Southwest Airlines Co. — Form 10-Q Summary
Reporting period: Three and six months ended June 30, 2016; filed July 27, 2016. Southwest operates scheduled passenger air service in the U.S. and near-international markets. Figures below are in U.S. dollars; financial statement amounts are in millions unless noted.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Operating revenue | $5,384 | $5,111 | $10,210 | $9,525 |
| Operating income | $1,276 | $1,085 | $2,220 | $1,865 |
| Net income | $820 | $608 | $1,333 | $1,061 |
| Diluted EPS | $1.28 | $0.90 | $2.07 | $1.57 |
| Operating margin | 23.7% | 21.2% | 21.7% | 19.6% |
| Operating cash flow | $1,112 | $627 | $2,728 | $2,079 |
- Q2 GAAP revenue rose 5.3%, operating income 17.6%, and net income 34.9% year over year. Six-month revenue rose 7.2%, operating income 19.0%, and net income 25.6%.
- Q2 non-GAAP net income was $757 million, up 9.6%, and diluted EPS was $1.19, up 15.5%. Six-month non-GAAP net income was $1,326 million, up 16.1%, and diluted EPS was $2.06, up 21.9%. These company-defined non-GAAP measures adjust for fuel-hedge effects and identified special items; they are not GAAP measures.
- Q2 passenger revenue increased 1.1%, while passenger revenue per available seat mile fell 3.5%; six-month passenger revenue increased 3.0%, while passenger revenue per available seat mile fell 3.6%. Passenger yield declines and the loyalty-card accounting change weighed on passenger unit revenue.
- Q2 load factor was a record 85.6%, versus 84.6%; capacity grew 4.8%. For the first half, load factor was 83.2%, versus 82.5%, and capacity grew 6.9%.
- Q2 operating expenses increased 2.0% against 4.8% capacity growth; expenses per available seat mile declined 2.6%, largely on lower fuel prices. Excluding fuel and special items, unit costs increased 2.5% in Q2 and 1.4% for the first half. Six-month expenses increased 4.3%, including higher wages, maintenance, and depreciation.
- Fuel and oil expense declined 10.1% in Q2 and 6.7% for the first half. However, fuel-hedge losses recorded in fuel expense were $187 million in Q2 and $462 million for the first half. Economic fuel cost per gallon was $1.81 in Q2 and $1.80 for the first half.
- Cash and cash equivalents were $2.040 billion and short-term investments $1.375 billion at June 30, 2016, totaling $3.415 billion in cash and short-term investments. Total debt, including current maturities, was $3.354 billion. The $1 billion revolving credit facility was undrawn; the company reported covenant compliance.
- Six-month investing cash outflow was $849 million, including $900 million of capital expenditures. Financing cash outflow was $1.422 billion, including $1.2 billion of share repurchases, $160 million of dividends, and $103 million of debt and lease repayments.
Material changes and unusual items
- An amended Chase co-branded card agreement changed the allocation and timing of loyalty-program revenue. It increased Q2 operating revenue by $137 million and net income by $73 million; first-half revenue increased $261 million and net income $139 million. The shift raised other revenue while reducing passenger revenue. The company also recorded a separate $172 million one-time revenue adjustment in Q3 2015, making some comparisons less comparable.
- Southwest accelerated retirement of its 737-300 fleet to no later than Q3 2017, rather than extending to 2021, and expects to retire all 737-500 aircraft in 2016. The change added $34 million of Q2 and $62 million of first-half depreciation expense; management estimated a further $56 million increase for the remainder of 2016.
- A $21 million noncash impairment charge related to Newark airport slots followed the FAA’s change in Newark’s scheduling designation. The filing says this does not prevent Southwest from continuing Newark service.
- The company completed a $500 million accelerated share repurchase in Q2 and approved a new $2 billion repurchase authorization. It also raised the quarterly dividend 33%, from $0.075 to $0.10 per share.
Outlook, risks and contingencies
- Management expected 2016 capacity growth of 5%–6%, with Q3 capacity growth of 4%–5%. Based on bookings and yields, it forecast Q3 operating unit revenue to decline 3%–4% year over year, excluding the Q3 2015 one-time revenue adjustment. Q3 and full-year unit costs excluding fuel, profit-sharing, and special items were expected to rise about 2% and 1%, respectively.
- Management projected a 2016 effective tax rate of 37%–38%. It expected to end 2016 with 723 aircraft. The reservation-system replacement was planned in stages, with the first release expected by late 2016 and the second in the first half of 2017.
- At July 18, the company’s maximum stated hedge coverage at varying price levels was 63% of estimated 2017 fuel use and 37% for 2018. At June 30, fuel derivatives had a net fair-value liability of $957 million; $719 million of cash collateral had been provided. A 25% decline in relevant commodity prices could require approximately $328 million of additional collateral, although the company said it could post aircraft or letters of credit.
- The company expected about $442 million of net unrealized fuel-hedge losses in accumulated other comprehensive income to be recognized in earnings over the twelve months after June 30. Hedge settlements, market prices, and accounting treatment may cause reported fuel costs to differ from unhedged market fuel prices.
- Aircraft purchase commitments totaled 539 firm orders and options across Boeing 737 models. The company deferred $1.9 billion of planned capital spending beyond 2020. It guaranteed $439 million of outstanding Dallas Love Field bonds and guaranteed obligations of the RAIC credit facility for the Los Angeles airport project; the filing does not provide a clear outstanding guaranteed amount for the RAIC facility.
- A July 20 technology outage caused significant delays and cancellation of more than 2,000 flights; the company was evaluating its financial impact. This occurred after quarter-end and is not included in Q2 results.
- Antitrust matters include a certified class action involving former AirTran first-bag fees, with defendants’ summary-judgment motions pending, and ongoing U.S. investigations and class actions alleging capacity coordination. Southwest denies wrongdoing and intends to defend the cases. Management did not expect currently ongoing proceedings or IRS matters to have a material adverse effect.
- The filing identifies risks including fuel-price and hedging volatility, demand and competition, labor relations, regulation, and execution of technology projects. Management reported disclosure controls were effective and no material change in internal controls during the quarter.
Important facts for investors to verify
- How much of reported revenue and earnings growth reflects the Chase agreement’s accounting change, and how should the Q3 2015 one-time adjustment affect comparisons?
- What is the eventual cost and operational impact of the July 20 outage, including any customer compensation or disruption-related expenses?
- How will fuel-hedge settlements, collateral requirements, and the scheduled recognition of AOCI losses affect future cash flow and reported fuel costs?
- Are unit-revenue trends and management’s capacity and unit-cost forecasts tracking as expected, particularly as fuel prices and fare yields change?
- What are the eventual cash requirements from aircraft commitments, airport project guarantees, share repurchases, and the dividend, and how will these affect liquidity?
- What is the status and potential financial exposure from the antitrust litigation and governmental inquiries?