SOUTHWEST AIRLINES CO quarterly report, Q3 FY2011

Southwest Airlines Co. — Q3 2011 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2011. Amounts are in U.S. dollars; financial statement amounts are in millions unless noted. Southwest acquired AirTran on May 2, 2011, so 2011 reported results include AirTran only from that date, while 2010 comparatives are Southwest-only.

Financial performance

Metric	Q3 2011	Q3 2010	Nine months 2011	Nine months 2010
Operating revenue	$4,311	$3,192	$11,550	$8,990
Operating income	$225	$355	$546	$772
Net income (loss)	$(140)	$205	$26	$328
Diluted EPS	$(0.18)	$0.27	$0.03	$0.44
Operating cash flow	$(218)	$385	$985	$1,292

• Reported operating margin was approximately 5.2% in Q3 versus 11.1% a year earlier; nine-month margin was approximately 4.7% versus 8.6%.
• Management’s non-GAAP results, which adjust for fuel-hedge accounting volatility and specified special items, showed Q3 net income of $122 million ($0.15 diluted EPS) versus $195 million ($0.26); nine-month net income was $263 million ($0.34) versus $436 million ($0.58). These are supplemental, non-GAAP measures.
• Q3 consolidated revenue rose 35.1%, substantially reflecting AirTran. Excluding AirTran’s Q3 contribution, revenue increased 11.3%. Nine-month revenue excluding AirTran’s post-acquisition contribution increased 14.0%.
• Q3 fuel and oil expense was $1,586 million, up $660 million; the average fuel cost per gallon rose 30.8% to $3.23. Consolidated operating expenses increased 44.0% in Q3, while capacity increased 30.4%. Non-GAAP nonfuel unit costs, excluding special items, declined 1.2% in Q3 but rose 0.5% for the nine months.
• The Q3 $405 million of other expense, net, was primarily fuel-derivative mark-to-market and ineffectiveness charges. The filing attributes the sharp GAAP/non-GAAP earnings difference largely to noncash fuel-hedge accounting adjustments.

Balance sheet and liquidity

• At September 30, 2011, cash and cash equivalents were $1.016 billion and short-term investments were $2.640 billion, totaling approximately $3.7 billion. Total current assets were $4.594 billion and current liabilities were $5.320 billion.
• Balance-sheet long-term debt, including current maturities, was approximately $4.206 billion ($986 million current and $3.220 billion long-term). This includes acquired AirTran obligations; the filing’s contractual-obligations schedule reports $4.023 billion of principal.
• The company had an $800 million unsecured revolving credit facility, expiring April 2016, with no borrowings outstanding; it was in compliance with its financial covenant. Nine-month operating cash flow was down from 2010 and included $429 million of cash collateral provided to fuel-derivative counterparties.
• Investing cash use was $957 million for the nine months, including $548 million of net property and equipment purchases. Financing cash use was $273 million, including $175 million of share repurchases and $110 million of debt and capital-lease payments. Cash declined $245 million from year-end 2010.

Material changes, outlook and risks

• AirTran acquisition: consideration was approximately $1.0 billion in cash and stock; total transaction value including debt and capitalized aircraft leases was approximately $3.2 billion. AirTran contributed $758 million of Q3 revenue and $3 million of Q3 net income; for the post-acquisition period through September 30, it contributed $1.3 billion of revenue and a $24 million net loss.
• AirTran integration costs were $22 million in Q3 and $97 million year to date. Management expected approximately $500 million of total acquisition and integration costs through 2014, funded with cash. It expected net annual synergies above $400 million by 2013 and said the transaction was expected to be accretive to fully diluted EPS in 2011 and 2012, excluding one-time costs, and more accretive thereafter. These are forward-looking estimates.
• Management cited record Q3 and year-to-date passenger yield and load factor, stable business travel, and strong bookings; based on October trends, it expected solid Q4 year-over-year passenger unit-revenue growth. It expected Q4 2011 combined capacity about 2% above combined Q4 2010 and 2012 combined capacity approximately equal to 2011.
• Other stated expectations included Q4 nonfuel unit costs, excluding special items, rising approximately 2% versus combined Q4 2010; freight revenue comparable to Q3; and full-year 2011 non-GAAP effective tax rate of approximately 40%–45%.
• Fuel hedging remains a significant risk: the portfolio’s fair value was a $657 million liability before collateral, and $458 million of cash collateral had been posted. The filing warned that a one-third decline in relevant commodity prices could require about $800 million of additional collateral. WTI/jet-fuel basis divergence and hedge ineffectiveness could increase volatility or reduce protection; deferred hedge losses may also raise future fuel costs.
• Significant commitments include $5.397 billion of aircraft purchase commitments and $5.318 billion of operating lease commitments. Southwest guaranteed principal and interest on $310 million of Love Field project bonds; the project was estimated at approximately $519 million, with $152 million of construction costs and a corresponding liability recorded at quarter-end.
• Legal matters include a pending antitrust class action concerning baggage fees, capacity and pricing involving AirTran and Delta; merger-related shareholder litigation had largely been settled or dismissed, with dismissal proceedings still underway for certain actions. Management did not expect ongoing legal proceedings or IRS matters to materially harm financial condition, results or cash flow.

Most important facts for investors to verify

• Whether AirTran integration proceeds on schedule and delivers the forecast synergies, while costs remain within the approximately $500 million estimate.
• How fuel prices, hedge effectiveness, derivative settlements and collateral requirements affect future cash flow and reported earnings.
• Whether fare and revenue gains can offset fuel inflation and rising operating costs without materially weakening demand.
• Debt maturities, aircraft and lease commitments, Love Field guarantee exposure, and liquidity after integration spending and repurchases.
• Progress on labor agreements and integration, the remaining antitrust litigation, and finalization of provisional AirTran purchase-accounting values.