3rd Quarter 2006 10Q
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-Q
(Mark
One)
þ
|
QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF
1934
|
For
the
quarterly period ended September 30, 2006 or
¨
|
TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF
1934
|
For
the
transition period from ________ to ________
Commission
file No. 1-7259
Southwest
Airlines Co.
(Exact
name of registrant as specified in its charter)
TEXAS
|
74-1563240
|
(State
or other jurisdiction of
|
(IRS
Employer
|
incorporation
or organization)
|
Identification
No.)
|
|
|
P.O.
Box 36611, Dallas, Texas
|
75235-1611
|
(Address
of principal executive offices)
|
(Zip
Code)
|
Registrant's
telephone number, including area code: (214)
792-4000
Indicate
by check mark whether the registrant (1) has filed all reports required to
be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements
for
the past 90 days. Yes
þ No
¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange
Act.
Large
accelerated filer þ Accelerated
filer ¨ Non-accelerated
filer ¨
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes
¨ No
þ
Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date.
Number
of
shares of Common Stock outstanding as of the close of business on October 18,
2006:
791,833,168
SOUTHWEST
AIRLINES CO.
FORM
10-Q
SOUTHWEST
AIRLINES CO.
FORM
10-Q
Southwest
Airlines Co.
Condensed
Consolidated Balance Sheet
(in
millions)
(unaudited)
|
|
September
30, 2006
|
|
December
31, 2005
|
|
ASSETS
|
|
|
|
|
|
Current
assets:
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
1,947
|
|
$
|
2,280
|
|
Short-term
investments
|
|
|
354
|
|
|
251
|
|
Accounts
and other receivables
|
|
|
266
|
|
|
258
|
|
Inventories
of parts and supplies, at cost
|
|
|
181
|
|
|
150
|
|
Fuel
hedge contracts
|
|
|
500
|
|
|
641
|
|
Prepaid
expenses and other current assets
|
|
|
53
|
|
|
40
|
|
Total
current assets
|
|
|
3,301
|
|
|
3,620
|
|
|
|
|
|
|
|
|
|
Property
and equipment, at cost:
|
|
|
|
|
|
|
|
Flight
equipment
|
|
|
11,567
|
|
|
10,592
|
|
Ground
property and equipment
|
|
|
1,312
|
|
|
1,256
|
|
Deposits
on flight equipment purchase contracts
|
|
|
636
|
|
|
660
|
|
|
|
|
13,515
|
|
|
12,508
|
|
Less
allowance for depreciation and amortization
|
|
|
3,640
|
|
|
3,296
|
|
|
|
|
9,875
|
|
|
9,212
|
|
Other
assets
|
|
|
911
|
|
|
1,171
|
|
|
|
$
|
14,087
|
|
$
|
14,003
|
|
|
|
|
|
|
|
|
|
LIABILITIES
AND STOCKHOLDERS' EQUITY
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
568
|
|
$
|
524
|
|
Accrued
liabilities
|
|
|
1,823
|
|
|
2,074
|
|
Air
traffic liability
|
|
|
968
|
|
|
649
|
|
Current
maturities of long-term debt
|
|
|
585
|
|
|
601
|
|
Total
current liabilities
|
|
|
3,944
|
|
|
3,848
|
|
|
|
|
|
|
|
|
|
Long-term
debt less current maturities
|
|
|
1,275
|
|
|
1,394
|
|
Deferred
income taxes
|
|
|
1,834
|
|
|
1,681
|
|
Deferred
gains from sale and leaseback of aircraft
|
|
|
124
|
|
|
136
|
|
Other
deferred liabilities
|
|
|
286
|
|
|
269
|
|
Stockholders'
equity:
|
|
|
|
|
|
|
|
Common
stock
|
|
|
808
|
|
|
802
|
|
Capital
in excess of par value
|
|
|
990
|
|
|
963
|
|
Retained
earnings
|
|
|
4,369
|
|
|
4,018
|
|
Accumulated
other comprehensive income
|
|
|
719
|
|
|
892
|
|
Treasury
stock, at cost
|
|
|
(262
|
)
|
|
-
|
|
Total
stockholders' equity
|
|
|
6,624
|
|
|
6,675
|
|
|
|
$
|
14,087
|
|
$
|
14,003
|
|
|
|
|
|
|
|
|
|
See
accompanying notes.
|
|
|
|
|
|
|
|
Southwest
Airlines Co.
Condensed
Consolidated Statement of Income
(in
millions, except per share amounts)
(unaudited)
|
|
Three
months ended September 30,
|
|
Nine
months ended September 30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
|
|
|
|
OPERATING
REVENUES:
|
|
|
|
|
|
|
|
|
|
Passenger
|
|
$
|
2,258
|
|
$
|
1,912
|
|
$
|
6,558
|
|
$
|
5,372
|
|
Freight
|
|
|
30
|
|
|
32
|
|
|
103
|
|
|
99
|
|
Other
|
|
|
54
|
|
|
45
|
|
|
149
|
|
|
125
|
|
Total
operating revenues
|
|
|
2,342
|
|
|
1,989
|
|
|
6,810
|
|
|
5,596
|
|
OPERATING
EXPENSES:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Salaries,
wages, and benefits
|
|
|
771
|
|
|
712
|
|
|
2,273
|
|
|
2,056
|
|
Fuel
and oil
|
|
|
563
|
|
|
337
|
|
|
1,581
|
|
|
947
|
|
Maintenance
materials and repairs
|
|
|
117
|
|
|
116
|
|
|
341
|
|
|
334
|
|
Aircraft
rentals
|
|
|
39
|
|
|
36
|
|
|
119
|
|
|
121
|
|
Landing
fees and other rentals
|
|
|
128
|
|
|
118
|
|
|
374
|
|
|
345
|
|
Depreciation
and amortization
|
|
|
131
|
|
|
121
|
|
|
381
|
|
|
348
|
|
Other
operating expenses
|
|
|
332
|
|
|
301
|
|
|
981
|
|
|
860
|
|
Total
operating expenses
|
|
|
2,081
|
|
|
1,741
|
|
|
6,050
|
|
|
5,011
|
|
OPERATING
INCOME
|
|
|
261
|
|
|
248
|
|
|
760
|
|
|
585
|
|
OTHER
EXPENSES (INCOME):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
expense
|
|
|
32
|
|
|
32
|
|
|
100
|
|
|
89
|
|
Capitalized
interest
|
|
|
(12
|
)
|
|
(10
|
)
|
|
(38
|
)
|
|
(28
|
)
|
Interest
income
|
|
|
(23
|
)
|
|
(13
|
)
|
|
(62
|
)
|
|
(31
|
)
|
Other
(gains) losses, net
|
|
|
186
|
|
|
(104
|
)
|
|
71
|
|
|
(112
|
)
|
Total
other expenses (income)
|
|
|
183
|
|
|
(95
|
)
|
|
71
|
|
|
(82
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
INCOME
BEFORE INCOME TAXES
|
|
|
78
|
|
|
343
|
|
|
689
|
|
|
667
|
|
PROVISION
FOR INCOME TAXES
|
|
|
30
|
|
|
133
|
|
|
247
|
|
|
253
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET
INCOME
|
|
$
|
48
|
|
$
|
210
|
|
$
|
442
|
|
$
|
414
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET
INCOME PER SHARE, BASIC
|
|
|
$
.06
|
|
|
$
.27
|
|
|
$
.56
|
|
|
$
.53
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET
INCOME PER SHARE, DILUTED
|
|
|
$
.06
|
|
|
$
.26
|
|
|
$
.53
|
|
|
$
.52
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
WEIGHTED
AVERAGE SHARES
|
|
|
|
|
|
|
|
|
|
|
|
|
|
OUTSTANDING:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
789
|
|
|
789
|
|
|
796
|
|
|
786
|
|
Diluted
|
|
|
821
|
|
|
802
|
|
|
827
|
|
|
802
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See
accompanying notes.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Southwest
Airlines Co.
