Southwest Airlines Co. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2009. Amounts are in millions of dollars unless otherwise noted. Comparative periods are the corresponding 2008 periods.
Business context and results
Southwest reduced capacity amid recession-driven weakness in air travel, particularly business travel. In the third quarter, revenue passenger miles rose 4.7% while available seat miles fell 5.8%, lifting load factor 8.0 points to a record 79.6%. The company reported 545 aircraft in service at quarter-end.
Key financial metrics
| Metric | Third quarter 2009 | Third quarter 2008 | Nine months 2009 | Nine months 2008 |
|---|---|---|---|---|
| Operating revenue | $2,666 | $2,891 | $7,638 | $8,289 |
| Operating income | $22 | $86 | $95 | $380 |
| Operating margin | 0.8% | 3.0% | 1.2% | 4.6% |
| Net income (loss) | $(16) | $(120) | $(16) | $234 |
| Diluted earnings (loss) per share | $(0.02) | $(0.16) | $(0.02) | $0.32 |
| Operating cash flow | $72 | $(2,276) | $493 | $1,024 |
- Revenue and margins: Third-quarter revenue fell 7.8%; passenger revenue fell 7.8%, largely as passenger yield per revenue passenger mile declined 12.0%. Nine-month revenue declined 7.9%, and operating income fell 75.0%.
- Costs: Third-quarter operating expenses decreased 5.7%, but expense per available seat mile was unchanged at 10.67 cents. Nine-month expenses declined 4.6%; expense per available seat mile decreased 0.3% to 10.13 cents. Lower fuel costs were partly offset by labor, airport, maintenance, and depreciation costs.
- Fuel: Average fuel cost per gallon, including hedging and fuel taxes, was $2.27 in Q3, down 16.8%, and $2.07 for the first nine months, down 14.8%. Fuel hedging settlements were a $78 million loss in Q3 2009 versus a $448 million gain in Q3 2008.
- Liquidity: At September 30, cash and cash equivalents were $902 and short-term investments were $1,352, totaling $2,254. Cash and equivalents declined from $1,368 at December 31, 2008, while short-term investments increased from $435. The company had no borrowings under its new $600 million revolving credit facility.
- Debt: Balance-sheet debt was $3,576, including $198 current maturities and $3,378 long-term debt. The company borrowed $332 under a secured term loan and $124 under a secured term loan in 2009; it repaid $400 previously borrowed under its former revolver. Interest expense increased 47.4% for the nine-month period.
- Cash flow and investment: Nine-month operating cash flow was $493. Investing cash outflow was $1,312 and financing cash inflow was $353. Net cash decreased $466 to $902; investing activity included a net $842 increase in short- and noncurrent investments.
Material changes versus prior periods
- Third-quarter net loss improved from $120 to $16, primarily because fuel-derivative mark-to-market and hedge-ineffectiveness results were substantially less adverse: Q3 2009 recorded $39 of net gains on these contracts, compared with $247 of net losses in Q3 2008. Management considers operating income a more useful performance indicator because substantial derivative adjustments can affect net income below the operating line.
- Despite lower fuel costs, operating income weakened as lower passenger yields and revenue more than offset savings. Nine-month net results shifted from $234 income to a $16 loss.
- The company recorded a $66 charge for its Freedom ’09 early-retirement program, accepted by 1,404 employees; $32 was paid by September 30 and $34 remained payable. Management expects future savings to exceed the program’s cost.
- Credit ratings were downgraded: Moody’s senior unsecured rating to Baa3 in July and S&P’s rating to BBB in October; Fitch also lowered its rating to BBB in July. Ratings remained investment grade, but the company expected somewhat higher future borrowing costs.
Outlook, risks, contingencies, and unusual items
- Capacity and demand: Management expected 2009 capacity to be about 5%–6% below 2008, with Q4 2009 available seat miles down approximately 8% year over year. It planned roughly flat capacity and fleet for 2010, subject to adjustment. October passenger unit revenue was approximately 1% above the year-earlier month-to-date level based on results and bookings then available.
- Costs and fuel outlook: Management expected Q4 unit costs, excluding fuel and the Freedom ’09 charge, to exceed Q3 levels. Based on October 14 forward prices and expected Q4 hedge settlements, it estimated Q4 fuel cost at approximately $2.25 per gallon, including taxes. About 66% of estimated 2010 fuel consumption was hedged; management’s sensitivity analysis indicated hedge-related fuel costs could be above or below unhedged market prices depending on crude prices.
- Fuel-derivative exposure: At September 30, fuel derivatives had a gross estimated fair-value liability of $664, before collateral. The company had posted $425 in cash collateral and reported $724 of after-tax fuel-hedge losses in accumulated other comprehensive loss; approximately $278 of after-tax losses was expected to be recognized in earnings over the following 12 months. Changes in fuel prices, hedge effectiveness, accounting designation, and collateral requirements could materially affect earnings and cash flows.
- Liquidity and commitments: Firm aircraft commitments required approximately $3.2 billion of funding, subject to inflation adjustments, over future periods. The Love Field modernization program was expected to involve a potential company guarantee of debt service on up to $520 million of bonds, offset by airport-related revenue transfers; the company said it did not expect a significant effect on capital resources or financial position. It had spent $33 on the project and had not finalized the accounting treatment.
- Other risks and legal matters: Risks include weak travel demand, fare discounting, fuel-price volatility, labor negotiations, credit-market conditions, and possible higher insurance costs if federal supplemental war-risk coverage expires in August 2010. Southwest said it did not expect ongoing legal proceedings or IRS matters to have a material adverse effect. A proposed settlement in a shareholder derivative action had preliminary court approval.
- Controls and reporting: Management concluded disclosure controls were not effective as of September 30, 2009, following discovery of a material weakness in hedge-accounting controls and a restatement of the Q2 2009 financial statements. The company described planned remedial training, documentation, and policy changes. It reported that controls for its new passenger revenue accounting system were effective at period-end.
Most important facts for investors to verify
- Whether passenger yields and unit revenues recover, and whether record load factors can be sustained without further fare discounting.
- The timing and earnings impact of deferred fuel-hedge losses, hedge-accounting effectiveness, and collateral demands as fuel prices change.
- Execution of the control-remediation plan and any subsequent changes to reported results or hedge accounting.
- Available liquidity relative to aircraft commitments, debt service, and the final structure and accounting for the Love Field project.
- Whether expected Freedom ’09 savings, capacity reductions, and new revenue initiatives offset wage, airport, maintenance, and other unit-cost pressures.