Southwest Airlines Co. — Q1 2018 Form 10-Q
Business context and period: Southwest operates a scheduled passenger airline in the United States and near-international markets. This unaudited report covers the three months ended March 31, 2018; comparative 2017 results were recast for accounting changes. Airline results are seasonal and may not indicate full-year performance.
Financial and operating results
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Operating revenue | $4.944 billion | $4.854 billion | +1.9% |
| Operating income | $616 million | $606 million | +1.7% |
| Net income | $463 million | $339 million | +36.6% |
| Diluted EPS | $0.79 | $0.55 | +43.6% |
| Operating margin | 12.5% | 12.5% | Flat |
| Operating cash flow | $1.002 billion | $1.625 billion | Down $623 million |
Revenue growth reflected higher passenger volumes and other revenue, partly offset by lower passenger unit revenue. Net income growth was primarily driven by the lower federal corporate tax rate following the Tax Cuts and Jobs Act: the effective tax rate was 23.1%, versus 36.4% in Q1 2017. Excluding special items, net income was $438 million, or $0.75 per diluted share; non-GAAP operating income was $584 million.
Passenger revenue was $4.585 billion, up 0.9%; other revenue was $317 million, up 19.2%, primarily from the co-branded Chase card agreement; freight revenue was $42 million, flat. Passenger revenue per available seat mile declined 1.0%, and passenger yield fell 2.8%, while load factor rose to a first-quarter record 81.5% from 79.9%. Capacity increased 1.8%; passengers carried rose 6.1%. Average fare declined 4.9% to $146.33.
Operating expenses increased 1.9% to $4.328 billion, approximately in line with capacity growth. Expenses per available seat mile were 11.58 cents, up 0.1%. Fuel and oil expense rose 6.5% to $1.018 billion; economic fuel cost per gallon, including taxes, rose 3.0% to $2.09. A $25 million gain on sale of retired aircraft reduced reported expenses and was excluded from non-GAAP results.
Balance sheet and liquidity
At March 31, 2018, cash and cash equivalents were $1.822 billion and short-term investments were $1.421 billion, totaling $3.243 billion. Total debt, including current maturities, was $3.592 billion. Stockholders’ equity was $9.619 billion. Current assets were $4.801 billion against current liabilities of $7.162 billion; management described the working-capital deficit as customary in the airline industry, largely because of advance ticket and loyalty-program liabilities.
The company reported $1.002 billion of operating cash flow, used $409 million for capital expenditures, and had a $327 million increase in cash. Financing uses included $500 million of share repurchases and $148 million of dividends. Southwest had no borrowings under its $1.0 billion unsecured revolving credit facility, which expires in August 2022, and reported compliance with its financial covenant. Management said available liquidity and expected operating cash generation should meet known obligations.
Changes, outlook, risks and unusual items
- Operating cash flow fell year over year, in part because Southwest funded a $543 million 2017 profit-sharing contribution in Q1 2018; the increase in air traffic liability contributed $866 million of cash inflow.
- Management expected Q2 2018 operating unit revenue to decline 1%–3% year over year, including an estimated 1–2 percentage-point impact from booking softness after Flight 1380. It expected Q2 capacity growth of 3.5%–4%, and maintained full-year capacity growth guidance in the low 5% range, with low 7% growth in the second half.
- Management expected Q2 unit costs, excluding fuel and profit sharing, to rise 1%–2% year over year; it expected full-year unit costs on that basis to be comparable with 2017. The full-year 2018 effective tax rate was projected at 23%–23.5%. Fuel-cost estimates were market-sensitive; at April 20, the estimated 2018 economic fuel cost was $2.15–$2.20 per gallon.
- On April 17, 2018, Flight 1380 suffered an uncontained engine failure that caused a customer fatality and potential injuries. The cause was under investigation; the FAA ordered inspections, and Southwest said it would inspect all CFM engines in its fleet. The company could not estimate the full impact, including possible maintenance, litigation, regulatory, revenue and brand effects.
- Southwest adopted new revenue, retirement-benefit presentation and hedge-accounting standards. Revenue-standard adoption materially increased the loyalty liability; Q1 2017 figures were recast. Management noted that a hypothetical one-percentage-point change in estimated loyalty-point spoilage would have changed Q1 passenger revenue by about $27 million.
- Fuel hedging reduces but does not eliminate exposure to fuel-price movements and introduces counterparty and accounting risks. Fuel derivatives had a $340 million net fair-value asset at March 31; the valuation uses significant unobservable inputs. The company also disclosed substantial aircraft orders and airport-project commitments, including guarantees related to Los Angeles airport projects and $424 million of remaining guaranteed Love Field bond principal.
- Management did not expect ongoing legal proceedings or IRS matters to have a material adverse effect. A proposed domestic airline capacity-collusion settlement would require a $15 million payment, subject to court approval; other antitrust matters remained pending. No material risk-factor changes were reported.
Most important facts for investors to verify
- Subsequent disclosures on Flight 1380, engine inspections, claims, regulatory actions and effects on bookings, costs and brand.
- Whether passenger unit revenue and fare trends recover as schedule optimization and planned capacity growth proceed.
- Fuel prices, hedge coverage and settlement assumptions underlying reported and forecast fuel costs.
- Frequent-flyer liability valuation, redemption and spoilage estimates, given their sensitivity and the new revenue accounting method.
- Aircraft delivery and capital-spending plans, airport-project obligations and remaining share-repurchase authorization; distinguish post-quarter events from Q1 balances.