Condensed
Consolidated Statement of Cash Flows
(in
millions)
(unaudited)
|
|
Three
months ended September 30,
|
|
Nine
months ended September 30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
|
|
|
|
CASH
FLOWS FROM OPERATING ACTIVITIES:
|
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
48
|
|
$
|
210
|
|
$
|
442
|
|
$
|
414
|
|
Adjustments
to reconcile net income to
|
|
|
|
|
|
|
|
|
|
|
|
|
|
cash
provided by operating activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
131
|
|
|
121
|
|
|
381
|
|
|
348
|
|
Deferred
income taxes
|
|
|
24
|
|
|
130
|
|
|
238
|
|
|
247
|
|
Amortization
of deferred gains on sale and
|
|
|
|
|
|
|
|
|
|
|
|
|
|
leaseback
of aircraft
|
|
|
(4
|
)
|
|
(4
|
)
|
|
(12
|
)
|
|
(12
|
)
|
Share-based
compensation expense
|
|
|
20
|
|
|
19
|
|
|
66
|
|
|
57
|
|
Excess
tax benefits from share-based compensation expense
|
|
|
(25
|
)
|
|
(7
|
)
|
|
(55
|
)
|
|
(18
|
)
|
Changes
in certain assets and liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accounts and other receivables
|
|
|
3
|
|
|
(42
|
)
|
|
(29
|
)
|
|
(85
|
)
|
Other current assets
|
|
|
121
|
|
|
(83
|
)
|
|
47
|
|
|
(93
|
)
|
Accounts payable and accrued liabilities
|
|
|
(744
|
)
|
|
216
|
|
|
(173
|
)
|
|
1,006
|
|
Air traffic liability
|
|
|
10
|
|
|
28
|
|
|
319
|
|
|
246
|
|
Other
|
|
|
97
|
|
|
(12
|
)
|
|
39
|
|
|
(23
|
)
|
Net
cash provided by (used in) operating activities
|
|
|
(319
|
)
|
|
576
|
|
|
1,263
|
|
|
2,087
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
CASH
FLOWS FROM INVESTING ACTIVITIES:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Purchases
of property and equipment, net
|
|
|
(381
|
)
|
|
(255
|
)
|
|
(1,046
|
)
|
|
(942
|
)
|
Change
in short-term investments, net
|
|
|
42
|
|
|
(185
|
)
|
|
(103
|
)
|
|
72
|
|
Payment
for assets from ATA Airlines, Inc.
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
(6
|
)
|
Proceeds
from ATA Airlines, Inc. debtor in possession loan
|
|
|
-
|
|
|
-
|
|
|
20
|
|
|
-
|
|
Other
|
|
|
-
|
|
|
-
|
|
|
1
|
|
|
-
|
|
Net
cash used in investing activities
|
|
|
(339
|
)
|
|
(440
|
)
|
|
(1,128
|
)
|
|
(876
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
CASH
FLOWS FROM FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Issuance
of long-term debt
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
300
|
|
Proceeds
from Employee stock plans
|
|
|
90
|
|
|
21
|
|
|
226
|
|
|
58
|
|
Payments
of long-term debt and capital lease obligations
|
|
|
(1
|
)
|
|
(1
|
)
|
|
(137
|
)
|
|
(136
|
)
|
Payments
of cash dividends
|
|
|
(4
|
)
|
|
(4
|
)
|
|
(14
|
)
|
|
(14
|
)
|
Repurchase
of common stock
|
|
|
(98
|
)
|
|
-
|
|
|
(600
|
)
|
|
(55
|
)
|
Excess
tax benefits from share-based compensation expense
|
|
|
25
|
|
|
7
|
|
|
55
|
|
|
18
|
|
Other,
net
|
|
|
1
|
|
|
-
|
|
|
2
|
|
|
(2
|
)
|
Net
cash provided by (used in) financing activities
|
|
|
13
|
|
|
23
|
|
|
(468
|
)
|
|
169
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET
INCREASE (DECREASE) IN CASH
|
|
|
|
|
|
|
|
|
|
|
|
|
|
AND
CASH EQUIVALENTS
|
|
|
(645
|
)
|
|
159
|
|
|
(333
|
)
|
|
1,380
|
|
CASH
AND CASH EQUIVALENTS AT
|
|
|
|
|
|
|
|
|
|
|
|
|
|
BEGINNING
OF PERIOD
|
|
|
2,592
|
|
|
2,269
|
|
|
2,280
|
|
|
1,048
|
|
CASH
AND CASH EQUIVALENTS
|
|
|
|
|
|
|
|
|
|
|
|
|
|
AT
END OF PERIOD
|
|
$
|
1,947
|
|
$
|
2,428
|
|
$
|
1,947
|
|
$
|
2,428
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
CASH
PAYMENTS FOR:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest,
net of amount capitalized
|
|
$
|
20
|
|
$
|
21
|
|
$
|
58
|
|
$
|
53
|
|
Income
taxes
|
|
$
|
7
|
|
$
|
3
|
|
$
|
10
|
|
$
|
3
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See
accompanying notes.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Southwest
Airlines Co.
Notes
to Condensed Consolidated Financial Statements
(unaudited)
1. BASIS
OF
PRESENTATION
The
accompanying unaudited condensed consolidated financial statements of Southwest
Airlines Co. (Company or Southwest) have been prepared in accordance with
accounting principles generally accepted in the United States for interim
financial information and with the instructions to Form 10-Q and Article 10
of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements. The unaudited condensed consolidated
financial statements for the interim periods ended September 30, 2006 and 2005,
include all adjustments which are, in the opinion of management, necessary
for a
fair presentation of the results for the interim periods. This includes all
normal and recurring adjustments, and other accounting entries as described
herein.
See Note 2. However, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. Financial results for the Company, and airlines in general, are
seasonal in nature. Historically, the Company’s second and third fiscal quarters
have been more profitable than its first and fourth fiscal quarters. However,
as
a result of the extensive nature of the Company’s fuel hedging program, the
volatility of commodities used by the Company for hedging jet fuel, and the
unique accounting requirements of SFAS 133, as amended, the Company has
experienced significant volatility in its results in all fiscal periods. See
Note 5 for further information. Operating results for the three and nine months
ended September 30, 2006, are not necessarily indicative of the results that
may
be expected for the year ended December 31, 2006. For further information,
refer
to the consolidated financial statements and footnotes thereto included in
the
Southwest Airlines Co. Annual Report on Form 10-K for the year ended December
31, 2005 and the Form 8-K filed on August 14, 2006.
2. ACCOUNTING
CHANGES
Aircraft
and engine maintenance
In
first
quarter 2006, the Company changed its method of accounting for scheduled
airframe inspection and repairs for 737-300 and 737-500 aircraft from the
deferral method to the direct expense method, effective January 1, 2006. The
Company recorded the change in accounting in accordance with Statement of
Financial Accounting Standards No. 154, Accounting
Changes and Error Corrections (SFAS
154), which was effective for calendar year companies on January 1, 2006. SFAS
154 requires that all elective accounting changes be made on a retrospective
basis. As such, the accompanying unaudited Condensed Consolidated Statement
of
Income for the three and nine months ended September 30, 2005, and the Condensed
Consolidated Balance Sheet as of December 31, 2005, were adjusted in first
quarter 2006 to apply the direct expense method retrospectively to all prior
periods.
As
a
result, for the three and nine months ended September 30, 2005, Maintenance
materials and repairs expense was increased by $6 million and $15 million,
respectively, resulting in a reduction in net income of $4 million and $9
million, respectively. Net income per share, basic, was reduced by $.01 per
share for both the three and nine months ended September 30, 2005. Net income
per share, diluted, was unchanged for the three months ended September 30,
2005,
and was reduced by $.01 per share for the nine months ended September 30, 2005.
The impact of adopting the direct expense method on net income for the three
and
nine months ended September 30, 2006, was not material.
Share-based
Compensation
The
Company has share-based compensation plans covering the majority of its Employee
groups, including plans adopted via collective bargaining, a plan covering
the
Company's Board of Directors, and plans related
to employment contracts with one Executive Officer of the Company. Prior to
January 1, 2006, the Company accounted for stock-based compensation utilizing
the intrinsic value method in accordance with the provisions of Accounting
Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to
Employees" and related Interpretations. Accordingly,
no compensation expense was recognized for fixed option plans because the
exercise prices of Employee stock options equaled or exceeded the market prices
of the underlying stock on the dates of grant. However, share-based compensation
was included in pro forma disclosures in the financial statement footnotes
in
periods prior to 2006.
Effective
January 1, 2006, the Company adopted the fair value recognition provisions
of
SFAS No. 123R, “Share-Based Payment” using the modified retrospective transition
method. Among other items, SFAS 123R eliminates the use of APB 25 and the
intrinsic value method of accounting, and requires companies to recognize the
cost of Employee services received in exchange for awards of equity instruments,
based on the grant date fair value of those awards, in the financial statements.
Under
the
modified retrospective method, compensation cost is recognized in the financial
statements beginning with the effective date, based on the requirements of
SFAS
123R for all share-based payments granted after that date, and based on the
requirements of SFAS 123 for all unvested awards granted prior to the effective
date of SFAS 123R. In addition, results for prior periods were retrospectively
adjusted in first quarter 2006 utilizing
the pro forma disclosures in those prior financial statements, except as noted.
The
unaudited Condensed Consolidated Statement of Income for the nine months ended
September 30, 2006 and 2005 reflects share-based compensation cost of $66
million and $57 million, respectively. The total tax benefit recognized from
share-based compensation arrangements for the nine months ended September 30,
2006 and 2005, was $13 million and $18 million, respectively. The
Company’s earnings before income taxes and net earnings for the nine months
ended September 30, 2006, were reduced by $56 million (net of profitsharing)
and
$43 million, respectively, compared to the previous accounting method under
APB
25. Net income per share, basic and diluted were each reduced by $.05 during
the
nine months ended September 30, 2006 compared to the previous accounting under
APB 25. As
a
result of the SFAS 123R retroactive application, for the nine months ended
September 30, 2005, net income was reduced by $39 million, net income per share,
basic was reduced by $.05, and net income per share, diluted was reduced by
$.06. The Company currently estimates that share-based compensation expense
will
be approximately $80 million for the full year 2006, before income taxes and
profitsharing.
