Southwest Airlines Co. — 2017 Form 10-K
Reporting period: Fiscal year ended December 31, 2017. Although the request refers to 2017 Q4, this 10-K reports the full fiscal year; fourth-quarter figures are identified separately below. Unless noted, dollar amounts are in billions.
Business context
Southwest operates a primarily point-to-point airline using an all-Boeing 737 fleet. At year-end it had 706 aircraft and served 100 destinations in 40 states and 10 near-international countries. It reported its 45th consecutive profitable year. In 2017 it introduced the 737 MAX 8, retired its remaining 737-300 aircraft, expanded international service, and completed its new reservation-system transition.
Financial performance and liquidity
| Metric | 2017 | 2016 | Change or note |
|---|---|---|---|
| Operating revenue | $21.171 | $20.425 | Up 3.7% |
| Operating income | $3.515 | $3.760 | Down 6.5%; operating margin about 16.6%, versus 18.4% |
| Net income, GAAP | $3.488 | $2.244 | Up 55.4%; includes a $1.410 tax benefit from federal tax reform |
| Net income, excluding special items | $2.107 | $2.370 | Down 11.1% |
| Diluted EPS, GAAP / excluding special items | $5.79 / $3.50 | $3.55 / $3.75 | GAAP increase was materially tax-driven |
| Operating cash flow | $3.929 | $4.293 | Down 8.5% |
| Capital expenditures | $2.123 | $2.038 | Primarily aircraft, facilities, and technology |
| Cash and short-term investments | $3.273 | $3.305 | Year-end balance |
| Debt and capital lease obligations | $3.693 | $3.410 | Gross balance-sheet note amount; includes capital leases |
Passenger revenue rose 2.9%, supported by 3.6% capacity growth, but passenger revenue per available seat mile declined 0.6% and passenger yield fell 0.5% amid competitive fares. Load factor was 83.9%, compared with 84.0%. Operating expenses increased 5.9%; salaries, wages, and benefits rose 7.7%, and fuel expense rose 8.0%. Fuel was 22.3% of operating expenses and averaged $1.92 per gallon on the reported basis.
Year-end total assets were $25.110 billion and stockholders’ equity was $10.430 billion. Current liabilities exceeded current assets, which management said is typical for airlines because advance ticket sales create air traffic liabilities. Southwest reported $3.3 billion of unrestricted cash and short-term investments and an undrawn $1.0 billion revolving credit facility, with no covenant breach. It returned $1.9 billion to shareholders through dividends and repurchases.
Fourth quarter: Revenue was $5.274 billion, operating income $773 million, and net income $1.888 billion. The quarter’s net income included the tax-reform remeasurement benefit; it is not a direct indicator of underlying operating growth.
Material changes versus prior period
- GAAP net income increased sharply because the new 21% federal corporate tax rate reduced deferred tax liabilities by $1.410 billion; the company’s effective tax rate was negative 7.3% for 2017.
- Operating income and adjusted net income declined. Higher wages and fuel prices outweighed revenue growth; 2016 results also included $356 million of union contract ratification bonuses, so comparisons are affected by unusual items.
- Third-quarter hurricanes and earthquakes caused about 5,000 flight cancellations and an estimated $100 million in lost revenue.
- Southwest recorded a $63 million charge related to grounding leased 737-300 aircraft and $33 million of lease-termination expenses. Fleet modernization and retirements reduced maintenance and rental costs in some areas.
- The company completed its reservation-system conversion in May 2017. Its revised accounting for the Chase co-branded card agreement continued to affect revenue mix; management estimated it added $544 million to 2017 operating revenue versus the prior accounting basis.
Outlook, commentary, risks, and contingencies
- Management planned 2018 available-seat-mile growth in the low-5% range, with low-3% growth in the first half and low-7% in the second half. It expected first-quarter 2018 unit revenue to rise 1%–2% year over year.
- Management expected the reservation system to contribute approximately $200 million of incremental pretax benefit in 2018 and Classic fleet retirement to yield at least $200 million of cumulative pretax improvement by the end of 2020.
- For first-quarter 2018, management forecast unit-cost growth of 0.5%–1.5%, excluding fuel, special items, and profitsharing. It estimated 2018 economic fuel cost at $2.10–$2.15 per gallon using January 2018 market assumptions. Planned 2018 capital expenditures were approximately $1.9 billion; the projected full-year tax rate was 23%–23.5%.
- Hawaii service was planned subject to FAA ETOPS and other approvals; the company had applied for ETOPS authorization. Execution, regulatory approval, and start-up costs remain relevant uncertainties.
- Principal risks include volatile fuel prices and hedge-accounting effects, fare and capacity competition (including ULCCs), rising labor costs and ongoing union negotiations, weather and operational disruptions, technology or cybersecurity failures, reliance on Boeing and other concentrated suppliers, airport and air-traffic constraints, and extensive regulation. The company noted that competitors’ pricing and capacity decisions can pressure yields.
- Southwest agreed to a proposed $15 million settlement of a domestic airline-capacity antitrust class action and denied wrongdoing; preliminary court approval was granted in January 2018, with final approval pending. Separate AirTran baggage-fee litigation remained on appeal. Management did not expect the outcomes of ongoing proceedings to materially harm financial condition, results, or cash flow.
- ASU 2014-09, effective January 2018, was expected to increase the frequent-flyer liability by approximately $1.0–$1.2 billion under relative-fair-value accounting and reclassify certain revenue and expense items. This is primarily an accounting presentation and measurement change, not a stated equivalent cash obligation. The new lease standard was expected to significantly increase reported assets and liabilities from operating leases.
Most important facts for investors to verify
- Separate operating performance from the $1.410 billion noncash tax-reform benefit; review adjusted results alongside GAAP results.
- Track passenger yield, unit revenue, capacity growth, and unit costs to assess whether revenue can keep pace with wage and fuel inflation.
- Compare the 2018 reservation-system benefits and fleet-retirement savings with actual reported results and implementation costs.
- Review fuel-hedge coverage, cash settlements, collateral exposure, and any resulting earnings volatility as market prices change.
- Assess the effect of the frequent-flyer and lease accounting changes on reported liabilities, revenue classifications, and comparability.
- Monitor Hawaii approval and launch progress, union negotiations, the proposed antitrust settlement’s final approval, aircraft commitments, and planned capital spending.