Southwest Airlines Co. — Q1 2017 Form 10-Q
Reporting period: Three months ended March 31, 2017; filed May 3, 2017. Southwest operates scheduled passenger air service in the United States and nearby international markets. Unless noted, financial amounts are in millions of dollars. Comparisons are year over year.
Financial performance
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Operating revenue | $4,883 | $4,826 | +1.2% |
| Operating expenses | $4,225 | $3,882 | +8.8% |
| Operating income | $658 | $944 | -30.3% |
| Net income | $351 | $513 | -31.6% |
| Diluted earnings per share | $0.57 | $0.79 | -27.8% |
| Operating cash flow | $1,625 | $1,616 | +$9 |
Operating margin was approximately 13.5%, versus 19.6%; net margin was approximately 7.2%, versus 10.6%. Non-GAAP net income was $372 million ($0.61 per diluted share), down from $569 million ($0.88); non-GAAP operating income was $626 million, down from $952 million. These company-defined measures adjust for fuel-hedge accounting effects and special items and are not GAAP measures.
Passenger revenue rose 0.6% to $4,424 million, while passenger revenue per available seat mile fell 3.3%. Capacity (ASMs) grew 4.1%, but load factor declined 0.6 percentage points to 79.9%; passenger yield fell 2.6%. Other revenue increased 8.0% to $417 million, mainly from the co-branded credit card and ancillary services. Freight revenue was flat at $42 million.
Costs, cash, debt and liquidity
- Operating expenses per ASM increased 4.5% to 11.51 cents. Salaries, wages and benefits rose 12.6%, primarily reflecting negotiated wage increases; fuel and oil expense rose 8.2% to $922 million.
- Economic fuel cost, including taxes, increased 10.1% to $1.96 per gallon. Fuel derivatives generated $143 million in cash settlement payments in the quarter; the filing reports net fuel-hedge losses of $105 million in fuel expense, compared with $275 million a year earlier.
- Cash and cash equivalents were $1,851 million and short-term investments were $1,631 million at March 31, for combined cash and short-term investments of about $3.5 billion. Total debt, including current maturities, was $3,066 million, down from $3,387 million at December 31, 2016. The company repaid $300 million of notes at maturity on March 1.
- Operating cash flow was $1,625 million; capital expenditures were $414 million. Investing activities used $470 million and financing activities used $984 million, including $550 million of share repurchases, $123 million of dividends and $369 million of debt and capital-lease payments. Cash increased by $171 million to $1,851 million.
- Current liabilities exceeded current assets, largely reflecting advance ticket sales and frequent-flyer obligations. Management said the working-capital deficit is typical for the airline and believes available liquidity and expected operating cash flows are adequate. The $1.0 billion revolving credit facility was undrawn; the company reported covenant compliance.
Material changes, outlook and risks
- Management attributed the earnings decline chiefly to higher labor costs, fuel prices and other operating costs, alongside weaker passenger unit revenue amid competitive fares and a shift in Easter travel demand. Active full-time-equivalent employees increased 7.3% to 54,652.
- Management expected Q2 2017 operating unit revenue to increase approximately 1%–2% year over year, capacity to rise about 5%, and full-year 2017 ASMs to grow about 3.5%. Q2 unit costs excluding fuel, special items and profit-sharing were expected to rise about 6%. The projected full-year effective tax rate was approximately 37%.
- The company planned to retire its remaining 79 Boeing 737-300 aircraft by the end of Q3 2017 and expected its fleet to decline to 703 aircraft by year-end, after deliveries and retirements. The reservation-system replacement was in progress; the next major release was expected May 9, 2017.
- Fuel hedging remains a material source of earnings and liquidity volatility. At March 31, fuel derivatives had a net fair-value liability of $337 million, and $263 million in cash collateral had been provided. Approximately $275 million of net unrealized fuel-hedge losses in accumulated other comprehensive income was expected to be recognized in earnings over the following 12 months. The filing notes hedge coverage varies with market prices and instruments.
- Southwest disclosed ongoing U.S. investigations and consumer class actions alleging airline capacity coordination; the company denies wrongdoing. A separate AirTran baggage-fee antitrust case had been dismissed in March, but plaintiffs appealed. Management did not expect current legal proceedings or IRS matters to materially adversely affect financial condition, results or cash flow.
- The company guaranteed $432 million of outstanding Love Field modernization bonds. It also guaranteed obligations associated with the LAX terminal project financing; the filing does not provide a clear current guaranteed balance in this text. Airport construction obligations and aircraft purchase commitments are additional exposures.
- Management identified demand, competition, fuel prices and hedge accounting, technology implementation, third-party dependencies, regulation and execution of initiatives as risks. It cautioned that quarterly results are seasonal and not necessarily indicative of full-year results. No material changes to the prior annual report’s risk factors were reported.
Important facts for investors to verify
- Whether fare and passenger-yield trends improve enough to offset capacity growth, and whether the stated Q2 unit-revenue outlook is achieved.
- Whether wage, technology and other unit-cost increases track management’s projections, and the operational execution of the reservation-system transition and fleet retirements.
- Fuel-hedge settlement outcomes, collateral requirements and the timing and effect of deferred hedge losses; compare the company’s non-GAAP economic fuel measures with GAAP results.
- Capital allocation and liquidity after substantial repurchases and dividends, including aircraft capital commitments, airport-project guarantees and the undrawn credit facility.
- Developments in the antitrust investigations and litigation, labor agreements, and any change in management’s assessment of legal or other contingencies.