The
unaudited Condensed Consolidated Statement of Income for the three months ended
September 30, 2006 and 2005 reflects share-based compensation cost of $20
million and $19 million, respectively. The total tax benefit recognized from
share-based compensation arrangements for the three months ended September
30,
2006 and 2005, was $6 million and $6 million, respectively. For third quarter
2006, the Company’s earnings before income taxes and net earnings were reduced
by $17 million (net of profitsharing) and $12 million, respectively, compared
to
the previous accounting method under APB 25. Net income per share, basic was
reduced by $.01 and net income per share, diluted was reduced by $.01 in third
quarter 2006 compared to the previous accounting under APB 25. As
a
result of the SFAS 123R retroactive application, for the three months ended
September 30, 2005, net income was reduced by $13 million, net income per share,
basic was reduced by $.01, and net income per share, diluted was reduced by
$.02.
Prior
to
the adoption of SFAS 123R, the Company was required to record benefits
associated with the tax deductions in excess of recognized compensation cost
as
an operating cash flow. However, SFAS 123R requires that such benefits be
recorded as a financing cash inflow and corresponding operating cash outflow.
In
the accompanying unaudited Condensed Consolidated Statement of Cash Flows for
the three and nine months ended September 30, 2006, the respective $25 million
and $55 million tax benefits classified as financing cash flows (and
corresponding operating cash outflows) would have been classified as operating
cash inflows prior to the adoption of SFAS 123R. In addition, the cash flow
presentation for the three and nine months ended September 30, 2005, has been
adjusted to conform to the current year presentation.
Stock
Plans
The
Company has stock plans covering Employees subject to collective bargaining
agreements (collective bargaining plans) and stock plans covering Employees
not
subject to collective bargaining agreements (other Employee plans).
None of
the collective bargaining plans were required to be approved by shareholders.
Options granted to Employees under collective bargaining plans are
non-qualified, granted at or above the fair market value of the Company’s Common
Stock on the date of grant, and generally have terms ranging from six to twelve
years. Neither Executive Officers nor members of the Company’s Board of
Directors are eligible to participate in any of these collective bargaining
plans. Options granted to Employees through other Employee plans are both
qualified as incentive stock options under the Internal Revenue Code of 1986
and
non-qualified stock options, granted at the fair market value of the Company’s
Common
Stock on the date of grant, and have ten-year terms. All of the options included
under the heading
of
“Other Employee Plans” have been approved by shareholders, except the plan
covering non-management, non-contract Employees, which had
options
outstanding to purchase 5.6
million
shares
of the Company’s Common Stock as of September 30, 2006. Although the Company
does not have a formal policy per se, upon option exercise, the Company will
typically issue Treasury stock, to the extent such shares are available.
Vesting
terms for the collective bargaining plans differ based on the grant made, and
have ranged in length from immediate vesting to vesting periods in accordance
with the period covered by the respective collective bargaining agreement.
For
“Other Employee Plans,” options vest
and
become fully exercisable over three, five, or ten years of continued employment,
depending upon the grant type. For grants in any of the Company’s plans that are
subject to graded vesting over a service period, we recognize expense on a
straight-line basis over the requisite service period for the entire award.
None
of the Company’s grants include performance-based or market-based vesting
conditions, as defined.
The
fair
value of each option grant is estimated on the date of grant using a modified
Black-Scholes option pricing model. The following weighted-average assumptions
were used for grants made under the fixed option plans for the current and
prior
year:
|
|
Nine
months ended September 30, 2006
|
|
Year
ended December 31, 2005
|
|
|
|
|
|
|
|
Expected
stock volatility
|
|
|
25.9
|
%
|
|
26.2
|
%
|
Expected
life of option (years)
|
|
|
5.1
|
|
|
4.7
|
|
Wtd-average
risk-free interest rate
|
|
|
4.6
|
%
|
|
4.1
|
%
|
Expected
dividend yield
|
|
|
0.07
|
%
|
|
0.09
|
%
|
The
Black-Scholes option valuation model was developed for use in estimating the
fair value of short-term traded options that have no vesting restrictions and
are fully transferable. In addition, option valuation models require the input
of somewhat subjective assumptions including expected stock price volatility.
For 2006 and 2005, the Company has relied on observations of both historical
volatility trends as well as implied future volatility observations as
determined by independent third parties. For both 2006 and 2005 stock option
grants, the Company utilized expected volatility based on the expected life
of
the option, but within a range of 25% to 27%. In determining the expected life
of the option grants, the Company has observed the actual terms of prior grants
with similar characteristics, the actual vesting schedule of the grant, and
assessed the expected risk tolerance of different optionee groups. The risk-free
interest rates used, which were actual U.S. Treasury zero-coupon rates for
bonds
matching the expected term of the option as of the option grant date, ranged
from 4.26% to 5.24%
for
the nine months ended September 30, 2006, versus 3.37% to 4.47% for all of
2005.
The
fair
value of options granted under the fixed option plans during the nine months
ended September 30, 2006, ranged from $2.48 to $6.99, with a weighted-average
fair value of $5.55. The fair value of options granted under the fixed option
plans during 2005 ranged from $2.90 to $6.79, with a weighted-average fair
value
of $3.84.
Aggregated
information regarding the Company’s fixed stock option plans is summarized
below:
|
|
COLLECTIVE
BARGAINING PLANS
|
|
|
|
|
Options
(000)
|
|
Wtd.
average exercise price
|
|
|
Wtd.
average remaining contractual term
|
|
Aggregate
intrinsic value (millions)
|
|
Outstanding
December 31, 2005
|
|
|
105,244
|
|
$
|
11.65
|
|
|
|
|
|
|
|
|
Granted
|
|
|
814
|
|
|
16.81
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
(20,780
|
)
|
|
8.09
|
|
|
|
|
|
|
|
|
Surrendered
|
|
|
(1,130
|
)
|
|
14.19
|
|
|
|
|
|
|
|
|
Outstanding
September 30, 2006
|
|
|
84,148
|
|
$
|
12.55
|
|
|
|
4.2
|
|
$
|
359
|
|
Vested
or expected to vest at September 30, 2006
|
|
|
77,568
|
|
$
|
12.41
|
|
|
|
4.2
|
|
$
|
341
|
|
Exercisable
at September 30, 2006
|
|
|
70,931
|
|
$
|
12.19
|
|
|
|
3.9
|
|
$
|
328
|
|
|
|
OTHER
EMPLOYEE PLANS
|
|
|
Options
(000)
|
|
Wtd.
average exercise price
|
|
|
Wtd.
average remaining contractual term
|
|
Aggregate
intrinsic value (millions)
|
|
Outstanding
December 31, 2005
|
|
|
35,820
|
|
$
|
13.96
|
|
|
|
|
|
|
|
|
Granted
|
|
|
2,831
|
|
|
17.52
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
(4,586
|
)
|
|
9.68
|
|
|
|
|
|
|
|
|
Surrendered
|
|
|
(1,114
|
)
|
|
15.75
|
|
|
|
|
|
|
|
|
Outstanding
September 30, 2006
|
|
|
32,951
|
|
$
|
14.80
|
|
|
|
5.8
|
|
$
|
76
|
|
Vested
or expected to vest at September 30, 2006
|
|
|
31,608
|
|
$
|
14.79
|
|
|
|
5.8
|
|
$
|
73
|
|
Exercisable
at September 30, 2006
|
|
|
18,970
|
|
$
|
14.33
|
|
|
|
4.8
|
|
$
|
53
|
|
The
total
aggregate intrinsic value of options exercised during the nine months ended
September 30, 2006 and 2005, was $225 million and $73 million, respectively.
The
total fair value of shares vesting during the nine months ended September 30,
2006 and 2005, was $89 million and $71 million, respectively. As of September
30, 2006, there was $87 million of total unrecognized compensation cost related
to share-based compensation arrangements, which is expected to be recognized
over a weighted-average period of 1.9 years. The total recognition period for
the remaining unrecognized compensation cost is approximately ten years;
however, the majority of this cost will be recognized over the next two years,
in accordance with vesting provisions.
Employee
Stock Purchase Plan
Under
the
amended 1991 Employee Stock Purchase Plan (ESPP), which has been approved by
shareholders, the Company is authorized to issue up to a remaining balance
of
1.1
million shares of Common Stock to Employees of the Company. These shares may
be
issued at a price equal to 90 percent of the market value at the end of each
monthly purchase period. Common Stock purchases are paid for through periodic
payroll deductions. For the nine months ended September 30, 2006, and for the
full year 2005, participants under the plan purchased .9 million shares and
1.5
million shares at average prices of $15.08 and $13.19, respectively. The
weighted-average fair value of each purchase right under the ESPP granted for
the nine months ended September 30, 2006 and full year 2005, which is equal
to
the ten percent discount from the market value of the Common Stock at the end
of
each monthly purchase period, was $1.68 and $1.47, respectively.
