Southwest Airlines Co. — Q2 2015 Form 10-Q
Business context and reporting period. Southwest operates a major domestic airline and included AirTran subsidiaries in its consolidated results; AirTran’s final passenger service was December 28, 2014. This unaudited quarterly report covers the three and six months ended June 30, 2015, compared with the corresponding 2014 periods. Unless otherwise noted, amounts are in millions.
Financial performance and position
| Metric | Three months ended June 30 | Six months ended June 30 |
|---|---|---|
| Operating revenue | $5,111; +2.0% year over year | $9,525; +3.8% |
| Operating income | $1,085; +40.0% | $1,865; +88.2% |
| Net income | $608; +30.8% | $1,061; +72.0% |
| Diluted EPS | $0.90 vs. $0.67 | $1.57 vs. $0.88 |
| Operating margin | Approximately 21.2% vs. 15.5% | Approximately 19.6% vs. 10.8% |
| Net margin | Approximately 11.9% vs. 9.3% | Approximately 11.1% vs. 6.7% |
| Operating cash flow | $627 vs. $1,338 | $2,079 vs. $2,458 |
Margins are calculated from reported revenue and income. Q2 passenger revenue rose 2.1% to $4,852, while freight revenue was $46 and other revenue $213. Six-month passenger revenue increased 4.0% to $9,030. Q2 passenger traffic (RPMs) grew 7.9% and capacity (ASMs) 7.0%; load factor reached 84.6%, up 0.7 percentage points. Passenger yield fell 5.4% in Q2, and passenger revenue per ASM declined 4.6%.
Fuel and oil expense fell 29.5% in Q2 and 31.3% for the six months, primarily reflecting lower fuel prices. Economic fuel cost was $2.02 per gallon in Q2, down 33.1%. Reported operating expenses declined 5.0% in Q2 and 6.4% year to date despite capacity growth. Salaries, wages and benefits increased 14.3% in Q2, including labor ratification bonuses and higher profitsharing; Q2 salaries and benefits per ASM rose 6.8%.
Balance sheet and liquidity at June 30, 2015: Cash and cash equivalents were $1,772 and short-term investments were $1,360, or approximately $3.1 billion combined. Total debt, including current maturities, was approximately $2,687. Current assets were $4,596 and current liabilities $6,876; air traffic liability was $3,815. Stockholders’ equity was $7,158. The company had a fully available $1 billion revolving credit facility, no borrowings under it, and was in compliance with its covenant. Moody’s upgraded its senior unsecured debt rating to Baa1 on July 8.
Six-month capital expenditures were $1,001. Financing cash outflows included $680 of share repurchases, $131 of dividends and $92 of debt and capital-lease repayments. The quarterly dividend was increased 25% to $0.075 per share. Cash provided by operations was lower year over year, partly due to $394 of additional cash collateral posted to fuel-derivative counterparties and timing of accounts payable and accrued liabilities.
Material changes versus the prior comparable period
- Profitability improved sharply as lower fuel costs more than offset higher labor and other costs. Q2 GAAP net income reached a quarterly record; management also reported record non-GAAP net income of $691, or $1.03 diluted EPS. These non-GAAP figures exclude specified fuel-hedge effects and special items and are not substitutes for GAAP results.
- Revenue growth reflected higher capacity and strong demand, but lower passenger yields and longer average stage lengths and larger aircraft weighed on unit revenue. The prior-year Q2 included a $47 revenue benefit from a change in frequent-flyer breakage estimates, affecting the year-over-year passenger unit-revenue comparison by about one percentage point.
- A 2014 change in the estimated spoilage rate for Rapid Rewards points increased 2015 passenger revenue by approximately $41 in Q2 and $85 year to date. After profitsharing and taxes, the estimated net-income benefit was $22 ($0.03 per share) and $45 ($0.07 per share), respectively.
- Fuel-hedge effects were less favorable: Q2 fuel expense included $43 of net hedge losses versus $19 of net gains in 2014; six-month fuel expense included $90 of net losses versus $37 of net gains. Q2 other expenses also included $71 of mark-to-market losses on fuel contracts settling in future periods.
