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Southwest Airlines Co. Q2 2006 10-Q Summary

Business Context and Reporting Period

This filing covers the quarterly period ended June 30, 2006. Southwest Airlines reported its 61st consecutive quarterly profit. The airline operates a low-cost, high-frequency model, primarily utilizing Boeing 737 aircraft. The reporting period reflects strong demand, reduced competitive capacity in key markets, and the impact of significant fuel hedging activities.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Operating revenues increased 26.0% in Q2 2006, driven by a 26.4% increase in passenger revenue. This was fueled by a 15.3% increase in Revenue Passenger Miles (RPMs) and a 9.7% increase in RPM yield due to fare increases and strong demand.
• Profitability: Net income surged 131.3% year-over-year. Operating income rose 57.0% to $402 million.
• Fuel Costs: Despite hedging, the average fuel cost per gallon increased 47.1% to $1.50. However, the company realized $198 million in cash settlements from fuel hedges, which reduced reported fuel expense.
• Non-Operating Gains: The company recorded $123 million in net gains in "Other (gains) losses" related to the ineffectiveness of fuel hedges and the discontinuation of hedge accounting for certain contracts. This significantly boosted net income but is excluded from operating income.
• Cost Trends: Cost per Available Seat Mile (CASM) excluding fuel increased 4.9%, primarily due to higher profitsharing expenses and wage rate increases. Total CASM increased 13.1% including fuel.

Guidance, Outlook, and Risks

• Outlook: Management expects third-quarter 2006 capacity to grow approximately 8% year-over-year. Unit costs excluding fuel are expected to increase in Q3, but at a lower rate than Q2. Fuel costs for Q3 are expected to exceed Q2 levels despite hedging.
• Strategic Developments: Southwest is part of an agreement to potentially lift the Wright Amendment restrictions on Dallas Love Field, which could allow expanded service. New service to Washington Dulles is scheduled to begin in October 2006.
• Accounting Changes: The company adopted SFAS 123R (Share-Based Payment) effective Jan 1, 2006, resulting in a $25 million reduction in net income for the six months ended June 30, 2006, compared to the previous method. They also changed the accounting method for aircraft maintenance from deferral to direct expense.
• Risks:
  • Fuel Hedging: Significant exposure to market volatility and hedge ineffectiveness. The fair value of fuel hedges is $2.1 billion, with $1.1 billion in unrealized gains in accumulated other comprehensive income.
  • Regulatory: The Wright Amendment agreement requires Congressional approval by the end of 2006 or it expires.
  • Insurance: Federal war-risk insurance coverage expires Dec 31, 2006; failure to extend could increase costs.

Investor Verification Checklist

• Hedge Realization: Verify the sustainability of the $123 million non-operating gain from hedge ineffectiveness and the timing of the $1.1 billion unrealized gain in OCI.
• Fuel Cost Trajectory: Confirm Q3 fuel cost projections given the weaker hedge position compared to 2005 and rising market prices.
• Wright Amendment: Monitor Congressional progress on the Love Field agreement, as expiration would impact long-term growth strategy.
• Share Repurchases: Note the completion of two $300 million buyback programs in Q2 and Q3, totaling $503 million in the first half of 2006.
• Accounting Impact: Assess the full-year impact of SFAS 123R on reported earnings and cash flow classification.