Non-Employee
Director grants and Incentive Plan
During
the term of the 1996 Non-Qualified Stock Option Plan (1996 Plan), upon initial
election to the Board, non-Employee Directors received a one-time option grant
to purchase 10,000 shares of Southwest Common Stock at the fair market value
of
such stock on the date of the grant. The Company’s 1996 Plan, which is
administered by the Compensation Committee of the Board of Directors, has
expired and no additional options may be granted from the plan. Outstanding
stock options to the Board under the 1996 Plan become exercisable over a period
of five years from the grant date and have a term of 10 years.
In
2001,
the Board adopted the Southwest Airlines Co. Outside Director Incentive Plan.
The purpose of the plan is to align more closely the interests of the
non-Employee Directors with those of the Company’s Shareholders and to provide
the non-Employee Directors with retirement income. To accomplish this purpose,
the plan compensates each non-Employee Director based on the performance of
the
Company’s Common Stock and defers the receipt of such compensation until after
the non-Employee Director ceases to be a Director of the Company. Pursuant
to
the plan, on the date of the 2002 Annual Meeting of Shareholders, the Company
granted 750 non-transferable Performance Shares to each non-Employee Director
who had served as a Director since at least May 2001. Thereafter, on the date
of
each Annual Meeting of Shareholders, the Company will grant 750 Performance
Shares to each non-Employee Director who has served since the previous Annual
Meeting. A Performance Share is a unit of value equal to the Fair Market Value
of a share of Southwest Common Stock, based on the average closing sale price
of
the Common Stock as reported on the New York Stock Exchange during a specified
period. On the 30th
calendar
day following the date a non-Employee Director ceases to serve as a Director
of
the Company for any reason, Southwest will pay to such non-Employee Director
an
amount equal to the Fair Market Value of the Common Stock during the 30 days
preceding such last date of service multiplied by the number of Performance
Shares then held by such Director. The plan contains provisions contemplating
adjustments on changes in capitalization of the Company. The Company accounts
for grants made under this plan as liability awards, as defined, and since
the
awards are not stock options, they are not reflected in the above tables.
The fair value of the awards as of September 30, 2006, which is not material
to
the Company, is included in Accrued liabilities in the accompanying Condensed
Consolidated Balance Sheet.
Taxes
A
portion
of the Company’s granted options qualify as incentive stock options (ISO) for
income tax purposes. As such, a tax benefit is not recorded at the time the
compensation cost related to the options is recorded for book purposes due
to
the fact that an ISO does not ordinarily result in a tax benefit unless there
is
a disqualifying disposition. Stock option grants of non-qualified options result
in the creation of a deferred tax asset, which is a temporary difference, until
the time that the option in exercised. Due to the treatment of incentive stock
options for tax purposes, the Company’s effective tax rate will likely be
subject to more variability in 2006 and in future periods.
3. DIVIDENDS
During
the three month periods ended March 31, June 30, and September 30, 2006,
dividends of $.0045 per share were declared on the 803 million shares, 798
million shares, and
791
million shares of Common Stock then outstanding, respectively. During the three
month periods ended March 31, June 30, and September 30, 2005, dividends of
$.0045 per share were declared on the 783 million shares, 787 million shares,
and 790 million shares of Common Stock then outstanding,
respectively.
4. NET
INCOME PER SHARE
The
following table sets forth the computation of basic and diluted net income
per
share (in millions except per share amounts):
|
|
Three
months ended September 30,
|
|
Nine
months ended September 30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
|
|
|
|
NUMERATOR:
|
|
|
|
|
|
|
|
|
|
Net
income available to
|
|
|
|
|
|
|
|
|
|
common
stockholders
|
|
$
|
48
|
|
$
|
210
|
|
$
|
442
|
|
$
|
414
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
DENOMINATOR:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average
shares
|
|
|
|
|
|
|
|
|
|
|
|
|
|
outstanding,
basic
|
|
|
789
|
|
|
789
|
|
|
796
|
|
|
786
|
|
Dilutive
effect of Employee stock
|
|
|
|
|
|
|
|
|
|
|
|
|
|
options
|
|
|
32
|
|
|
13
|
|
|
31
|
|
|
16
|
|
Adjusted
weighted-average shares
|
|
|
|
|
|
|
|
|
|
|
|
|
|
outstanding,
diluted
|
|
|
821
|
|
|
802
|
|
|
827
|
|
|
802
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET
INCOME PER SHARE:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
$
.06
|
|
|
$
.27
|
|
|
$
.56
|
|
|
$
.53
|
|
Diluted
|
|
|
$
.06
|
|
|
$
.26
|
|
|
$
.53
|
|
|
$
.52
|
|
5. FINANCIAL
DERIVATIVE INSTRUMENTS
Fuel
Contracts
Airline
operators are inherently dependent upon energy to operate and, therefore, are
impacted by changes in jet fuel prices. Jet fuel and oil consumed for the three
months ended September 30, 2006 and 2005 represented approximately 27.1 percent
and 19.4 percent of Southwest’s operating expenses, respectively. The Company
endeavors to acquire jet fuel at the lowest possible cost. Because jet fuel
is
not traded on an organized futures exchange, liquidity for hedging is limited.
However, the Company has found commodities for hedging of jet fuel costs,
primarily crude oil, and refined products such as heating oil and unleaded
gasoline. The Company utilizes financial derivative instruments to decrease
its
exposure to jet fuel price increases. The Company does not purchase or hold
any
derivative financial instruments for trading purposes.
The
Company has utilized financial derivative instruments for both short-term and
long-term time frames. In addition to the significant protective fuel derivative
positions the Company had in place during the first nine months of 2006, the
Company also has significant future positions. The Company currently has a
mixture of purchased call options, collar structures, and fixed price swap
agreements in place to protect against over 85 percent of its remaining 2006
total anticipated jet fuel requirements at average crude oil equivalent prices
of approximately $43 per barrel, and has also added refinery margins on most
of
those positions. Based on current growth plans, the Company is also
approximately 85 percent protected for 2007 at approximately $49 per barrel,
over 43 percent protected for 2008 at approximately $44 per barrel, over 38
percent protected for 2009 at approximately $47 per barrel, approximately 17
percent protected for 2010 at $63 per barrel, and has modest positions in 2011
and 2012.
Upon
proper qualification, the Company accounts for its fuel derivative instruments
as cash flow hedges, as defined in Statement of Financial Accounting Standards
No. 133, Accounting
for Derivative Instruments and Hedging Activities,
as
amended (SFAS 133). Under SFAS 133, all derivatives designated as hedges that
meet certain requirements are granted special hedge accounting treatment.
Generally, utilizing the special hedge accounting, all periodic changes in
fair
value of the derivatives designated as hedges that are considered to be
effective, as defined, are recorded in "Accumulated other comprehensive income"
until the underlying jet fuel is consumed. See Note 6 for further information
on
Accumulated other comprehensive income. The Company is exposed to the risk
that
periodic changes will not be effective, as defined, or that the derivatives
will
no longer qualify for special hedge accounting. Ineffectiveness, as defined,
results when the change in the total fair value of the derivative instrument
does not exactly equal the change in the value of the Company’s expected future
cash outlay to purchase and consume jet fuel. To the extent that the periodic
changes in the fair value of the derivatives are not effective, that
ineffectiveness is recorded to Other gains and losses in the income statement.
Likewise, if a hedge ceases to qualify for hedge accounting, those periodic
changes in the fair value of derivative instruments are recorded to Other gains
and losses in the income statement in the period of the change.
Ineffectiveness
is inherent in hedging jet fuel with derivative positions based in other crude
oil related commodities, especially given the magnitude of the current fair
market value of the Company’s fuel derivatives and the recent volatility in the
prices of refined products. Due to the volatility in markets for crude oil
and
related products, the Company is unable to predict the amount of ineffectiveness
each period, including the loss of hedge accounting, which could be determined
on a derivative by derivative basis or in the aggregate. This may result, and
has resulted, in increased volatility in the Company’s results. The significant
increase in the amount of hedge ineffectiveness and unrealized gains and losses
on derivative contracts settling in future periods recorded during recent
quarters has been due to a number of factors. These factors included: the
significant fluctuation in energy prices, the number of derivative positions
the
Company holds, significant weather events that have affected refinery capacity
and the production of refined products, and the volatility of the different
types of products the Company uses for protection. The number of instances
in
which the Company has discontinued hedge accounting for specific hedges and
for
specific refined products, such as unleaded gasoline, has increased recently,
primarily due to these reasons. In these cases, the Company has determined
that
the hedges will not regain effectiveness in the time period remaining until
settlement and therefore must discontinue special hedge accounting, as defined
by SFAS 133. When this happens, any changes in fair value of the derivative
instruments are marked to market through earnings in the period of change.
