SOUTHWEST AIRLINES CO annual report, FY2014

Southwest Airlines Co. — FY 2014 Form 10-K

Reporting period: Fiscal year ended December 31, 2014; fourth-quarter figures are included where available. Southwest operates primarily a U.S. point-to-point airline. AirTran’s final passenger service was December 28, 2014, effectively completing the integration. Southwest began international service in 2014 and ended the year serving 93 destinations with 665 Boeing 737 aircraft.

Financial performance

Metric	2014	2013	Change
Operating revenue	$18.605 billion	$17.699 billion	+5.1%
Operating income	$2.225 billion	$1.278 billion	+74.1%
Operating margin	12.0%	7.2%	+4.8 percentage points
Net income	$1.136 billion	$754 million	+50.7%
Diluted EPS	$1.64	$1.05	+56.2%
Operating cash flow	$2.902 billion	$2.477 billion	+17.2%

• Passenger revenue rose 5.6% to $17.658 billion, reflecting higher load factor and yields. Load factor increased to 82.5% from 80.1%; passenger yield increased to 16.34 cents per revenue passenger mile from 16.02 cents.
• Operating expenses declined 0.2% to $16.380 billion. Fuel and oil expense fell 8.2% to $5.293 billion as the average economic fuel price declined to $2.92 per gallon from $3.12. Salaries, wages, and benefits rose 7.9% to $5.434 billion, including record profitsharing expense of $355 million.
• Operating expenses per available seat mile were 12.50 cents, down 0.8%; excluding fuel and special items, the company-defined measure increased 3.1% to 8.36 cents. Company-defined non-GAAP diluted EPS was $2.01 versus $1.12 in 2013; this measure excludes specified fuel-hedge effects and special items and is not GAAP.
• Fourth-quarter revenue was $4.628 billion, operating income $621 million, and net income $190 million, or $0.28 per diluted share.
• At year-end, cash and cash equivalents were $1.282 billion and short-term investments $1.706 billion. The company reported $2.692 billion of current maturities and long-term debt combined, calculated from balance-sheet amounts; long-term debt less current maturities was $2.434 billion. Stockholders’ equity was $6.775 billion.
• Capital expenditures were $1.748 billion. The company repurchased approximately $955 million of stock and paid $139 million in dividends during 2014. It had no borrowings under its $1 billion revolving credit facility and reported compliance with its financial covenant.

Material changes and operating developments

• AirTran integration produced estimated 2014 net pretax synergies of approximately $500 million, excluding acquisition and integration costs. AirTran’s 717 aircraft were removed from Southwest service and are being transitioned to Delta; remaining aircraft deliveries were expected to continue into 2015.
• Southwest expanded at LaGuardia and Reagan National through acquired slots and added Dallas Love Field destinations following repeal of federal flight restrictions in October 2014. The company announced additional Love Field service for 2015.
• 2014 operating revenue increased by $906 million, while operating income increased by $947 million. Lower fuel expense and stronger passenger revenue supported results; higher wages, benefits, and profitsharing partially offset those gains.
• Other (gains) losses, net, shifted to a $309 million expense from a $32 million gain in 2013, primarily reflecting fuel-derivative mark-to-market effects. The 2014 comprehensive-income statement also recorded a $727 million after-tax unrealized loss on fuel derivatives; year-end accumulated other comprehensive loss was $738 million.

Outlook, risks, and contingencies

• For 2015, management expected available seat miles to rise approximately 6%–7% year over year. It expected first-quarter passenger revenue growth broadly in line with capacity growth and first-quarter unit costs excluding fuel, special items, and profitsharing to decline 1%–2% year over year. These are management estimates, not guarantees.
• Management estimated 2015 capital expenditures of $1.7–$1.8 billion, excluding $50–$100 million for assets constructed for others, net of reimbursements. The company had $20.0 billion of disclosed contractual obligations, including $11.048 billion of aircraft purchase commitments and $5.155 billion of operating lease commitments.
• Following the sharp fuel-price decline, the company was effectively unhedged at current market prices for 2015 and 2018, and had approximately 10% of estimated 2016 consumption and 30% of 2017 consumption covered. Fuel derivatives had a net fair-value liability of approximately $1.0 billion at year-end; legacy hedge losses may raise future fuel costs above unhedged market prices. Hedge collateral demands and accounting volatility remain risks.
• Other principal risks include volatile fuel prices and supply, labor costs and negotiations, intense competition, economic and seasonal demand swings, operational disruption and weather, technology and reservation-system implementation, regulatory changes, and reliance on Boeing and other concentrated suppliers. Approximately 83% of employees were union-represented; several large groups were in negotiations.
• AirTran remained involved in a consolidated antitrust class action concerning baggage fees and alleged pricing conduct. Class certification and summary judgment proceedings remained unresolved; the company said outcomes could not be predicted, although management did not expect ongoing legal matters collectively to have a material adverse effect.
• The company reported $970 million of goodwill from the AirTran acquisition and no impairment in its 2014 annual test. Future impairment is possible if operating assumptions deteriorate. Management also reported a prospective estimate change that increased 2014 passenger revenue by approximately $55 million from higher estimated frequent-flyer point spoilage; the estimated net-income effect was $29 million, or $0.04 per share.
• Ernst & Young issued unqualified opinions on the financial statements and internal control over financial reporting. Management concluded disclosure controls and internal controls were effective as of December 31, 2014.

Key investor verification points

• Assess how much earnings improvement is sustainable at lower fuel prices, given the reduced hedge coverage and expected settlement of deferred hedge losses.
• Review the $55 million frequent-flyer spoilage estimate change, its assumptions, and its continuing 2015 revenue impact.
• Track labor negotiations, wage and benefit inflation, and the effect of capacity growth on unit costs and margins.
• Monitor execution and returns on aircraft purchases, airport construction projects, international expansion, and the multi-year Amadeus reservation-system conversion.
• Evaluate cash generation after capital spending, shareholder distributions, and contractual aircraft commitments, as well as the potential liquidity effects of hedge collateral.
• Follow the antitrust litigation and any material developments in the transition of AirTran’s 717 aircraft to Delta.