Southwest Airlines Co. — Q3 2015 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2015; filed October 29, 2015. Southwest operates scheduled passenger air service in the United States and near-international markets. Figures below are in millions unless stated otherwise.
Financial performance
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Operating revenue | $5,318 | $4,800 | $14,843 | $13,977 |
| Operating income | $1,225 | $614 | $3,090 | $1,605 |
| Net income | $584 | $329 | $1,645 | $946 |
| Diluted EPS | $0.88 | $0.48 | $2.45 | $1.36 |
| Operating cash flow | $836 | $240 | $2,914 | $2,698 |
Reported Q3 operating income increased 99.5% and net income increased 77.5% year over year. On the company’s non-GAAP basis, Q3 operating income was $1,047, net income was $623, and diluted EPS was $0.94; corresponding nine-month figures were $2,965, $1,764, and $2.63. These measures exclude specified fuel-hedge effects and other special items and are not GAAP results.
Q3 operating expenses fell 2.2% despite 7.6% capacity growth. Fuel expense declined 32.5%, while salaries, wages, and benefits rose 24.7%, reflecting higher staffing, contractual increases, pilot ratification bonuses and profitsharing. Operating expenses per available seat mile declined 9.1%; excluding fuel and specified special items, unit costs rose 0.7% in Q3. For the first nine months, reported operating expenses fell 5.0%, while unit costs excluding fuel and special items were relatively flat.
Passenger revenue rose 3.3% in Q3, while passenger revenue per available seat mile fell 4.0% and yield fell 5.1%. Load factor reached a company record 85.4%. For the nine months, passenger revenue rose 3.8%, but passenger revenue per available seat mile declined 3.0%. Lower fuel prices were a major earnings driver: average economic fuel cost per gallon fell 25.2% in Q3 and 30.9% year to date.
Balance sheet, liquidity and capital allocation
- At September 30, cash and cash equivalents were $1,740 and short-term investments were $1,356, or approximately $3.1 billion combined.
- Total debt, including current maturities, was $2,668, compared with $2,692 at December 31, 2014. Stockholders’ equity was $6,968.
- Cash from operations was $2,914 for the nine months; investing activities used $967 and financing activities used $1,489. Capital expenditures were $1,231.
- The company repurchased $1,180 of common stock and paid $180 in dividends during the first nine months. It reported $700 remaining under its $1.5 billion share-repurchase authorization at quarter-end.
- A $1 billion unsecured revolving credit facility, expiring April 2018, was fully undrawn; Southwest reported compliance with its financial covenant.
Material changes and unusual items
- Amended Chase co-branded card agreement: A July 2015 agreement changed accounting for loyalty-point and related deliverables, allocating more value to marketing-related items recognized in other revenue and less to transportation deferred revenue. Southwest recorded a one-time, non-cash $172 revenue adjustment from reducing the deferred revenue liability. The accounting change also affected the timing and classification of revenue; management estimated an approximately $130 million Q4 2015 revenue effect. The reported figures therefore include material accounting-related benefits that should be distinguished from underlying operating trends.
- Fuel hedging: Q3 fuel-hedge cash settlements included $245 paid to counterparties; year-to-date settlements included $326 paid. Other gains and losses included substantial mark-to-market effects. At September 30, fuel derivatives were a net liability of approximately $1.2 billion before collateral. Southwest was effectively unhedged for remaining Q4 2015 fuel consumption at prevailing prices.
- Other items: Q3 results included $140 of labor ratification bonuses and $6 of acquisition/integration costs. Nine-month results included a $37 litigation settlement gain and $32 of acquisition/integration costs. The company said significant future AirTran integration spending was not expected, apart from remaining Boeing 717 conversion and sublease activity.
Outlook, risks and contingencies
- Southwest expected 2015 capacity growth of approximately 7% and Q4 capacity growth of approximately 8%–9% year over year. It expected Q4 operating unit revenue to increase approximately 1% year over year, including the estimated Chase-accounting effect.
- Management expected Q4 unit costs, excluding fuel, profitsharing and special items, to be comparable with Q4 2014. It expected Q4 freight revenue to remain flat year over year.
- The company forecast a 2015 effective tax rate of 37%–38%. Its pre-tax return on invested capital, excluding special items, was 31.1% for the twelve months ended September 30, 2015, versus 19.0% a year earlier.
- Fuel-price and hedge-accounting volatility are key risks. The filing notes a mismatch risk between some hedge commodities and jet fuel, potential future hedge losses, and collateral exposure. Southwest had posted $478 of cash and $300 of aircraft collateral; a 25% decline in relevant market prices could require an additional estimated $474 of collateral, which it expected could be met with aircraft or letters of credit.
- Southwest faced federal and state inquiries and putative class actions alleging airline capacity coordination, as well as a separate older AirTran/Delta baggage-fee antitrust case. The company said it would defend the matters vigorously; management did not expect ongoing legal proceedings to have a material adverse financial effect. The filing reported no material changes to the risk factors in its 2014 Form 10-K.
- Aircraft purchase commitments were substantial: the filing listed $272 due for the remainder of 2015, $1.2 billion in each of 2016 and 2017, $1.0 billion in 2018, and $1.1 billion in 2019, with $5.7 billion thereafter. The company also had airport construction obligations and guarantees described in the filing.
Most important facts for investors to verify
- Separate recurring operating performance from the $172 million one-time revenue adjustment and the ongoing timing/classification effects of the amended Chase agreement.
- Assess underlying passenger pricing: passenger yield and passenger revenue per ASM declined despite stronger traffic, load factor and capacity.
- Review the cash and earnings implications of fuel hedges, including the net derivative liability, expected AOCI reclassifications, Q4 exposure and collateral requirements.
- Track labor costs, ratification bonuses, profitsharing and the outcome of the pilot contract ratification vote scheduled for November 4, 2015.
- Monitor the antitrust investigations and litigation, aircraft delivery and capital-spending commitments, and execution of capacity and network plans.