As
the fair value of the Company’s hedge positions increases in amount, there is a
higher degree of probability that there will be continued variability recorded
in the income statement and that the amount of hedge ineffectiveness and
unrealized gains or losses recorded in future periods will be material. This
is
primarily due to the fact that small differences in the correlation of crude
oil
related products are leveraged over large dollar volumes.
Primarily
due to the significant decrease in fair values of the Company’s fuel derivatives
and the loss of hedge accounting for specific hedges, during the three months
ended September 30, 2006, the Company recognized approximately $173 million
of
net losses in Other (gains) losses, net, related to the ineffectiveness of
its
hedges and the loss of hedge accounting for certain fuel derivatives. Of this
net total, approximately $123 million was unrealized, mark-to-market losses
in
the fair value of derivatives as a result of the discontinuation of hedge
accounting for certain contracts that will settle in future periods, $32 million
was ineffectiveness and mark-to-market losses related to contracts that settled
during third quarter 2006, and $18 million was losses related to unrealized
ineffectiveness from hedges designated for future periods. During the three
months ended September 30, 2005, the Company recognized approximately $109
million of additional gains in Other (gains) losses, net, related to the
ineffectiveness of its hedges and the loss of hedge accounting for certain
fuel
derivatives. Of this amount, approximately $73 million was gains from
unrealized, mark-to-market changes in the fair value of derivatives due to
the
discontinuation of hedge accounting for certain contracts that will settle
in
future periods, approximately $14 million was gains from ineffectiveness
associated with hedges designated for future periods, and $22 million was
ineffectiveness and mark-to-market gains related to hedges that settled during
third quarter 2005. During the three months ended September 30, 2006 and 2005,
the Company recognized approximately $13 million and $9 million of net expense,
respectively, related to amounts excluded from the Company's measurements of
hedge effectiveness, in Other (gains) losses, net.
During
the three months ended September 30, 2006 and 2005, the Company
recognized gains in Fuel and oil expense of $201 million and $276 million,
respectively, from hedging activities. At September 30, 2006, approximately
$42
million due from third parties from settled derivative contracts is included
in
Accounts and other receivables in the accompanying unaudited Condensed
Consolidated Balance Sheet. The fair value of the Company's financial derivative
instruments at September 30, 2006, was a net asset of approximately $1.3
billion. The current portion of these financial derivative instruments, $500
million, is classified as Fuel hedge contracts and the long-term portion, $776
million, is classified as Other assets in the unaudited Condensed Consolidated
Balance Sheet. The
fair
value of the derivative instruments, depending on the type of instrument, was
determined by the use of present value methods or standard option value models
with assumptions about commodity prices based on those observed in underlying
markets.
As
of
September
30, 2006, the Company had approximately $719 million in unrealized gains, net
of
tax, in Accumulated other comprehensive income related to fuel hedges. Included
in this total are approximately $295 million in net unrealized gains that are
expected to be realized in earnings during the twelve months following September
30, 2006.
Interest
Rate Swaps
In
previous periods, the Company entered into interest rate swap agreements
relating to its $350 million 5.25% senior unsecured notes due October 1, 2014,
its $385 million 6.5% senior unsecured notes due March 1, 2012 and its $375
million 5.496% Class A-2 pass-through certificates due November 1, 2006. Under
these interest rate swap agreements, the Company pays the London InterBank
Offered Rate (LIBOR) plus a margin every six months on the notional amount
of
the debt, and receives the fixed stated rate of the notes every six months
until
the date the notes become due.
The
Company’s interest rate swap agreements qualify as fair value hedges, as defined
by SFAS 133. The fair value of the interest rate swap agreements, which are
adjusted regularly, are recorded in the Company’s balance sheet as an asset or
liability, as necessary, with a corresponding adjustment to the carrying
value of the long-term debt. The fair value of the interest rate swap
agreements, excluding accrued interest, at September 30, 2006, was a liability
of approximately $31 million. Of this amount $30 million is recorded in Other
deferred liabilities, and $1 million is recorded in Accrued liabilities in
the
unaudited Condensed Consolidated Balance Sheet. In accordance with fair value
hedging, the offsetting entry is an adjustment to decrease the carrying value
of
long-term debt.
6. COMPREHENSIVE
INCOME (LOSS)
Comprehensive
income included changes in the fair value of certain financial derivative
instruments, which qualify for hedge accounting, and unrealized gains and losses
on certain investments. Comprehensive loss totaled $337
million for the three months ended September 30, 2006 and comprehensive income
totaled $404 million for the three months ended September 30, 2005. For the
nine
months ended September 30, 2006 and 2005, comprehensive income totaled $269
million and $1.2 billion, respectively. The differences between net income
and
comprehensive income for each of these periods were as follows (in
millions):
|
|
Three
months ended September 30,
|
|
|
2006
|
|
|
2005
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
48
|
|
|
$
|
210
|
Unrealized
gain (loss) on derivative instruments,
|
|
|
|
|
|
|
|
net
of deferred taxes of $(240) and $123
|
|
|
(386
|
)
|
|
|
194
|
Other,
net of deferred taxes of $1 and $0
|
|
|
1
|
|
|
|
-
|
Total
other comprehensive income (loss)
|
|
|
(385
|
)
|
|
|
194
|
|
|
|
|
|
|
|
|
Comprehensive
income (loss)
|
|
$
|
(337
|
)
|
|
$
|
404
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine
months ended September 30,
|
|
|
|
|
|
2006
|
|
|
|
2005
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
442
|
|
|
$
|
414
|
Unrealized
gain (loss) on derivative instruments,
|
|
|
|
|
|
|
|
net
of deferred taxes of $(118) and $493
|
|
|
(175
|
)
|
|
|
777
|
Other,
net of deferred taxes of $1 and $0
|
|
|
2
|
|
|
|
-
|
Total
other comprehensive income (loss)
|
|
|
(173
|
)
|
|
|
777
|
|
|
|
|
|
|
|
|
Comprehensive
income
|
|
$
|
269
|
|
|
$
|
1,191
|
A
rollforward of the amounts included in Accumulated other comprehensive income,
net of taxes, is shown below (in millions):
|
|
|
|
|
|
Accumulated
|
|
|
|
Fuel
|
|
|
|
other
|
|
|
|
hedge
|
|
|
|
comprehensive
|
|
|
|
derivatives
|
|
Other
|
|
income
(loss)
|
|
|
|
|
|
|
|
|
|
Balance
at June 30, 2006
|
|
$
|
1,101
|
|
$
|
3
|
|
$
|
1,104
|
|
Third
quarter 2006 changes in value
|
|
|
(269
|
)
|
|
1
|
|
|
(268
|
)
|
Reclassification
to earnings
|
|
|
(117
|
)
|
|
-
|
|
|
(117
|
)
|
Balance
at September 30, 2006
|
|
$
|
715
|
|
$
|
4
|
|
$
|
719
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated
|
|
|
|
|
Fuel
|
|
|
|
|
|
other
|
|
|
|
|
hedge
|
|
|
|
|
|
comprehensive
|
|
|
|
|
derivatives
|
|
|
Other
|
|
|
income
(loss)
|
|
Balance
at December 31, 2005
|
|
$
|
890
|
|
$
|
2
|
|
$
|
892
|
|
2006
changes in value
|
|
|
119
|
|
|
2
|
|
|
121
|
|
Reclassification
to earnings
|
|
|
(294
|
)
|
|
-
|
|
|
(294
|
)
|
Balance
at September 30, 2006
|
|
$
|
715
|
|
$
|
4
|
|
$
|
719
|
|
7. LONG-TERM
DEBT
During
the nine months ended September 30, 2006, the Company redeemed
two separate $29 million non-interest bearing notes on their maturity dates
of
February 24, 2006 and April 28, 2006, respectively.
