LUV

Southwest Airlines Co. 2007 Annual Report (10-K) Summary

Business Context and Reporting Period

This report covers the fiscal year ended December 31, 2007. Southwest Airlines Co. is the largest U.S. air carrier by originating passengers and domestic departures. The company operates a single-fleet strategy using 520 Boeing 737 aircraft, serving 64 cities across 32 states. In 2007, Southwest extended its record of consecutive profitable years to 35 and quarters to 67. The company recommenced service to San Francisco International Airport and implemented a new boarding method and fare structure ("Business Select") to enhance revenue and customer experience.

Key Financial Metrics

Material Changes vs. Prior Period

• Net Income vs. Operating Income Divergence: While Net Income increased 29.3% to $645 million, Operating Income decreased 15.3% to $791 million. The increase in Net Income was driven by a $360 million net gain from fuel derivative accounting (SFAS 133), whereas the decline in Operating Income was caused by rising fuel costs that outpaced fare increases.
• Fuel Costs: Fuel and oil expenses rose to $2.536 billion (28.0% of operating expenses) from $2.138 billion (26.2%) in 2006. The average cost per gallon increased 11.1% despite significant hedging gains of $686 million.
• Revenue Growth: Operating revenues grew 8.5%, primarily due to a 7.5% increase in capacity (Available Seat Miles) and a 1.2% increase in passenger yield. However, the revenue environment was pressured by a slowing economy and competitive low-fare pressures.
• Cost Structure: Cost per Available Seat Mile (CASM) increased 3.4% to 9.10 cents. Approximately 80% of this increase was attributable to fuel. Maintenance materials and repairs per ASM increased 21.6% due to higher engine and airframe inspection costs.
• Capital Allocation: The company repurchased 66 million shares of common stock for $1.0 billion in 2007. It also invested $1.5 billion in aircraft purchases and progress payments.

Guidance, Outlook, and Risks

• 2008 Outlook: Management expects net cash expenditures for jet fuel to increase by more than $500 million compared to 2007. The company has reduced its 2008 growth plans, targeting a net fleet increase of only seven aircraft (adding 29, returning/selling 22), resulting in a 4-5% capacity increase.
• Fuel Hedging: As of January 2008, Southwest held fuel derivative contracts protecting over 70% of its expected 2008 consumption at an average price of approximately $51 per barrel. First-quarter 2008 jet fuel costs are expected to average approximately $2.00 per gallon.
• Labor Relations: Approximately 82% of employees are unionized. Agreements for Pilots, Flight Attendants, and Ramp Agents are amendable or in negotiation in 2008. The company offered an early retirement program in 2007, resulting in a $25 million charge.
• Risks: Primary risks include continued high fuel prices, inability to pass costs to consumers, labor contract negotiations, and potential disruptions in fuel supply. The company also faces regulatory risks regarding the Wright Amendment (Dallas Love Field) and potential new environmental regulations on greenhouse gas emissions.

Investor Verification Checklist

• Operating Income Trend: Verify the 15.3% decline in Operating Income to understand core business performance excluding derivative accounting gains.
• Fuel Hedge Effectiveness: Review Note 10 to assess the volatility in earnings caused by SFAS 133 hedge ineffectiveness and mark-to-market adjustments.
• 2008 Capacity Constraints: Confirm the reduced growth rate (net +7 aircraft) and its impact on future revenue potential versus cost control.
• Labor Contract Status: Monitor the status of negotiations with the Pilots (SWAPA) and Flight Attendants (TWU) unions, as agreements are amendable in 2008.
• Maintenance Costs: Investigate the 21.6% increase in maintenance per ASM to determine if this is a one-time spike due to fleet maturation or a structural cost increase.