Southwest Airlines Co. — Q3 2014 Form 10-Q
Reporting period: Three and nine months ended September 30, 2014. Southwest operates a major domestic airline and was completing integration of AirTran, with integration expected to be effectively complete by year-end 2014. Unless noted, financial amounts are in millions.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Operating revenue | $4,800 | $4,545 | $13,977 | $13,271 |
| Operating income | $614 | $390 | $1,605 | $893 |
| Net income | $329 | $259 | $946 | $542 |
| Diluted EPS | $0.48 | $0.37 | $1.36 | $0.75 |
| Operating margin | 12.8% | 8.6% | 11.5% | 6.7% |
| Net margin | 6.9% | 5.7% | 6.8% | 4.1% |
| Operating cash flow | $240 | $428 | $2,698 | $2,188 |
Revenue growth reflected strong travel demand and improved load factors. Q3 load factor was 84.4%, up 3.6 percentage points; capacity (ASMs) rose 1.1%. Q3 passenger revenue increased 6.0%. Lower fuel expense partly offset higher labor and other costs. Reported operating expenses rose 0.7% in Q3 and were essentially flat for the nine-month period. Margins above are calculated from reported revenue and income.
Management also reported non-GAAP Q3 operating income of $649 million and net income of $382 million ($0.55 diluted EPS); nine-month non-GAAP operating income was $1.710 billion and net income was $993 million ($1.42 diluted EPS). These measures adjust primarily for fuel-hedge accounting effects and AirTran integration costs and are not GAAP substitutes.
Balance sheet, liquidity and capital allocation
- At September 30, cash and cash equivalents were $1.832 billion and short-term investments were $1.728 billion, or $3.560 billion combined. Total current assets were $4.985 billion and current liabilities $6.446 billion.
- Debt was $2.732 billion, including $607 million of current maturities. The $350 million 5.25% notes matured and were repaid from cash on October 1, 2014.
- Nine-month capital expenditures were $1.340 billion. Financing cash outflow included $755 million of share repurchases, $138 million of dividends and $167 million of debt and capital-lease repayments.
- The company had an undrawn $1 billion revolving credit facility through April 2018 and reported compliance with its financial covenant. It expected approximately $550 million in total AirTran integration costs, of which $488 million had been incurred by September 30.
Changes, outlook and management commentary
- Q3 GAAP net income increased 27.0% year over year; nine-month net income increased 74.5%. Management cited stronger demand, strategic initiatives and lower fuel prices. Nine-month operating cash flow benefited in part from an $806 million increase in air traffic liability from advance bookings and loyalty-point sales.
- Q3 economic fuel cost was $2.94 per gallon versus $3.06 a year earlier; fuel expense per ASM declined 5.5%. Ex-fuel and special-item unit costs rose, and management expected Q4 unit costs excluding fuel, profitsharing and special items to increase approximately 2% year over year.
- Management expected Q4 ASMs to rise approximately 2%–3% year over year and full-year 2014 ASMs to be up less than 1%. October passenger unit revenue was expected to increase 2%–3% year over year; current November and December bookings were described as good. Q4 freight revenue was expected to increase and other revenue to decrease year over year.
- The company launched international service in 2014 and expanded service from Dallas Love Field after federal restrictions were repealed on October 13. The planned network, fleet and integration transitions could affect costs and operations.
- Fuel hedges covered up to 62% of Q3 consumption; coverage depends on market prices and instruments. WTI-based derivatives no longer qualified for hedge accounting, creating earnings volatility. Management said fuel costs in some future periods could exceed unhedged market prices. A 25% fall in relevant commodity prices could require substantial collateral, although management expected lower fuel costs to provide an offset.
- A Q2 estimate revision for expected ticket spoilage added $47 million to passenger revenue and, net of profitsharing and taxes, $25 million to nine-month net income, or $0.04 per share. This was an estimate change, not a Q3-specific item.
- AirTran-related B717 transition costs included a $17 million Q2 2014 expense adjustment; the remaining B717 fleet was scheduled to leave Southwest service by December 28, 2014. Management said possible further transition charges were not expected to be material.
Risks, commitments and contingencies
- Key disclosed risks include demand and economic conditions, competition, fuel prices and hedge effectiveness, technology execution, AirTran integration, and reliance on third parties. The company reported no material change to the risk factors in its 2013 Form 10-K.
- Southwest guaranteed principal and interest on $456 million of Dallas Love Field project bonds; at September 30 it had recorded $484 million of gross project construction costs and a $481 million net construction obligation. It also guaranteed obligations for the LAX terminal project financing, with a project cost cap of $525 million. Additional airport development projects carry funding, construction and accounting obligations.
- An antitrust class-action case involving AirTran and Delta remained pending; proceedings included a discovery-sanctions dispute. Management did not expect ongoing legal proceedings or IRS matters to have a material adverse effect.
- Moody’s upgraded Southwest’s senior unsecured debt rating to Baa2 in August 2014; Fitch affirmed BBB and revised its outlook to positive in September.
- Management stated disclosure controls were effective at September 30, 2014; no material change in internal control over financial reporting was reported.
Most important facts for investors to verify
- Whether elevated revenue, load factors and margins persisted after Q3, and whether the stated Q4 unit-cost and capacity outlook was achieved.
- How much of earnings and fuel expense reflects cash hedge settlements versus noncash mark-to-market effects, and the effect of future hedge settlements and collateral requirements.
- Progress and remaining cost of AirTran integration and B717 transitions, alongside aircraft deliveries, capital expenditures and related commitments.
- Liquidity after the October 2014 debt repayment, continued repurchases and dividends, and exposure under airport-project guarantees.
- The size and duration of the ticket-spoilage estimate benefit and its effect on comparisons with prior periods.
- Developments in the antitrust litigation and other contingencies; the filing did not provide a clear quantified estimate of potential loss.