8. OTHER
ASSETS AND ACCRUED LIABILITIES (in millions)
|
|
September
30,
|
|
December
31,
|
|
|
2006
|
|
2005
|
|
|
|
|
|
Noncurrent
fuel hedge contracts, at fair value
|
|
$
|
776
|
|
$
|
1,037
|
Other
|
|
|
135
|
|
|
134
|
Other
assets
|
|
$
|
911
|
|
$
|
1,171
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September
30,
|
|
|
December
31,
|
|
|
|
2006
|
|
|
2005
|
|
|
|
|
|
|
|
Retirement
Plans
|
|
$
|
136
|
|
$
|
142
|
Aircraft
Rentals
|
|
|
120
|
|
|
116
|
Vacation
Pay
|
|
|
148
|
|
|
135
|
Advances
and deposits
|
|
|
680
|
|
|
955
|
Deferred
income taxes
|
|
|
456
|
|
|
489
|
Other
|
|
|
283
|
|
|
237
|
Accrued
liabilities
|
|
$
|
1,823
|
|
$
|
2,074
|
9. POSTRETIREMENT
BENEFITS
The
following table sets forth the Company’s periodic postretirement benefit cost
for each of the interim periods identified:
|
|
Three
months ended September 30,
|
|
(In
millions)
|
|
2006
|
|
|
2005
|
|
|
|
|
|
|
|
|
Service
cost
|
|
$
|
4
|
|
|
$
|
3
|
|
Interest
cost
|
|
|
1
|
|
|
|
1
|
|
Amortization
of prior service cost
|
|
|
-
|
|
|
|
-
|
|
Recognized
actuarial loss
|
|
|
-
|
|
|
|
-
|
|
Net
periodic postretirement benefit cost
|
|
$
|
5
|
|
|
$
|
4
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine
months ended September 30,
|
|
(In
millions)
|
|
|
2006
|
|
|
|
2005
|
|
|
|
|
|
|
|
|
|
|
Service
cost
|
|
$
|
11
|
|
|
$
|
9
|
|
Interest
cost
|
|
|
4
|
|
|
|
3
|
|
Amortization
of prior service cost
|
|
|
1
|
|
|
|
1
|
|
Recognized
actuarial loss
|
|
|
-
|
|
|
|
-
|
|
Net
periodic postretirement benefit cost
|
|
$
|
16
|
|
|
$
|
13
|
|
10. CONTINGENCIES
The
Company is subject to various legal proceedings and claims arising in the
ordinary course of business, including, but not limited to, examinations by
the
Internal Revenue Service (IRS). The IRS regularly examines the Company’s federal
income tax returns and, in the course thereof, proposes adjustments to the
Company’s federal income tax liability reported on such returns. It is the
Company’s practice to vigorously contest those proposed adjustments it deems
lacking of merit.
The
Company's management does not expect that the outcome in any of its currently
ongoing legal proceedings or the outcome of any proposed adjustments presented
to date by the IRS, individually or collectively, will have a material adverse
effect on the Company's financial condition, results of operations or cash
flow.
11. RECENT
ACCOUNTING PRONOUNCEMENTS
In
July
2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
No. 48, Accounting
for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109
(FIN
48),
which clarifies the accounting and disclosure for uncertainty in tax positions,
as defined. FIN 48 seeks to reduce the diversity in practice associated with
certain aspects of the recognition and measurement related to accounting for
income taxes. This interpretation is effective for fiscal years beginning after
December 15, 2006. The Company has not yet determined the impact this
interpretation will have on our results from operations or financial
position.
In
September 2006, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 108 (SAB 108). Due to diversity in practice among
registrants, SAB 108 expresses SEC staff views regarding the process by which
misstatements in financial statements are evaluated for purposes of determining
whether financial statement restatement is necessary. SAB 108 is effective
for
fiscal years ending after November 15, 2006, and early application is
encouraged. The Company does not believe SAB 108 will have a material impact
on
our results from operations or financial position.
In
September 2006, the FASB issued Statement No. 158, Employers’
Accounting for Defined Benefit Pension and Other Postretirement Plans, an
amendment of FASB Statements No. 87, 88, 106, and 132(R) (Statement
158). Among other items, Statement 158 requires recognition of the overfunded
or
underfunded status of an entity’s defined benefit postretirement plan as an
asset or liability in the financial statements, requires the measurement of
defined benefit postretirement plan assets and obligations as of the end of
the
employer’s fiscal year, and requires recognition of the funded status of defined
benefit postretirement plans in other comprehensive income. Statement 158 is
effective for fiscal years ending after December 15, 2006, and early application
is encouraged. The Company has not yet determined the impact this interpretation
will have on our financial position.
Item
2. Management's
Discussion and Analysis of Financial Condition and Results of Operations
Comparative
Consolidated Operating Statistics
Relevant
Southwest comparative operating statistics for the three and nine months ended
September 30, 2006 and 2005 are as follows:
|
|
Three
months ended September 30,
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2006
|
|
2005
|
|
Change
|
|
|
|
|
|
|
|
|
|
Revenue
passengers carried
|
|
|
21,558,982
|
|
|
20,637,620
|
|
|
4.5
|
%
|
Enplaned
passengers
|
|
|
24,880,646
|
|
|
23,595,749
|
|
|
5.4
|
%
|
Revenue
passenger miles (RPMs) (000s)
|
|
|
17,767,128
|
|
|
16,365,420
|
|
|
8.6
|
%
|
Available
seat miles (ASMs) (000s)
|
|
|
23,784,615
|
|
|
21,853,579
|
|
|
8.8
|
%
|
Load
factor
|
|
|
74.7
|
%
|
|
74.9
|
%
|
|
(0.2)
|
pts |
Average
length of passenger haul (miles)
|
|
|
824
|
|
|
793
|
|
|
3.9
|
%
|
Average
aircraft stage length (miles)
|
|
|
625
|
|
|
612
|
|
|
2.1
|
%
|
Trips
flown
|
|
|
279,032
|
|
|
261,812
|
|
|
6.6
|
%
|
Average
passenger fare
|
|
|
$104.75
|
|
|
$92.63
|
|
|
13.1
|
%
|
Passenger
revenue yield per RPM (cents)
|
|
|
12.71
|
|
|
11.68
|
|
|
8.8
|
%
|
Operating
revenue yield per ASM (cents)
|
|
|
9.85
|
|
|
9.10
|
|
|
8.2
|
%
|
Operating
expenses per ASM (cents)
|
|
|
8.75
|
|
|
7.97
|
|
|
9.8
|
%
|
Operating
expenses per ASM, excluding fuel (cents)
|
|
|
6.38
|
|
|
6.42
|
|
|
(0.6
|
)%
|
Fuel
costs per gallon, excluding fuel tax
|
|
|
$1.56
|
|
|
$1.01
|
|
|
54.5
|
%
|
Fuel
consumed, in gallons (millions)
|
|
|
359
|
|
|
332
|
|
|
8.1
|
%
|
Number
of Employees at period-end
|
|
|
32,144
|
|
|
31,382
|
|
|
2.4
|
%
|
Size
of fleet at period-end
|
|
|
475
|
|
|
439
|
|
|
8.2
|
%
|
|
|
Nine
months ended September 30,
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2006
|
|
2005
|
|
Change
|
|
|
|
|
|
|
|
|
|
Revenue
passengers carried
|
|
|
62,757,726
|
|
|
58,208,534
|
|
|
7.8
|
%
|
Enplaned
passengers
|
|
|
72,202,988
|
|
|
66,154,155
|
|
|
9.1
|
%
|
Revenue
passenger miles (RPMs) (000s)
|
|
|
50,891,473
|
|
|
45,083,739
|
|
|
12.9
|
%
|
Available
seat miles (ASMs) (000s)
|
|
|
68,748,057
|
|
|
63,424,106
|
|
|
8.4
|
%
|
Load
factor
|
|
|
74.0
|
%
|
|
71.1
|
%
|
|
2.9
|
pts. |
Average
length of passenger haul (miles)
|
|
|
811
|
|
|
775
|
|
|
4.6
|
%
|
Average
aircraft stage length (miles)
|
|
|
620
|
|
|
605
|
|
|
2.5
|
%
|
Trips
flown
|
|
|
812,428
|
|
|
769,262
|
|
|
5.6
|
%
|
Average
passenger fare
|
|
|
$104.50
|
|
|
$92.30
|
|
|
13.2
|
%
|
Passenger
revenue yield per RPM (cents)
|
|
|
12.89
|
|
|
11.92
|
|
|
8.1
|
%
|
Operating
revenue yield per ASM (cents)
|
|
|
9.91
|
|
|
8.82
|
|
|
12.4
|
%
|
Operating
expenses per ASM (cents)
|
|
|
8.80
|
|
|
7.90
|
|
|
11.4
|
%
|
Operating
expenses per ASM, excluding fuel (cents)
|
|
|
6.50
|
|
|
6.41
|
|
|
1.4
|
%
|
Fuel
costs per gallon, excluding fuel tax
|
|
|
$1.53
|
|
|
$.98
|
|
|
56.1
|
%
|
Fuel
consumed, in gallons (millions)
|
|
|
1,032
|
|
|
961
|
|
|
7.4
|
%
|
Number
of Employees at period-end
|
|
|
32,144
|
|
|
31,382
|
|
|
2.4
|
%
|
Size
of fleet at period-end
|
|
|
475
|
|
|
439
|
|
|
8.2
|
%
|
Material
Changes in Results of Operations
Summary
Third
quarter 2006 represented the Company’s 62nd
consecutive
quarterly profit. The Company’s third quarter 2006 net income was $48 million
($.06 per share, diluted), 77.1 percent lower than third quarter 2005, primarily
due to a significant fluctuation in ineffectiveness and mark-to-market
adjustments related to the Company’s fuel derivative contracts. In third quarter
2006, both current and forward prices for the commodities Southwest uses for
hedging jet fuel fell significantly, resulting in a reduction in the unrealized
gains the Company had experienced in prior periods. Primarily as a result of
these falling prices for fuel derivatives that settled in the quarter or will
settle in future periods that were ineffective, as defined, or did not qualify
for special hedge accounting, the Company recorded $173 million in losses,
which
are included in Other (gains) losses. In third quarter 2005, when commodity
prices rose significantly, the Company recorded a total of $109 million in
gains
associated with fuel derivatives that were ineffective, as defined, or did
not
qualify for special hedge accounting. See Note 5 to the unaudited condensed
consolidated financial statements for further information on the Company’s
hedging activities. Although the Company’s fuel hedge position was not as strong
as the position we held in 2005, our hedging program still resulted in the
realization of $200 million in cash settlements during third quarter 2006.
