LUV

Business Context and Reporting Period

Company: Southwest Airlines Co.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2005
Business Overview: Southwest Airlines reported its 57th consecutive quarterly profit despite a challenging operating environment characterized by record-high fuel prices. The airline expanded capacity by 13.7% in the second quarter through the net addition of 29 aircraft, while maintaining flat headcount to drive productivity gains.

Key Financial Metrics

Unit Metrics (Q2 2005 vs Q2 2004):
- Load Factor: 72.5% (down 3.8 points from 76.3%)
- CASM (Cost per Available Seat Mile): 7.81 cents (down 3.5%)
- CASM Excluding Fuel: 6.27 cents (down 7.7%)
- Fuel Cost per Gallon: $1.02 (up 24.5%)

Material Changes vs. Prior Period

• Revenue Growth: Operating revenues increased 13.3% in Q2 and 12.8% YTD, driven by an 8.1% increase in Revenue Passenger Miles (RPMs) and a 4.6% increase in passenger yield per RPM.
• Profitability: Net income rose 40.7% in Q2 and 69.1% YTD. Operating income increased 40.6% in Q2, primarily due to cost performance and revenue growth.
• Fuel Hedging Impact: Despite market fuel prices rising 24.5%, the company recognized $196 million in hedging gains in Q2 (and $351 million YTD), significantly mitigating expense. The company is hedged for approximately 85% of remaining 2005 fuel needs at an effective cap of $26 per barrel.
• Cost Efficiency: Non-fuel unit costs decreased significantly. Salaries, wages, and benefits per ASM dropped 5.4% due to productivity gains (headcount per aircraft fell from 78 to 72) and the absence of one-time 2004 charges (early-out plan and flight attendant contract costs).
• Liquidity: Cash and cash equivalents increased from $1.048 billion at year-end 2004 to $2.269 billion at June 30, 2005, bolstered by strong operating cash flows and a $300 million debt issuance in February 2005.

Guidance, Outlook, and Risks

• Outlook: Management expects Q3 2005 unit costs (excluding fuel) to be in line with Q2 levels (6.27 cents per ASM). Unit revenue for Q3 is expected to exceed Q3 2004 levels despite 12% capacity growth.
• Expansion: Service began in Pittsburgh in May 2005; Fort Myers, Florida, is scheduled for October 2005 (61st city).
• ATA Airlines Partnership: The codeshare agreement with ATA Airlines is performing better than anticipated, expected to generate $50 million in annual additional revenue. Southwest provided $40 million in debtor-in-possession financing to ATA, which is extended to December 31, 2005.
• Risks & Contingencies:
  • Fuel Volatility: While hedged for 2005, the company faces exposure to rising energy prices in 2006-2009, though hedges are in place for 65% of 2006 needs.
  • Insurance: Federal war-risk insurance coverage expires August 31, 2005, with an expected extension to December 31, 2005. Failure to extend could result in substantially higher costs.
  • ATA Credit Risk: There is no assurance ATA will emerge from bankruptcy by December 2005; if not, the $40 million loan may not be fully repaid.
  • Accounting Changes: Adoption of SFAS 123R (Share-Based Payment) is expected January 1, 2006, which will impact reported net income and cash flow classification.

Investor Verification Checklist

• Fuel Hedge Effectiveness: Verify the continued qualification of fuel hedges for special hedge accounting under SFAS 133, as ineffectiveness could introduce earnings volatility.
• ATA Loan Status: Monitor ATA Airlines' progress toward bankruptcy emergence and capital infusion to assess the collectibility of the $40 million loan.
• Insurance Extension: Confirm the extension of federal war-risk insurance beyond August 31, 2005, to avoid unexpected cost spikes.
• Load Factor Trends: Track if the decline in load factor (72.5% vs 76.3% prior year) stabilizes as capacity continues to grow.
• Capital Expenditures: Review the $1.6 billion in firm aircraft commitments and the company's ability to fund these via cash on hand ($2.3 billion) and operating cash flow.