Southwest Airlines Co. 2006 Annual Report (10-K) Summary
Business Context and Reporting Period
This report covers the fiscal year ended December 31, 2006. Southwest Airlines Co. is the largest U.S. carrier by originating passengers and domestic departures. The company operates a point-to-point network using an all-Boeing 737 fleet, which totaled 481 aircraft at year-end. In 2006, Southwest extended its streak of consecutive profitable years to 34 and profitable quarters to 63. The company expanded service to Denver and Washington Dulles and benefited from the Wright Amendment Reform Act, which lifted through-ticketing restrictions at Dallas Love Field.
Key Financial Metrics
| Metric | 2006 | 2005 |
|---|---|---|
| Operating Revenues | $9,086 million | $7,584 million |
| Operating Income | $934 million | $725 million |
| Net Income | $499 million | $484 million |
| Diluted EPS | $0.61 | $0.60 |
| Operating Cash Flow | $1,406 million | $2,118 million |
| Total Assets | $13,460 million | $14,003 million |
| Long-term Debt | $1,567 million | $1,394 million |
| Stockholders' Equity | $6,449 million | $6,675 million |
| Fuel Cost (Avg/Gallon) | $1.53 | $1.03 |
| Load Factor | 73.1% | 70.7% |
Material Changes vs. Prior Period
- Revenue Growth: Operating revenues increased 19.8% to $9.086 billion, driven by an 8.8% increase in capacity (addition of 36 aircraft), a 6.9% increase in passenger yield, and a record 73.1% load factor.
- Profitability: Operating income rose 28.8% to $934 million. However, net income growth was modest (3.1%) due to a $101 million net loss recorded in "Other expenses (income)" related to fuel hedge ineffectiveness and the loss of hedge accounting, contrasting with a $110 million gain in 2005.
- Cost Structure: Fuel costs increased 48.5% per gallon to $1.53, representing 26.2% of operating expenses. Despite this, Cost per Available Seat Mile (CASM) excluding fuel remained flat compared to 2005 due to productivity gains.
- Capital Allocation: The company repurchased 49.1 million shares of common stock for $800 million in 2006. It also issued $300 million in senior unsecured notes and repaid $607 million in debt.
Guidance, Outlook, and Risks
- 2007 Outlook: Management expects to add 37 new aircraft, increasing capacity by approximately 8%. Fuel expenditures are projected to increase by $400 million to $500 million compared to 2006, even with hedging.
- Fuel Hedging: As of January 2007, the company had derivative contracts protecting nearly 95% of its 2007 fuel consumption at an average price of $50 per barrel. Management expects Q1 2007 fuel costs to range between $1.65 and $1.70 per gallon.
- Key Risks:
- Fuel Prices: Continued high fuel costs and supply disruptions remain the primary risk to operations.
- Labor Relations: Approximately 82% of employees are unionized. The pilots' agreement became amendable in September 2006, and negotiations are ongoing.
- Security and Regulation: New TSA security measures (e.g., liquid restrictions) negatively impacted demand in late 2006. The company estimates a $40 million revenue loss in August and September due to these measures.
- Accounting Volatility: Changes in fair value of fuel derivatives and hedge ineffectiveness continue to create volatility in non-operating income.
Investor Verification Checklist
- Fuel Hedge Effectiveness: Verify the extent of "hedge ineffectiveness" charges in future quarters and the correlation between crude oil prices and jet fuel costs.
- Labor Contract Progress: Monitor the status of negotiations with the Southwest Airlines Pilots' Association (SWAPA) and potential wage/benefit impacts.
- Wright Amendment Expansion: Assess the financial impact of expanded service from Dallas Love Field following the 2006 Reform Act.
- Share Repurchase Program: Confirm the remaining authorization under the $1.0 billion buyback program and the company's commitment to returning capital to shareholders.
- Security Impact: Evaluate whether the negative impact of TSA security measures on short-haul business travel has stabilized or persisted into 2007.