These
settlements resulted in a reduction to Fuel and oil expense of $201 million
in
third quarter 2006. However, even with the Company’s hedge position, fuel cost
per gallon increased 54.5 percent versus third quarter 2005.
Third
quarter 2006 operating income increased $13 million, or 5.2 percent, compared
to
third quarter 2005. The Company believes operating income provides a better
indication of the Company’s financial performance for third quarter 2006 and
third quarter 2005 than does net income. This is due to the fact that the
adjustments that relate to fuel derivatives expiring in future periods are
included in Other (gains) losses, which is below the operating income line,
in
both periods. The increase in operating income was primarily due to a strong
revenue performance. Operating revenues grew 17.7 percent, led by an 18.1
percent increase in Passenger revenues. The Company grew capacity (available
seat miles) by 8.8 percent, and has also been able to implement several modest
fare increases over the past twelve months due to strong demand and competitive
capacity decreases. RPM yields improved 8.8 percent as a result of the modest
fare increases. Third quarter 2006 load factor was 74.7 percent, which was
just
slightly below the Company’s record load factor performance experienced in third
quarter 2005.
Third
quarter 2006 CASM (cost per available seat mile) decreased .6 percent compared
to third quarter 2005, excluding fuel. As a result of the Company’s continued
focus on controlling non-fuel costs and attempting to offset wage rate and
benefit increases through productivity and efficiency improvements, the Company
was able to experience either flat or lower unit costs in almost every cost
category compared to third quarter 2005. In addition, the Company’s headcount
per aircraft at September 30, 2006 was 68, which was an improvement versus
a
year-ago level of 71. Including fuel expense, third quarter 2006 CASM increased
9.8 percent compared to the same prior year period, primarily due to the 54.5
percent increase in the Company’s fuel cost per gallon, including the effects of
hedging.
Third
quarter 2006 also presented challenges to the airline industry in the way of
new
security measures mandated by the Transportation Security Administration (TSA),
as a result of the terrorist plot uncovered by authorities in London. The
stringent new rules, mostly regarding the types of items that can be carried
onboard the aircraft, had a negative impact on air travel beginning in
mid-August, especially on shorthaul routes and with business travelers. The
Company estimates more than a $40 million revenue impact for August and
September related to the security threat and these new restrictions. Although
the TSA recently relaxed some of the requirements for carryon luggage, the
Company is not able to predict the ongoing impact, if any, that these security
changes will have on passenger revenues, both in the short-term and the
long-term. Thus far in fourth quarter 2006, load factors and bookings remain
solid, and year-over-year unit revenue growth is currently in the four to five
percent range.
During
second quarter 2006, the Company was part of an historic agreement that will
eventually lift all flight restrictions from Dallas Love Field, which is a
significant destination for the Company as well as the location of our
headquarters. The original Wright Amendment was passed by the U.S. Congress
in
1979 and restricted commercial flights from Dallas Love Field to all states,
other than states bordering Texas, along with Kansas, Missouri, Mississippi,
and
Alabama. In conjunction with the cities of Dallas and Fort Worth, DFW
International Airport, and American Airlines, the Company agreed to a plan
that
would, among other items, immediately lift through-ticketing restrictions so
that Customers could purchase a single ticket from Dallas to any U.S.
destination (while still requiring the Customer to connect through a Wright
Amendment state), and eventually eliminate all restrictions associated with
the
Wright Amendment in 2014. The agreement also reduced the maximum number of
available gates at Love Field from 32 to 20, of which the Company would have
leases for 16. The agreement was signed into law by President Bush on October
13, 2006, and became effective on October 16, 2006. Although Southwest believes
that through-ticketing at Dallas Love Field will provide a passenger revenue
boost to the Company, we are unable to predict the amount or the timing of
those
benefits.
The
Company began
new
service to Washington Dulles International Airport in northern Virginia on
October 5, 2006. Washington Dulles is the 63rd
destination served by Southwest and began with daily nonstop service to Chicago
Midway, Las Vegas, Tampa Bay, and Orlando. Based on our current forecast, the
Company expects fourth quarter 2006 capacity to grow approximately ten percent
versus fourth quarter 2005.
Comparison
of three months ended September 30, 2006, to three months ended September 30,
2005
Revenues
Consolidated
operating revenues increased by $353 million, or 17.7 percent, primarily due
to
a $346 million, or 18.1 percent, increase in Passenger revenues. The
increase
in Passenger revenues was fairly equally distributed between the 8.8 percent
increase in RPM yield and the 8.8 percent increase in capacity. The higher
RPM
yield primarily resulted from modest fare increases and enhanced revenue
management.
The
capacity increase
resulted
from the addition of 36 aircraft since the end of third quarter 2005
(and
no
aircraft retirements).
Load
factor was relatively flat compared to third quarter 2005. Unit revenue
(operating revenue per ASM) increased 8.2 percent, primarily due to the higher
RPM yields.
Consolidated
freight revenues decreased by $2 million, or 6.3 percent, primarily as a result
of the Company’s decision to discontinue the carrying of mail for the U.S.
Postal Service effective as of the end of second quarter 2006. Therefore, the
Company had no mail revenue in third quarter 2006 versus $6 million in mail
revenue in third quarter 2005. This decrease was partially offset by higher
freight and cargo revenues, primarily as a result of higher rates charged.
The
Company also expects a similar decline in consolidated freight revenues for
fourth quarter 2006 compared to the level recorded in fourth quarter 2006.
Other
revenues increased by $9 million, or 20.0 percent, compared to third quarter
2005. The increase was due to higher commissions earned from programs the
Company sponsors with certain business partners, such as the Company sponsored
Chase Visa card. The Company expects a year-over-year Other revenue increase
in
fourth quarter 2006, although at a lower level than experienced in third
quarter.
Operating
expenses
To
a
large extent, except for the potential for large swings in market prices for
fuel, changes in operating expenses for airlines are driven by changes in
capacity, or ASMs. The following presents Southwest’s operating expenses per ASM
for the three months ended September 30, 2006 and 2005, followed by explanations
of changes on a per-ASM basis (in cents, except for percentages):
|
|
Three
months ended September 30,
|
|
Per
ASM
|
|
Percent
|
|
|
|
2006
|
|
|
2005
|
|
Change
|
|
Change
|
|
|
|
|
|
|
|
|
|
|
|
|
Salaries,
wages, and benefits
|
|
|
3.24
|
|
|
|
3.26
|
|
|
(.02
|
)
|
(.6
|
)
|
Fuel
and oil
|
|
|
2.37
|
|
|
|
1.54
|
|
|
.83
|
|
53.9
|
|
Maintenance
materials
|
|
|
|
|
|
|
|
|
|
|
|
|
|
and
repairs
|
|
|
.49
|
|
|
|
.53
|
|
|
(.04
|
)
|
(7.5
|
)
|
Aircraft
rentals
|
|
|
.16
|
|
|
|
.16
|
|
|
-
|
|
-
|
|
Landing
fees and other rentals
|
|
|
.54
|
|
|
|
.54
|
|
|
-
|
|
-
|
|
Depreciation
|
|
|
.55
|
|
|
|
.55
|
|
|
-
|
|
-
|
|
Other
operating expenses
|
|
|
1.40
|
|
|
|
1.39
|
|
|
.01
|
|
0.7
|
|
Total
|
|
|
8.75
|
|
|
|
7.97
|
|
|
.78
|
|
9.8
|
|
Operating
expenses per ASM were 8.75 cents, a 9.8 percent increase compared to 7.97 cents
for third quarter 2005. The majority of the year-over-year CASM increase was
due
to higher
fuel costs, as the Company’s average cost per gallon of fuel increased 54.5
percent versus the prior year, net of hedging. Excluding fuel, year-over-year
CASM decreased .6 percent to 6.38 cents. This slight decrease was primarily
due
to lower profitsharing expense and lower maintenance materials and
repairs
expense
per ASM. Based
on current unit operating cost trends, excluding fuel, the Company expects
a
year-over-year decrease in fourth quarter 2006 unit costs, primarily due to
a
$24
million retroactive assessment the Company incurred from the Transportation
Security Administration in fourth quarter 2005.
Salaries,
wages, and benefits expense per ASM decreased .6 percent compared to third
quarter 2005, primarily due to a decrease in profitsharing expense. The
Company’s profitsharing
contributions are based on net income excluding unrealized gains and losses
from
hedging activities. The
decrease in profitsharing expense was primarily due to retrospective adjustments
associated with the Company's adoption of SFAS 123R and change in accounting
for
airframe maintenance, both of which were effective January 1, 2006. These two
items resulted in a $25 million reduction in third quarter 2005 pretax income;
however, previously calculated profitsharing contributions were not adjusted,
as
the Company's Profitsharing Plan prohibits such an adjustment. See
Note
5 to the Condensed consolidated financial statements for further information
on
the Company’s hedging activities and Note 2 for further information on the
Company’s 2006 accounting changes.
