system transition was completed in May. Management reported temporary revenue pressure greater than anticipated, with adjustments underway and expected to be largely implemented by year-end; it did not expect significant adverse impact after Q3. The company forecast annual incremental pretax benefits from system capabilities to ramp to approximately $200 by 2018.
- The accelerated retirement of remaining Boeing 737-300 Classic aircraft was expected to reduce the fleet to 707 aircraft by year-end 2017. Management projected at least $200 of cumulative incremental cost savings and pretax profit improvement by the end of 2020. It expected an approximately $60 Q3 charge, primarily for remaining lease payments on aircraft retired before lease end.
- Management expected a full-year 2017 effective tax rate of approximately 37%. The company increased its quarterly dividend by 25% and authorized a new $2.0 billion share-repurchase program; it planned a further $300 million accelerated repurchase beginning August 1, 2017.
- Fuel derivatives had a net fair-value liability of $242 at June 30, excluding collateral. The company had posted $165 of cash collateral and said a 25% decline in relevant commodity prices could require approximately $80 more collateral, while lower fuel prices would benefit operating fuel costs. Hedge coverage and realized results vary with market prices and derivative terms.
- Accounting changes may affect presentation and balance-sheet amounts: the company expected the lease standard to significantly increase assets and liabilities, principally from operating leases, and expected the revenue standard to significantly increase frequent-flyer liabilities. It estimated applying the relative-fair-value method could increase the $62 flight-point liability by approximately 20–25 times that amount. Planned adoption was January 1, 2018.
- Risks and contingencies include volatile fuel prices and hedge-accounting effects, fare competition and demand, labor costs, reservation and other technology execution, and aircraft delivery and retirement plans. Antitrust proceedings and investigations remained ongoing; management did not expect current legal matters or IRS adjustments to have a material adverse effect. The filing reported no material change to previously disclosed risk factors.
Most important facts for investors to verify
- Whether Q3 and later passenger unit revenue trends meet management’s outlook, including the duration and magnitude of reservation-system effects.
- Whether labor, fuel, and other unit-cost growth moderates as forecast, and whether the Classic fleet retirement delivers projected savings after the Q3 charge.
- Fuel-hedge coverage, cash settlements, collateral requirements, and the resulting effects on reported earnings and liquidity.
- Execution of aircraft commitments, capital spending, share repurchases, and dividends relative to operating cash generation and liquidity.
- The ultimate balance-sheet impact and implementation assumptions for the lease and revenue accounting standards, including frequent-flyer liability remeasurement.
- Developments in the antitrust matters and any resulting financial exposure; the filing does not provide a clear quantified loss estimate.