Southwest Airlines Co. — FY2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016; the filing also reports fourth-quarter results. Southwest operates scheduled passenger service primarily in the U.S. and near-international markets. At year-end, it served 101 destinations with 723 Boeing 737 aircraft and reported its 44th consecutive profitable year.
Financial performance and position
| Metric | FY2016 | FY2015 |
|---|---|---|
| Operating revenue | $20.425 billion | $19.820 billion |
| Operating income | $3.760 billion | $4.116 billion |
| Net income | $2.244 billion | $2.181 billion |
| Diluted EPS | $3.55 | $3.27 |
| Operating margin | 18.4% | 20.8% |
| Operating cash flow | $4.293 billion | $3.238 billion |
| Capital expenditures | $2.038 billion | $2.041 billion |
Operating margin is calculated from reported operating income and revenue. Fourth-quarter 2016 revenue was $5.076 billion, operating income $846 million, and net income $522 million; in fourth-quarter 2015, the respective figures were $4.977 billion, $1.026 billion, and $536 million.
- Revenue and operations: Passenger revenue rose 1.6% to $18.594 billion; capacity increased 5.7%, and annual load factor reached a company record 84.0%. Passenger revenue per available seat mile fell 3.8%; average fare declined to $149.09 from $154.85.
- Costs and margins: Operating expenses rose 6.1% to $16.665 billion, faster than revenue. Costs per available seat mile increased 0.4% to 11.22 cents; excluding fuel and special items, they rose 1.6% to 8.49 cents. Salaries, wages, and benefits increased 6.5% to $6.798 billion.
- Fuel: Reported fuel expense was $3.647 billion, up slightly year over year despite lower market fuel prices. The company recorded $820 million of net fuel-hedging losses in fuel expense, versus $254 million in 2015. Economic fuel cost per gallon, including taxes, fell to $1.92 from $2.07.
- Liquidity and debt: Cash and cash equivalents were $1.680 billion and short-term investments $1.625 billion at year-end, totaling $3.305 billion. The $1 billion revolving credit facility was undrawn; the company reported covenant compliance. Long-term debt, including current maturities, was about $3.4 billion before debt discounts and issuance costs. Stockholders’ equity was $8.441 billion.
- Capital returns: Southwest returned a reported record $2.0 billion to shareholders in 2016: $222 million in dividends and approximately $1.75 billion through share repurchases. Dividends declared per share totaled $0.375.
Material changes versus the prior period
- Revenue increased 3.1%, but operating income declined 8.6%; net income rose 2.9%. Diluted EPS grew 8.6%, supported in part by share repurchases.
- Other revenue increased 41.9%, primarily because of the amended Chase co-branded credit card agreement and associated revenue-accounting change. The company estimated that the agreement increased 2016 operating revenue by $544 million and net income by $293 million. In 2015, a separate $172 million one-time, noncash revenue adjustment was recorded.
- Fuel and oil expense increased $31 million as fuel-hedging losses offset lower market prices. Excluding hedging, fuel expense fell $535 million, or 15.9%.
- Depreciation and amortization increased 20.3%, including $123 million of accelerated depreciation after the company moved up the planned retirement of its remaining Classic aircraft to no later than third-quarter 2017.
- Operating cash flow increased to $4.293 billion, including a $535 million net inflow of cash collateral from derivative counterparties, compared with a $570 million outflow in 2015.
Outlook, commentary, and risks
- Management outlook: Southwest planned 2017 available-seat-mile growth of approximately 3.5%, with about 2.5 percentage points from domestic growth. Based on early-2017 trends, it expected first-quarter operating unit revenue to be flat to down 1% year over year, and first-quarter unit costs excluding fuel, special items, and profitsharing to rise 6%–7%, largely due to amended labor agreements.
- Investment and fleet: Estimated 2017 capital expenditures were approximately $2.3 billion. The company expected its fleet to decline to 703 aircraft by year-end 2017 after accelerated retirement of the remaining 87 Classic aircraft; the new 737-8 was expected to enter service in fourth-quarter 2017.
- Hedging exposure: As of January 20, 2017, fuel derivatives covered up to 63% of estimated 2017 fuel consumption at a single price level. Year-end derivative fair value was a net liability of $326 million, and $301 million of cash collateral had been posted. The company warned that hedge settlements could make fuel costs exceed unhedged market prices in some periods.
- Other cost and execution risks: Labor represented about 41% of operating expenses, and approximately 83% of employees were union-represented. Mechanics, Material Specialists, and Facilities Maintenance Technicians were in negotiations. The domestic reservation-system migration continued; its second foundational release was expected May 9, 2017. The filing identifies implementation, operational disruption, and cybersecurity risks.
- Legal and regulatory matters: Southwest faced federal and state investigations and putative class actions alleging airline capacity coordination; the company denied wrongdoing and said it would defend the cases. Management did not expect currently ongoing legal matters, individually or collectively, to materially adversely affect financial condition, results, or cash flow. The filing also describes risks from fuel volatility, economic conditions, competition, airport and air-traffic constraints, regulation, and reliance on Boeing and other sole suppliers.
- Accounting change ahead: The company expected the revenue-from-contracts standard, planned for adoption in 2018, to materially increase its frequent-flyer liability; it estimated a relative-fair-value approach could increase the $63 million incremental-cost liability by approximately twenty times. The company was still evaluating the impact.
Key facts for investors to verify
- Separate underlying passenger demand and unit-revenue trends from the Chase agreement’s significant revenue-classification and timing effects.
- Track 2017 fuel-hedge settlements, cash collateral needs, and the gap between reported and economic fuel costs.
- Assess whether capacity growth and high load factors can support revenue and margins amid lower fares and rising labor and other unit costs.
- Monitor execution and cost of the Classic-fleet retirement, aircraft commitments, and reservation-system migration.
- Review developments in the capacity-related investigations and lawsuits, unresolved labor negotiations, and adoption of the new frequent-flyer accounting standard.