LUV

Business Context and Reporting Period

Company: Southwest Airlines Co.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 1997
Business Overview: Southwest is a major domestic airline providing shorthaul, high-frequency, point-to-point, low-fare service. As of year-end 1997, the company operated 261 Boeing 737 aircraft serving 52 airports in 51 cities across 25 states. The company achieved a record annual profit for the sixth consecutive year.

Key Financial Metrics

Operational Highlights:

• Load Factor: 63.7% (down from 66.5% in 1996 due to less promotional fare activity).
• Revenue Passenger Miles (RPMs): Increased 4.7% to 28.36 billion.
• Fleet Size: 261 aircraft (average age 8.3 years).
• Employees: 23,974 active employees.

Material Changes vs. Prior Period

• Profitability Surge: Net income increased 53.3% to $317.8 million, driven by record passenger revenue yields and continued cost control.
• Revenue Growth: Operating revenues rose 12.1%, primarily due to an 11.3% increase in passenger revenues. This was fueled by a 6.4% increase in passenger revenue yield per RPM and a 4.7% increase in RPMs.
• Cost Efficiency: Operating expenses per Available Seat Mile (ASM) decreased 1.3% to 7.40 cents, despite a 9.2% increase in capacity. This was largely due to lower jet fuel prices (average cost dropped to $0.6246/gallon from $0.6547) and lower engine repair costs.
• Freight and Other: Freight revenues increased 18.4% to $94.8 million, and "Other" revenues jumped 45.6% to $82.9 million, largely due to sales of frequent flyer segment credits.

Guidance, Outlook, Risks, and Contingencies

Outlook and Expansion:

• Plans for 1998 include adding 14 net aircraft and service to two new cities.
• Expansion is dependent on aircraft availability; Boeing production delays are temporarily impacting delivery schedules, though Southwest is receiving cash penalties.
• Management expects unit costs to benefit in Q1 1998 from lower fuel prices, though maintenance costs are expected to rise.

Risks and Contingencies:

• Fuel Costs: Jet fuel represents approximately 15% of operating expenses. The company hedges on a limited basis but cannot predict future price changes.
• Regulatory/Tax: The Taxpayer Relief Act of 1997 introduced changes to federal excise taxes. Management estimates this may increase the tax burden by roughly $30 million in 1998, shifting more burden to low-fare carriers. Fares were raised in Q4 1997 to offset this.
• Wright Amendment: Restrictions on service from Dallas Love Field remain, though recent amendments allow limited service to Alabama, Mississippi, and Kansas.
• Environmental Compliance: The company is compliant with the Airport Noise and Capacity Act (ANCA) interim requirements (over 80% Stage 3 fleet) and expects to qualify for a waiver to extend Stage 2 aircraft operations until 2003.
• Legal: An ongoing dispute with the IRS regarding aircraft maintenance deductions for 1989-1991 is in Tax Court; management does not expect a material adverse effect.
• Year 2000: Remediation costs are estimated at $15 million total; the company expects to complete internal efforts by March 31, 1999.

Investor Verification Checklist

• Boeing Delivery Schedule: Verify the impact of Boeing's production delays on 1998 expansion plans and the receipt of penalty payments.
• Fuel Price Sensitivity: Monitor jet fuel prices, as a significant portion of operating expenses is fuel-related and hedging is limited.
• Tax Burden Impact: Assess the actual financial impact of the new federal excise tax structure on 1998 profitability versus the $30 million estimate.
• Labor Negotiations: Track the status of collective bargaining agreements for Customer Service/Reservation employees and Flight Dispatchers, which became amendable in late 1997.
• Load Factor Trends: Monitor if the 1997 load factor decline (to 63.7%) stabilizes or improves in 1998 given the reduction in promotional fare activity.