Southwest Airlines Co. Q1 2006 Filing Summary
Business Context and Reporting Period
This Form 10-Q covers the quarterly period ended March 31, 2006. Southwest Airlines reported its 60th consecutive quarterly profit. The airline operates a low-cost, high-frequency model, primarily utilizing Boeing 737 aircraft. The reporting period reflects significant accounting changes effective January 1, 2006, including the adoption of SFAS 123R for share-based compensation and a change in the accounting method for aircraft maintenance.
Key Financial Metrics
| Metric | Q1 2006 | Q1 2005 (Adjusted) |
|---|---|---|
| Total Operating Revenues | $2,019 million | $1,663 million |
| Operating Income | $98 million | $81 million |
| Net Income | $61 million | $59 million |
| Diluted EPS | $0.07 | $0.07 |
| Operating Cash Flow | $751 million | $864 million |
| Cash and Equivalents (End of Period) | $2,600 million | $1,908 million |
| Total Debt (Current + Long-term) | $1,942 million | $1,995 million |
| Load Factor | 69.2% | 65.4% |
| CASM (Cost per ASM) | 8.70 cents | 7.82 cents |
Material Changes vs. Prior Period
- Revenue Growth: Operating revenues increased 21.4% to $2.019 billion, driven by a 15.4% increase in Revenue Passenger Miles (RPMs) and a 5.4% increase in passenger yield. The load factor reached a record 69.2% for a first quarter.
- Fuel Costs: Fuel and oil expenses rose significantly to $501 million (up from $279 million) due to higher market prices and a less favorable hedge position compared to the prior year. Average fuel cost per gallon increased 67.7% to $1.51.
- Accounting Changes:
- SFAS 123R: Adoption of fair value accounting for share-based compensation reduced Q1 2006 net income by $12 million compared to the previous method. Prior year results were retrospectively adjusted.
- Maintenance: Changed from deferral to direct expense method for 737-300/500 airframe maintenance, increasing maintenance expenses by $5 million in the adjusted Q1 2005 comparison.
- Unit Costs: Total CASM increased 11.3% primarily due to fuel. Excluding fuel, CASM remained flat at 6.43 cents per ASM.
Guidance, Outlook, and Risks
- Outlook: Management expects Q2 2006 capacity to grow approximately 7% year-over-year. Unit costs excluding fuel are expected to exceed Q1 levels in Q2. The effective tax rate for the full year 2006 is projected to be in the 38% to 39% range.
- Fleet Expansion: On April 20, 2006, Southwest exercised options to purchase 79 additional Boeing 737-700 aircraft for delivery between 2007 and 2012. The company has firm orders and options totaling 317 aircraft.
- Capital Allocation: The company repurchased $214 million of common stock in Q1 2006 under a $300 million authorization. It maintains a $600 million revolving credit facility.
- Risks:
- Fuel Hedging: While hedged for over 70% of remaining 2006 needs at ~$36/barrel, the company faces volatility from hedge ineffectiveness and potential loss of hedge accounting status.
- Insurance: Government-provided war-risk insurance expires December 31, 2006; failure to extend could result in substantially higher costs.
- Accounting Volatility: The adoption of SFAS 123R introduces variability in effective tax rates due to the treatment of incentive stock options.
Investor Verification Checklist
- Verify the impact of the SFAS 123R adoption on future quarterly earnings and tax rates, as the company expects expense to decrease in the second half of 2006.
- Monitor fuel hedge effectiveness and the potential for mark-to-market volatility in "Other gains/losses" as energy prices fluctuate.
- Assess the sustainability of the 69.2% load factor and yield growth in a competitive environment.
- Review the status of the war-risk insurance extension prior to the December 2006 expiration.
- Confirm the execution of the Boeing 737-700 purchase agreements and associated capital funding requirements ($3.9 billion aggregate for firm commitments).