LUV

Business Context and Reporting Period

Company: Southwest Airlines Co.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2004
Context: Southwest reported its 54th consecutive quarterly profit despite industry-wide challenges, including rising fuel prices, increased competitive capacity, and disruptions from four major hurricanes in the third quarter. The airline successfully increased capacity by 7.0% year-over-year while maintaining profitability through aggressive cost controls and a robust fuel hedging program.

Key Financial Metrics

Unit Metrics (Q3 2004 vs Q3 2003):
- Load Factor: 72.7% (up 2.2 points)
- CASM (Cost per Available Seat Mile): 7.61 cents (up 1.3%)
- CASM Excluding Fuel: 6.34 cents (flat vs. prior year)
- Fuel Cost per Gallon: 80.3 cents (up 10.3%)

Material Changes vs. Prior Period

• Revenue Growth: Operating revenues increased 7.8% in Q3 and 10.3% YTD, driven by a 10.4% increase in Revenue Passenger Miles (RPMs) and a 7.0% increase in capacity (Available Seat Miles). However, passenger yields per RPM declined 2.8% in Q3 due to competitive fare sales.
• Profitability: Q3 Net Income rose 12.3% to $119 million. YTD Net Income decreased 31.4% to $258 million; however, this comparison is skewed by a $271 million government grant received in Q2 2003. Excluding the grant, YTD 2004 Net Income increased 10.7% over the adjusted 2003 figure.
• Cost Management: Operating expenses per ASM increased 1.3% in Q3, primarily due to higher fuel and labor costs. Excluding fuel, unit costs remained flat. The elimination of travel agency commissions (effective Dec 2003) significantly reduced operating expenses.
• Balance Sheet: Cash balances remained stable at $1.876 billion. Long-term debt increased due to the issuance of $350 million in senior unsecured notes in Q3 2004. Fuel hedge contracts (current asset) grew to $558 million from $164 million year-over-year.

Guidance, Outlook, and Risks

• Outlook: Management expects Q4 2004 CASM excluding fuel to decline slightly to match Q3 levels (6.34 cents). Full-year 2005 CASM excluding fuel is expected to be in line with or below 2004 levels due to productivity improvements.
• Fuel Hedging: The company is over 80% hedged for remaining 2004 fuel requirements (capped under $24/barrel) and over 80% hedged for 2005 (capped at ~$25/barrel). This strategy mitigated the impact of record-high market fuel prices.
• Operational Initiatives: Southwest is retrofitting its 737-700 fleet with Blended Winglets to achieve ~3% fuel savings per aircraft. The company also reduced headcount by 5.9% while increasing flights, aided by internet booking adoption and the consolidation of reservations centers.
• Risks:
  • Insurance: Federal war-risk insurance coverage expires December 31, 2004; non-extension could lead to significantly higher costs in 2005.
  • Accounting Standards: A new FASB standard on stock-based compensation (effective Jan 1, 2005) may require expensing stock options, potentially reducing reported net income by approximately $63 million for the first nine months of 2004 on a pro forma basis.
  • Market Conditions: Continued pressure on yields due to industry capacity growth and competitive fare sales.

Investor Verification Checklist

• Government Grant Impact: Verify the non-GAAP reconciliation excluding the $271 million 2003 Wartime Act grant to accurately assess year-over-year operating performance trends.
• Fuel Hedge Effectiveness: Confirm the valuation of the $937 million fuel hedge portfolio and the specific cap prices for 2005-2007 to assess future cost protection.
• Stock-Based Compensation: Review the pro forma impact of the upcoming FASB standard (Note 2), which could reduce 2005 earnings significantly if stock options are expensed.
• Debt Structure: Note the recent issuance of $350 million in 5.25% notes due 2014 and the associated interest rate swap converting this to a floating rate.
• Insurance Exposure: Monitor the status of federal war-risk insurance extension beyond December 31, 2004, as a potential cost driver for 2005.