Outlook, commentary, risks and unusual items
- Operating outlook: Management planned for approximately 7% year-over-year ASM growth for 2015 and expected Q3 ASMs to rise about 8%. Based on bookings and revenue trends, Q3 operating unit revenue was estimated to decline approximately 1% year over year, including the expected benefit from the amended credit-card agreement described below. Management expected Q3 unit costs excluding fuel, profitsharing and special items to decline approximately 1% year over year.
- Chase agreement: After quarter-end, Southwest amended its co-branded credit-card agreement. The revised revenue-allocation method is expected to accelerate recognition of revenue. The company estimated a one-time, noncash revenue increase of approximately $150 in Q3 from reducing deferred revenue, and an approximately $400 total operating-revenue benefit in the second half of 2015 from the agreement and accounting change; approximately $250 was expected to affect second-half unit revenues. The precise impact depends on transaction volumes.
- Fuel and hedging exposure: Fuel derivatives had a net fair-value liability of approximately $1.0 billion at June 30, excluding collateral effects; this was approximately $1.3 billion on July 20. The company reported $660 of cash collateral posted. A 25% decline in relevant commodity prices from June 30 levels could require an estimated additional $876 of collateral, though the company said it could also pledge aircraft or provide letters of credit and would benefit from lower fuel prices. Fuel-hedge fair values and accounting can cause substantial earnings volatility; WTI-based derivatives no longer qualify for hedge accounting prospectively. Management noted future hedges could make fuel costs exceed unhedged market prices in some periods.
- Labor and fleet: Flight attendants rejected a tentative agreement in July, and negotiations were to continue; a $55 Q2 bonus accrual was associated with the tentative agreement and other labor ratification bonuses. The company expected continuing costs to convert and sublease remaining B717 aircraft to Delta. It expected six new 737-800s and eight pre-owned 737-700s to be delivered during the remainder of 2015.
- Legal matters: The DOJ issued a Civil Investigative Demand in June concerning airline capacity, and the Connecticut Attorney General requested information. Beginning in July, multiple consumer class actions alleged airline collusion to limit capacity and maintain fares. Southwest said it was cooperating with inquiries and intended to defend the cases vigorously. The filing also describes an older AirTran/Delta baggage-fee antitrust action. Management stated that ongoing legal matters and IRS matters were not expected to have a material adverse effect, but these capacity-related investigations and claims remain important uncertainties.
- Other contingencies and commitments: Southwest guaranteed obligations tied to airport and terminal projects, including Love Field bonds and a Los Angeles terminal project credit facility. Aircraft purchase commitments included substantial future payments; the filing lists $343 due for the remainder of 2015, $1.2 billion in 2016, $1.2 billion in 2017 and $1.0 billion in 2018 for specified firm orders and additional 737-700 aircraft.
- Management cited demand, economic conditions, fuel prices, competition, labor relations, regulation, third-party fleet dependencies, consumer behavior and information-technology execution among forward-looking risks. The filing reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether passenger yields and unit revenues stabilize as capacity grows, and how much reported revenue growth reflects the Chase agreement’s accelerated recognition rather than underlying demand.
- The actual Q3 and second-half revenue benefit from the Chase agreement, including the one-time $150 noncash adjustment and the expected $250 prospective benefit.
- Fuel-hedge valuations, future settlement losses, collateral requirements and the resulting cash-flow and earnings volatility; distinguish GAAP results from management’s non-GAAP “economic” measures.
- Labor negotiations and the final treatment of the $55 bonus accrual following rejection of the flight-attendant tentative agreement.
- Developments in DOJ and state capacity inquiries, consumer antitrust litigation, and the company’s airport-project guarantees and aircraft delivery commitments.
- Capital allocation and liquidity after significant buybacks: the company launched a further $500 accelerated repurchase in July, with $700 remaining under the $1.5 billion authorization after that launch.