SOUTHWEST AIRLINES CO quarterly report, Q2 FY2011

Southwest Airlines Co. — Q2 2011 Form 10-Q

Reporting period: Three and six months ended June 30, 2011. Unaudited interim results. Southwest acquired AirTran on May 2, 2011; reported 2011 results include AirTran only from that date, while 2010 comparatives exclude AirTran. This limits direct year-over-year comparability.

Financial performance and position

Metric	Q2 2011	Q2 2010	First half 2011	First half 2010
Operating revenue	$4.136 billion	$3.168 billion	$7.238 billion	$5.798 billion
Operating income	$207 million	$363 million	$321 million	$417 million
Net income	$161 million	$112 million	$166 million	$123 million
Diluted EPS	$0.21	$0.15	$0.22	$0.17
Operating cash flow	$237 million	$540 million	$1.202 billion	$913 million

• Q2 operating margin was approximately 5.0%, down from 11.5%; net margin was approximately 3.9%, versus 3.5%. First-half operating margin was approximately 4.4%, versus 7.2%; net margin was approximately 2.3%, versus 2.1%.
• Q2 GAAP net income included a $113 million net gain in “Other (gains) losses,” largely reflecting fuel-derivative accounting effects; the comparable 2010 period had $146 million of net losses. Management’s non-GAAP Q2 net income was $121 million, or $0.15 diluted EPS, versus $216 million, or $0.29. First-half non-GAAP net income was $142 million versus $239 million.
• Fuel and oil expense was $1.527 billion in Q2 and $2.565 billion for the first half. Q2 fuel cost per gallon, including tax, rose 32.0% to $3.30; first-half cost rose 25.7% to $3.13. Q2 operating expenses per available seat mile (ASM) increased 13.4%; excluding fuel and special items, management’s measure increased 1.4% to 7.45 cents.
• Q2 passenger revenue rose 28.5% as reported. Excluding AirTran’s May–June contribution, it increased 13.0%; Southwest reported higher fares and load factor. Q2 consolidated load factor was 82.3%, up 3.0 points, though this comparison also includes AirTran.
• At June 30, cash and cash equivalents were $1.595 billion and short-term investments were $2.779 billion, totaling $4.374 billion. Current assets were $5.421 billion and current liabilities $5.318 billion. Total debt on the balance sheet was approximately $4.232 billion, including $990 million of current maturities; stockholders’ equity was $7.202 billion.
• First-half investing cash outflow was $820 million and financing cash outflow was $48 million. Cash increased by $334 million during the first half to $1.595 billion. Operating cash flow benefited from a $576 million increase in air traffic liability and a $305 million increase in accounts payable and accrued liabilities.

Material changes and business developments

• AirTran added 140 aircraft and contributed $540 million of Q2 revenue and a $27 million net loss, before certain acquisition accounting effects and with specified AirTran acquisition costs excluded. Consolidated Q2 operating income fell 43.0% year over year; excluding AirTran, operating revenue rose 13.5% while operating expenses rose 21.2%.
• AirTran acquisition consideration included approximately $518 million cash and $523 million fair value of Southwest shares; the transaction value, including existing debt and capitalized aircraft leases, was approximately $3.2 billion. Southwest recorded provisional goodwill of $971 million. Acquisition and integration costs were $58 million in Q2 and $75 million for the first half.
• Management estimated approximately $500 million of total integration and closing costs and expected net annual synergies above $400 million by 2013. It expected the acquisition to be accretive to diluted EPS in 2011 and 2012 excluding one-time costs, and more strongly accretive thereafter; these are forward-looking estimates.
• The combined active fleet was 694 aircraft at quarter-end. Management expected approximately 4%–5% combined ASM growth for 2011 versus 2010, but announced a 2012 capacity plan at or below 2011 combined ASMs, emphasizing network optimization and more profitable capacity deployment.

Outlook, risks and contingencies

• Management expected Q3 2011 unit revenue to improve versus combined Q3 2010 results, and freight revenue to be comparable with Q2. It expected Q3 nonfuel unit costs, excluding special items, to increase versus the combined prior-year period. Management cautioned that summer revenue momentum might not continue into the seasonally weaker fall period.
• As of August 2, management estimated fuel-derivative coverage of approximately 50% of second-half 2011 consumption and 65% of 2012 consumption at then-current market assumptions. Fuel costs and hedge results remain sensitive to commodity prices, hedge-accounting treatment, and the spread between WTI and jet fuel; management noted that a wider WTI/jet-fuel spread can reduce hedge effectiveness.
• Management estimated a full-year 2011 effective tax rate of approximately 40%–45%. It cited non-deductible acquisition costs and first-half tax charges as contributors to the higher year-over-year rate.
• Southwest had an undrawn $800 million unsecured revolving credit facility, expiring April 2016, and reported compliance with its financial covenant. The company disclosed $400 million of debt maturities in December 2011 and $385 million in March 2012. Standard & Poor’s downgraded its senior unsecured rating from BBB to BBB- after the acquisition and maintained a stable outlook.
• Contractual obligations totaled $16.923 billion, including $5.438 billion of operating lease commitments and $5.581 billion of aircraft purchase commitments. Southwest guaranteed principal and interest on $310 million of bonds issued for the Dallas Love Field modernization project; $130 million of project construction costs had been recorded as an asset and corresponding obligation at quarter-end.
• Potential risks include execution and cost of AirTran integration, labor relations and collective bargaining, fuel-price volatility and hedge counterparty exposure, economic weakness affecting travel demand, and competitive capacity and pricing. The filing also describes an antitrust class action involving AirTran and Delta; the company stated it intended to defend the claims. AirTran merger-related shareholder suits were settled, with final court approval obtained July 28, 2011, while attorneys’ fees remained for determination.
• In August, the board authorized up to $500 million of common-stock repurchases; none had been made through the filing date. Federal supplemental war-risk insurance coverage was scheduled to expire September 30, 2011; non-extension could increase insurance costs or limit coverage.

Important facts for investors to verify

• Separate underlying Southwest performance from AirTran’s partial-period contribution and acquisition accounting; review comparable combined results and the assumptions behind reported non-GAAP measures.
• Track fuel expense, hedge effectiveness, collateral requirements, and potential earnings volatility from derivative mark-to-market accounting.
• Assess whether projected synergies, integration costs, labor agreements, systems integration, and the planned single operating certificate are achieved on schedule.
• Monitor debt maturities, lease and aircraft commitments, liquidity, and the credit-rating impact of the acquisition.
• Confirm progress on capacity discipline, revenue trends, fuel coverage, and the disclosed legal and insurance matters.