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 June 30, 2008. The company reported its 69th consecutive quarterly profit. The airline operates a low-cost, point-to-point network primarily using Boeing 737 aircraft. The reporting period was significantly influenced by high jet fuel prices and the company's extensive fuel hedging program.
Key Financial Metrics
| Metric | Q2 2008 | Q2 2007 | YTD 2008 | YTD 2007 |
|---|---|---|---|---|
| Operating Revenues | $2,869 million | $2,583 million | $5,399 million | $4,781 million |
| Operating Income | $205 million | $328 million | $293 million | $412 million |
| Net Income | $321 million | $278 million | $355 million | $371 million |
| Diluted EPS | $0.44 | $0.36 | $0.48 | $0.47 |
| Operating Cash Flow | $2,336 million | $980 million | $3,300 million | $1,597 million |
| Cash & Equivalents | $4,653 million | $1,605 million | $4,653 million | $1,605 million |
| Total Debt (Current + Long-term) | $2,661 million | $2,091 million | $2,661 million | $2,091 million |
Note: Debt figures derived from Balance Sheet current maturities ($71M) and long-term debt ($2,590M) as of June 30, 2008.
Material Changes vs. Prior Period
- Revenue Growth: Operating revenues increased 11.1% in Q2 2008 compared to Q2 2007, driven by an 8.4% increase in average passenger fares and a 5.4% increase in capacity (Available Seat Miles).
- Operating Income Decline: Despite revenue growth, operating income fell 37.5% to $205 million. This was primarily due to a 42.2% increase in fuel costs per gallon (net of hedging) and a 12.1% increase in operating expenses per ASM.
- Net Income Increase: Net income rose 15.5% to $321 million. This increase was largely driven by significant unrealized gains from fuel derivative contracts ($361 million in Q2 2008) recorded in "Other (gains) losses, net," which offset the decline in operating income.
- Liquidity: Cash and cash equivalents more than doubled to $4.65 billion, bolstered by strong operating cash flows and a $600 million term loan secured in May 2008.
Guidance, Outlook, and Risks
- Capacity Outlook: Management expects 2008 ASM capacity growth to be no more than 4%. Q3 2008 growth is projected at 2.4%, and Q4 2008 at 1%. The company may not grow capacity in 2009 due to economic uncertainty.
- Fuel Hedging: The company has hedges in place for approximately 80% of Q3 2008 fuel needs at ~$61/barrel and 80% of Q4 2008 needs at ~$58/barrel. Estimated Q3 2008 fuel cost is in the $2.50/gallon range.
- Strategic Moves: Southwest announced a codeshare agreement with WestJet. The company also reduced its planned fleet retirements for 2008 from 22 to 14 aircraft to meet demand in developing markets.
- Risks and Contingencies:
- FAA Fine: The FAA is seeking a ~$10 million fine regarding an airworthiness directive. The company has accrued this amount and is in an informal conference with the FAA.
- Litigation: Two putative class-action lawsuits and shareholder derivative demands are pending related to the FAA incident. Management believes these are without merit.
- Auction Rate Securities: The company holds $268 million in auction rate securities. Due to market liquidity issues, these are valued using discounted cash flow models, resulting in a $12 million unrealized loss recorded in other comprehensive income.
Investor Verification Checklist
- Fuel Hedge Effectiveness: Verify the extent to which unrealized derivative gains (recorded in "Other income") will translate to actual cash savings in future quarters versus potential reversals if market prices drop.
- Operating Margin Sustainability: Assess whether the 12.1% increase in operating expenses per ASM can be contained given the 42.2% rise in fuel costs, particularly as hedging coverage decreases in future periods.
- FAA Resolution: Monitor the outcome of the informal conference with the FAA regarding the $10 million fine and the status of the related class-action lawsuits.
- Auction Rate Securities: Track the liquidity of the $268 million in auction rate securities and the potential for further valuation adjustments if credit markets do not improve.
- Stock Repurchase Program: Note that the company has paused its $500 million stock repurchase program due to market instability and fuel prices; verify if this pause extends beyond the current quarter.