Southwest Airlines Co. — Q1 2011 Form 10-Q
Reporting period: Three months ended March 31, 2011; financial statements are unaudited. Comparisons are against Q1 2010 unless stated otherwise. Dollar amounts are in millions except per-share and operating statistics.
Business context and operating performance
Southwest operates a domestic airline business. Q1 is generally seasonally weaker than the second and third quarters, and results are sensitive to economic conditions, travel demand, fuel prices and fuel-hedge accounting. The company reported improved passenger demand and pricing, while higher fuel and other costs constrained earnings.
- Revenue passengers increased 5.7%; revenue passenger miles rose 11.9% and available seat miles increased 8.3%. Load factor improved 2.4 percentage points to 78.3%.
- Average fare rose 11.4% to $139.18; passenger revenue yield per RPM increased 5.3%. Passenger revenue per ASM increased 8.7%.
- Southwest launched its redesigned Rapid Rewards program and began service to Charleston, Greenville/Spartanburg and Newark during the quarter.
Financial results and liquidity
| Metric | Q1 2011 | Q1 2010 / prior balance | Change |
|---|---|---|---|
| Operating revenue | $3,103 | $2,630 | Up 18.0% |
| Operating expenses | $2,989 | $2,576 | Up 16.0% |
| Operating income | $114 | $54 | Up 111.1% |
| Net income | $5 | $11 | Down 54.5% |
| Diluted EPS | $0.01 | $0.01 | Unchanged as reported |
| Operating cash flow | $965 | $373 | Up $592 |
| Cash and cash equivalents | $2,039 | $1,261 at Dec. 31, 2010 | Up $778 |
| Short-term investments | $2,426 | $2,277 at Dec. 31, 2010 | Up $149 |
| Total debt, including current maturities | $3,333 | $3,380 at Dec. 31, 2010 | Down $47 |
Operating margin was approximately 3.7% versus 2.1% in Q1 2010; net margin was approximately 0.2% versus 0.4%. Non-GAAP net income, excluding specified fuel-hedge effects and special items, was $20 million, or $0.03 diluted EPS, compared with $24 million, or $0.03, a 16.7% decline.
Operating cash flow benefited substantially from a $512 million increase in air traffic liability from advance bookings, a $238 million net increase in accounts payable and accrued liabilities, and $180 million of proceeds from fuel-derivative sales. Investing cash outflow was $231 million, including net property-and-equipment purchases of $57 million; financing cash inflow was $44 million, including $76 million from termination of interest-rate derivatives. Cash plus short-term investments totaled about $4.5 billion at quarter-end. The current ratio was approximately 1.22, compared with 1.29 at year-end.
Fuel and oil expense was $1,038 million, up 26.4%; average fuel cost including tax and hedge effects increased 16.9% to $2.91 per gallon, while economic fuel cost per gallon rose 26.5%. Operating expenses per ASM rose 7.1% to 12.20 cents; nonfuel unit costs excluding special items increased 1.9% to 7.91 cents. The filing does not provide a single directly comparable GAAP gross-margin measure.
Material changes, outlook and management commentary
- Revenue growth outpaced operating-cost growth, supporting higher operating income. However, net income fell as other expenses increased to $96 million from $37 million, including $59 million of net other losses, primarily related to derivative activity, versus $4 million in Q1 2010.
- The Q1 2011 effective tax rate was approximately 72%, including a $5 million IRS settlement charge for 2007–2009 tax years and a $2 million Illinois tax-law charge. Management projected a full-year 2011 effective rate of approximately 40%, excluding AirTran effects.
- Management expected Q2 passenger unit revenue to improve solidly year over year; April passenger unit revenue was expected to rise about 6%, with stronger combined May–June growth. It expected Q2 freight revenue growth comparable to Q1 and higher other revenue, but at a slower growth rate than Q1.
- Excluding AirTran, management expected full-year 2011 capacity growth of approximately 5%–6% and a year-end fleet of 558 aircraft. The filing also provided Q2 cost expectations: nonfuel unit-cost growth expected to exceed Q1’s rate, while maintenance, aircraft rentals and depreciation per ASM were expected to be at or below Q1 levels in the stated comparisons.
- As of April 19, 2011, management estimated Q2 economic fuel cost at approximately $3.35 per gallon, excluding AirTran. Fuel hedges covered varying portions of estimated consumption through 2014; coverage and realized costs depend on market prices and hedge terms. Premium costs were estimated at $25 million for Q2 and $118 million for full-year 2011.
- The proposed AirTran acquisition was expected to close May 2, 2011, subject to closing conditions. Southwest expected to use about $670 million of cash for stockholder consideration and estimated approximately $500 million of integration and closing costs. Management anticipated more than $400 million in annual net synergies by 2013 and expected the transaction to be accretive to fully diluted EPS in the first 12 months after closing, excluding one-time costs. These are forward-looking estimates, not reported results.
Risks, contingencies and unusual items
- Fuel and derivatives: Hedge-accounting ineffectiveness and mark-to-market movements can make reported earnings volatile. Derivative fair values included a net asset of $456 million before collateral effects; collateral posted was $224 million and collateral held was $188 million. A one-third fall in relevant commodity market prices from March 31 levels could require an additional $437 million of cash collateral under the company’s stated scenario.
- Acquisition and litigation: AirTran shareholder lawsuits challenged the transaction and disclosures. The parties reached a memorandum of understanding to settle specified cases, subject to court approval and other conditions. Completion, integration, costs and expected synergies remain uncertain.
- Dallas Love Field project: Southwest guaranteed principal and interest on $310 million of bonds issued for the modernization project and recorded $102 million of construction assets and corresponding liabilities at March 31. Total project spending was then estimated at approximately $519 million, with completion scheduled for the second half of 2014.
- Other exposures: The company disclosed $93 million of auction-rate securities with failed auctions and a $17 million temporary unrealized fair-value decline. Federal supplemental war-risk insurance was scheduled to expire September 30, 2011; failure to extend it could increase costs or limit coverage.
- Management stated that ordinary-course legal matters and IRS examinations were not expected to have a material adverse effect. No material change to the 2010 Form 10-K risk factors was reported. Disclosure controls were assessed as effective; no material change in internal control over financial reporting was reported.
Important facts for investors to verify
- Whether the AirTran merger closed as expected, its final cash and share consideration, total integration charges, and progress toward the stated synergy and EPS-accretion targets.
- Subsequent fuel prices, hedge settlements and hedge-accounting impacts, including cash-collateral needs and actual fuel cost per gallon.
- Whether passenger unit-revenue growth and load-factor gains continued, and whether fare increases affected demand.
- Drivers and sustainability of operating cash flow, especially advance bookings, payables and derivative-sale proceeds; also the ability to meet debt maturities and acquisition-related cash needs.
- Actual Q2 and full-year capacity, cost, tax-rate and fuel-cost outcomes versus management’s estimates, and the status of the Love Field project and war-risk insurance coverage.