Southwest Airlines Co. — Q2 2018 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2018. Southwest operates scheduled passenger air service in the United States and near-international markets. Comparative 2017 figures were recast for adopted accounting standards; the statements are unaudited.
Financial performance
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Operating revenue | $5.742B | $5.731B | $10.686B | $10.585B |
| Operating income | $972M | $1.215B | $1.588B | $1.822B |
| Net income | $733M | $743M | $1.195B | $1.082B |
| Diluted EPS | $1.27 | $1.23 | $2.05 | $1.77 |
| Operating margin | 16.9% | 21.2% | 14.9% | 17.2% |
| Operating cash flow | $1.631B | $746M | $2.632B | $2.370B |
Q2 revenue edged up 0.2%, while operating income fell 20.0% and net income declined 1.3%. Higher fuel expense was the main earnings pressure; the lower federal corporate tax rate partly offset it. Diluted EPS rose 3.3% in Q2 as weighted-average diluted shares declined to 579M from 605M. For the first half, net income rose 10.4%, primarily reflecting the lower tax rate, despite lower operating income.
Q2 operating expenses increased 5.6% to $4.770B, exceeding capacity growth of 3.3%. Fuel and oil expense rose 17.4% to $1.202B; fuel cost per gallon including tax increased 16.3% to $2.21. Fuel and oil expense per available seat mile (ASM) increased 13.7%, while total expense per ASM rose 2.3%. Q2 passenger revenue declined 0.4%; passenger yield fell 2.5% and load factor declined 0.9 percentage points to 84.7%.
Balance sheet, cash flow and capital allocation
- At June 30, cash and cash equivalents were $2.114B and short-term investments were $1.572B, totaling about $3.686B. Current assets were $5.408B and current liabilities $7.716B; Southwest notes that airline working capital deficits are common, chiefly because of advance-ticket and loyalty liabilities.
- Total long-term debt, including current maturities, was $3.520B ($365M current and $3.155B noncurrent), versus $3.668B at December 31, 2017. Stockholders’ equity was $9.997B.
- First-half capital expenditures were $929M. Financing cash outflows included $1.000B of share repurchases, $240M of dividends and $157M of debt and capital-lease repayments. Cash increased $619M during the first half.
- Southwest had no borrowings on its $1.0B unsecured revolving credit facility, expiring August 2022, and was in compliance with its financial covenant. Management said available liquidity and expected operating cash flows should meet ordinary-course obligations.
Material changes, outlook and risks
- Flight 1380: The April 17 engine failure caused a customer fatality. Management estimated an approximately $100M adverse effect on Q2 passenger revenue. The company also conducted a broad marketing effort and fare sale following the accident.
- Near-term outlook: Management expected Q3 operating unit revenue to range from 1% below to 1% above the prior-year period. It cited temporary fare-sale effects, the suboptimal schedule following accelerated retirement of the 737-300 fleet, and a revenue-recognition accounting effect as headwinds; it did not expect these particular headwinds to be material to Q4 unit-revenue trends.
- Capacity and fleet: 2018 ASM growth was expected in the low-4% range year over year; Q3 growth was forecast at 4.5%–5% and Q4 at 6.5%–7%. The fleet was expected to reach 751 aircraft by year-end, versus 730 at quarter-end. Southwest planned to begin selling tickets in 2018 for Hawaii service, subject to governmental and FAA approvals.
- Costs, fuel and tax: Excluding fuel, profitsharing and special items, Q3 unit costs were expected to rise 2%–3%; the full-year estimate was flat to up 1%. Management estimated a full-year 2018 effective tax rate of approximately 23%–23.5%. Fuel prices and hedge effectiveness remain important uncertainties; as of July 20, management estimated economic fuel cost near $2.25 per gallon for both Q3 and Q4 at then-current markets.
- Accounting and unusual items: New revenue accounting changed loyalty-program accounting to a relative-fair-value approach and increased the reported loyalty liability; 2017 comparisons were recast. A one-percentage-point change in estimated loyalty-point spoilage would have changed passenger revenue by about $30M in Q2 and $61M for the first half. A $25M first-half gain from sale of grounded 737-300 aircraft was treated as a special item. Hedging-standard adoption changed the presentation of fuel-hedge amounts but did not affect net income or cash flows on adoption.
- Commitments and contingencies: Aircraft purchase commitments totaled 412 firm orders/options shown in the filing, with capital commitments of $535M for the remainder of 2018, $900M in 2019, $1.4B in 2020 and $1.7B in 2021. Southwest guaranteed $424M of outstanding Dallas Love Field modernization bonds and $188M of LAX project credit-facility obligations. Management did not expect ongoing legal matters or IRS adjustments to have a material adverse effect. A proposed domestic-fare antitrust class settlement required a $15M payment and remained subject to court approval; other proceedings and a DOJ inquiry continued.
Important facts for investors to verify
- Whether revenue, yields and unit-revenue trends recovered after the Flight 1380-related disruption and fare sale.
- Actual fuel prices, realized hedge settlements, hedge coverage and the sensitivity of earnings and cash flow to commodity-price changes.
- Whether management met its 2018 capacity and unit-cost expectations, and the timing and regulatory status of Hawaii service.
- How loyalty redemptions, spoilage estimates and adoption of the revenue standard affect passenger revenue and the $2.9B loyalty liability.
- Progress on share repurchases, aircraft spending, airport-project guarantees and court approval of the $15M proposed settlement.