Southwest Airlines Co. 2008 Annual Report (10-K) Summary
Business Context and Reporting Period
This Form 10-K covers the fiscal year ended December 31, 2008. Southwest Airlines Co. is the largest U.S. air carrier by originating passengers and domestic departures. The company operates a single-fleet of 537 Boeing 737 aircraft serving 64 cities in 32 states. The reporting period was characterized by extreme volatility in jet fuel prices, which peaked near $150 per barrel in July 2008 before plummeting below $35 in the fourth quarter, alongside a severe domestic economic downturn and credit market crisis.
Key Financial Metrics
| Metric | 2008 | 2007 |
|---|---|---|
| Operating Revenues | $11,023 million | $9,861 million |
| Operating Income | $449 million | $791 million |
| Net Income | $178 million | $645 million |
| Diluted EPS | $0.24 | $0.84 |
| Operating Cash Flow | ($1,521 million) used | $2,845 million provided |
| Total Assets | $14,308 million | $16,772 million |
| Long-term Debt | $3,498 million | $2,050 million |
| Stockholders' Equity | $4,953 million | $6,941 million |
| Fuel Cost (Avg/Gallon) | $2.44 | $1.80 |
| Load Factor | 71.2% | 72.6% |
Material Changes vs. Prior Period
- Profitability Decline: Net income decreased 72.4% to $178 million. Operating income fell 43.2% to $449 million. The decline in net income was significantly driven by accounting adjustments related to fuel derivatives (SFAS 133), which resulted in $19 million in net losses in 2008 compared to $360 million in net gains in 2007.
- Fuel Costs: Fuel and oil expense increased $1.0 billion (38.0%) to $3.713 billion. Despite hedging gains of $1.3 billion in cash settlements, the average cost per gallon rose 35.6% due to market volatility.
- Cash Flow Reversal: Operating cash flow swung from a $2.8 billion inflow in 2007 to a $1.5 billion outflow in 2008. This was primarily due to a $2.2 billion net change in cash collateral deposits related to fuel derivatives (shifting from holding deposits to posting collateral) and the reduction in operating income.
- Debt Increase: Long-term obligations increased by approximately $1.45 billion as the company borrowed $1.0 billion in new debt (including a $600 million term loan and $400 million in secured notes) to enhance liquidity amidst credit market instability.
Guidance, Outlook, and Risks
- 2009 Outlook: Management expects a 4-5% reduction in capacity (Available Seat Miles) for Q1 2009 compared to Q1 2008, with a full-year 2009 decline of approximately 4%. The company plans to reduce its fleet by a net two aircraft in 2009.
- Fuel Hedging Strategy: Due to the collapse in fuel prices, Southwest significantly reduced its net fuel hedge position for 2009-2013 to approximately 10% of anticipated consumption. This leaves the company less protected against future price increases but reduces exposure to further losses from falling prices. The fair value of remaining fuel derivatives represents a net liability of $992 million.
- Liquidity and Credit: The company maintains an investment-grade credit rating (BBB+ from S&P and Fitch; Baa1 from Moody's), though ratings were recently downgraded from A-. Management believes it has sufficient liquidity ($1.8 billion in cash/short-term investments plus $200 million available on revolving credit) to meet 2009 requirements.
- Key Risks:
- Fuel Volatility: Continued fluctuations in fuel prices remain the primary risk to profitability.
- Economic Conditions: A recessionary environment continues to suppress demand for air travel.
- Labor Relations: Approximately 77% of employees are unionized. Negotiations are ongoing or in mediation for pilots, flight attendants, and other groups, though a tentative agreement was ratified for mechanics in January 2009.
- Legal Proceedings: The FAA is seeking a $10 million fine regarding an airworthiness directive; the company is in settlement discussions.
Investor Verification Checklist
- Fuel Hedge Liability: Verify the impact of the $992 million net liability in fuel derivatives on future earnings and cash collateral requirements.
- Labor Contract Status: Monitor the outcome of ongoing negotiations with pilots (SWAPA) and flight attendants (TWU), as these represent significant cost drivers.
- Capacity Reductions: Assess the effectiveness of the planned 4% capacity reduction in 2009 in maintaining yield and load factors during a recession.
- Debt Covenants: Review compliance with the Coverage Ratio covenant (1.25 to 1.00) on the $600 million revolving credit facility.
- Auction Rate Securities: Confirm the status of the $200 million in auction rate securities, which were reclassified to Level 3 fair value due to failed auctions and liquidity issues.