Southwest Airlines Co. 10-Q Summary
Business Context and Reporting Period
This filing is a Quarterly Report (Form 10-Q) for Southwest Airlines Co. for the period ended September 30, 2008. The airline operates a low-cost, point-to-point network primarily using Boeing 737 aircraft. The reporting period was significantly impacted by volatile jet fuel prices, a global financial crisis, and the accounting treatment of the company's extensive fuel hedging program.
Key Financial Metrics
| Metric (in millions) | Q3 2008 | Q3 2007 | 9 Months 2008 | 9 Months 2007 |
|---|---|---|---|---|
| Total Operating Revenues | $2,891 | $2,588 | $8,289 | $7,369 |
| Operating Income | $86 | $251 | $380 | $664 |
| Net Income (Loss) | $(120) | $162 | $234 | $533 |
| Diluted EPS | $(0.16) | $0.22 | $0.32 | $0.69 |
| Operating Cash Flow | $(2,276) | $154 | $1,024 | $1,751 |
| Cash & Equivalents (End of Period) | $2,390 | $1,050 | $2,390 | $1,050 |
| Total Debt (Current + Long-term) | $2,652 | $2,091 | $2,652 | $2,091 |
Note: Q3 2008 Operating Cash Flow was negatively impacted by a $2.3 billion increase in counterparty deposits related to fuel hedging.
Material Changes vs. Prior Period
- Net Loss vs. Profit: The company reported a net loss of $120 million in Q3 2008, compared to a net income of $162 million in Q3 2007. This reversal was primarily driven by a $247 million pre-tax charge recorded in "Other (gains) losses, net" due to mark-to-market adjustments on fuel derivative contracts that did not qualify for hedge accounting or were deemed ineffective.
- Operating Performance: Despite the net loss, the company maintained operating profitability for the 70th consecutive quarter. Operating income declined 65.7% to $86 million due to a 20% increase in operating expenses, largely driven by fuel costs.
- Fuel Costs: Average fuel cost per gallon (including hedging) increased 53.8% to $2.60 in Q3 2008. Excluding hedging, the cost was $3.61 per gallon. Fuel and oil expense represented 35.7% of total operating expenses.
- Revenue Growth: Operating revenues increased 11.7% year-over-year, driven by an 18% increase in average passenger fares and improved yield management, partially offset by a 5.0 point decrease in load factor.
Guidance, Outlook, and Risks
- Capacity Outlook: The company expects Q4 2008 capacity (ASMs) to increase approximately 1% year-over-year. However, Q1 2009 capacity is expected to decline 5-6% year-over-year due to economic conditions and a Boeing machinists' strike delaying aircraft deliveries.
- Fuel Hedging: As of October 15, 2008, the fair value of the fuel derivative portfolio dropped to approximately $550 million from $2.5 billion at quarter-end due to falling oil prices. The company has hedges covering ~85% of Q4 2008 fuel needs, estimating a cost of ~$2.00 per gallon.
- Liquidity Actions: In October 2008, the company accessed $400 million of its $600 million revolving credit facility to enhance liquidity amidst credit market instability. Standard & Poor's downgraded the company's credit rating from "A-" to "BBB+".
- Legal Contingencies: The FAA is seeking a $10 million fine regarding an airworthiness directive incident. The company has accrued this amount and is in settlement discussions. Several class-action and shareholder derivative lawsuits are pending but are expected to have no material adverse effect.
- Investment Risks: The company holds $239 million in auction rate securities. Due to market failures, these are classified as Level 3 assets with a temporary unrealized loss of $14 million recorded in other comprehensive income.
Investor Verification Checklist
- Fuel Hedge Valuation: Verify the impact of the $2.5 billion drop in fair value of fuel derivatives on future earnings and the potential for further mark-to-market losses if oil prices continue to decline.
- Liquidity Position: Confirm the utilization of the $400 million credit facility draw and the status of the $2.5 billion in cash collateral held by counterparties (classified as accrued liabilities).
- Boeing Strike Impact: Assess the operational and financial impact of the Boeing machinists' strike on aircraft deliveries and the company's ability to meet its 2009 capacity plans.
- Auction Rate Securities: Monitor the liquidity and fair value of the $239 million investment in auction rate securities, specifically the timeline for successful auctions or repurchase commitments.
- Operating Margins: Track the sustainability of operating margins given the 53.8% increase in fuel costs and the company's ability to pass these costs to consumers through fare increases.