As
explained in Note 2 to the unaudited condensed consolidated financial
statements, the Company adopted SFAS 123R, using the modified retrospective
method, effective January 1, 2006. As a result, in first quarter 2006, prior
year results were retrospectively adjusted to include share-based compensation
expense, primarily associated with Employee stock options. Third quarter 2005
now includes $19 million in share-based compensation expense. For the three
months ended September 30, 2006, Salaries, wages and benefits includes
share-based compensation expense of $20 million. The Company currently estimates
that share-based compensation expense will be approximately $80 million for
the
full year 2006. The Company currently expects Salaries, wages, and benefits
per
ASM in fourth quarter 2006 to be comparable to the 3.24 cents reported in third
quarter 2006.
The
Company’s Ramp, Operations, and Provisioning and Freight Agents are subject to
an agreement with the Transport Workers Union of America, AFL-CIO (“TWU”), which
becomes amendable on September 30, 2008. However, under certain conditions,
TWU
could elect to give notice to the Company by June 1, 2007, of its desire to
make
the agreement amendable on September 30, 2007. During second quarter 2006,
TWU
membership voted to not make the contract amendable on September 30, 2007.
The
Company is unable to predict whether future votes between now and June 2007
would result in the same outcome. If the contract is not made amendable prior
to
that date, it would remain in effect through September 30, 2008.
The
Company’s Pilots are subject to an agreement with the Southwest Airlines Pilots’
Association (“SWAPA”), which became amendable during September, 2006. The
Company and SWAPA recently began discussions on a new agreement.
Fuel
and
oil expense per ASM increased 53.9 percent primarily due to a weaker hedge
position held by the Company in third quarter 2006 versus third quarter 2005,
and higher market jet fuel prices. In third quarter 2006, the Company was hedged
at a lower percentage of anticipated fuel consumption versus the prior year,
and
at higher average crude oil-equivalent prices. The Company’s average fuel cost
per gallon in third quarter 2006 was $1.56, 54.5 percent higher than third
quarter 2005, including the effects of hedging activities. For third quarter
2006, the Company had protected against approximately 81 percent of its
anticipated fuel needs at a crude oil-equivalent price of approximately $41
per
barrel, resulting in gains recorded in Fuel and oil expense of $201 million.
Third quarter 2005 hedging gains recorded in Fuel and oil expense were $276
million.
For
fourth quarter 2006, the Company has fuel derivatives in place for approximately
85 percent of its expected fuel consumption with a combination of derivative
instruments that effectively cap prices at approximately $43 per barrel of
crude
oil and has added refinery margins on the majority of those positions. Based
on
this protection and current market prices, the Company expects its fourth
quarter 2006 jet fuel cost per gallon to substantially increase from fourth
quarter 2005’s $1.20. The majority of the Company's near term fuel derivatives
are in the form of option contracts. At September 30, 2006, the estimated net
fair value of the Company’s fuel derivative contracts was $1.3 billion. See Note
5 to the unaudited condensed consolidated financial statements for further
discussion of the Company’s hedging activities. Also, with the Company’s ongoing
efforts to conserve fuel, it has announced it will install Aviation Partners
Boeing Blended Winglets on up to 90 of its Boeing 737-300 aircraft with 59
firm
orders and 31 options. Installations are expected to begin in early
2007.
Maintenance
materials and repairs per ASM decreased 7.5 percent compared to third quarter
2005. The majority of the decrease was equally split between engine expense
and
airframe expense. As discussed in Note 2 to the unaudited condensed consolidated
financial statements, the Company changed its method of accounting for planned
airframe maintenance on its 737-300 and 737-500 aircraft in first quarter 2006.
As a result, in first quarter 2006, prior year Maintenance materials and repairs
expense was retrospectively adjusted to conform to the Company’s present method
of accounting for airframe maintenance. The Company currently expects
Maintenance materials and repairs per ASM for fourth quarter 2006 to be in
line
with or slightly higher than fourth quarter 2005’s 51 cents per ASM due to more
scheduled airframe repairs.
Other
operating expenses per ASM were slightly higher than third quarter 2005’s
performance of 1.39 cents due to higher revenue driven costs and security fees
assessed by the Transportation Security Administration (TSA), that were mostly
offset by lower expenses in other categories.
For
fourth quarter 2006, the
Company believes it is likely that Other operating expenses per ASM will be
under 1.50 due primarily to expected TSA assessments of approximately $6 million
versus the fourth quarter 2005 retroactive assessment of $24 million.
Through
the 2003 Emergency
Wartime Supplemental Appropriations Act, the federal government has continued
to
provide supplemental third-party war-risk insurance coverage to commercial
carriers for renewable 60-day periods, at substantially lower premiums than
prevailing commercial rates and for levels of coverage not available in the
commercial market. The government-provided supplemental coverage from the
Wartime Act is currently set to expire on December 31, 2006. Although another
extension beyond this date is expected, if such coverage is not extended by
the
government, the Company could incur substantially higher insurance costs in
future periods.
Other
Interest
expense was flat compared to third quarter 2005, as an increase in interest
rates was offset by a lower debt balance outstanding. The majority of the
Company’s long-term debt is at floating rates. See Notes 5 and 7
to the
unaudited condensed consolidated financial statements for more
information.
Capitalized
interest increased $2 million, or 20.0 percent compared to the prior year,
also
primarily due to an increase in interest rates.
Interest
income increased by $10 million, or 76.9 percent, primarily due to an increase
in rates earned on cash and investments.
Other
(gains) losses, net, primarily includes amounts recorded in accordance with
the
Company’s hedging activities and SFAS 133. During third quarter 2006, the
Company recognized approximately
$13 million of expense related to amounts excluded from the Company's
measurements of hedge effectiveness. Also in third quarter 2006, the
Company recognized approximately $173 million of net losses in Other (gains)
losses, net, related to the ineffectiveness of its hedges and the loss of hedge
accounting for certain fuel derivatives. Of this net total, approximately $123
million was unrealized, mark-to-market losses in the fair value of derivatives
due to the discontinuation of hedge accounting for certain contracts that will
settle in future periods, $32 million was ineffectiveness and mark-to-market
losses related to contracts that settled during third quarter 2006, and $18
million was losses related to unrealized ineffectiveness from hedges designated
for future periods.
See
Note 5
to the unaudited condensed consolidated financial statements for more
information on the Company’s hedging activities.
In
third quarter 2005, the Company recognized approximately $9 million of expense
related to amounts excluded from the Company's measurements of hedge
effectiveness and $109 million in gains related to the ineffectiveness of its
hedges
and the
loss of hedge accounting for certain fuel derivatives.
Of
this
$109 million, approximately $73 million was additional income from unrealized,
mark-to-market changes in the fair value of derivatives due to the
discontinuation of hedge accounting for certain contracts that will settle
in
future periods, $14 million was gains related to unrealized ineffectiveness
from
hedges designated for future periods, and $22 million was ineffectiveness and
mark-to-market gains related to contracts that settled during third quarter
2005.
The
Company’s effective tax rate was 38.9 percent in third quarter 2006 compared to
38.7 percent in third quarter 2005. The
Company currently expects its full year 2006 effective rate to be in the 36
to
37 percent range; however, future effective rates are more difficult to forecast
due to the Company’s January 1, 2006, adoption of SFAS 123R. See Note 2 to the
unaudited condensed consolidated financial statements for further
information.
Comparison
of nine months ended September 30, 2006, to nine months ended September 30,
2005
Revenues
Consolidated
operating revenues increased by $1.21 billion, or 21.7 percent, primarily due
to
a $1.19 billion, or 22.1 percent, increase in Passenger revenues. The
increase
in Passenger revenues was distributed among three items—approximately 40 percent
of the increase was due to the 8.1 percent increase in RPM yield, approximately
40 percent was attributable to the 8.4 percent increase in capacity, and the
majority of the remainder of the increase was from the 2.9 point or 4.1 percent
increase in load factor. Unit
revenue (operating revenue per ASM) increased 12.4 percent, due to the
combination of higher RPM yields and the higher load factor. The
Company also experienced a 7.8 percent increase in revenue passengers carried
compared to the same 2005 period.
Consolidated
freight revenues increased by $4
million, or 4.0 percent. Higher freight and cargo revenues, primarily as a
result of higher rates charged, were partially offset by lower mail revenues
versus the same period of 2005. The lower mail revenues were primarily due
to
the Company’s decision to discontinue the carrying of mail for the U.S. Postal
Service effective as of the end of second quarter 2006. Other revenues increased
by $24 million, or 19.2 percent, compared to the nine months ended September
30,
2005, primarily due to an increase in commissions earned from programs the
Company sponsors with certain business partners, such as the Company sponsored
Chase Visa card.
Operating
expenses
To
a
large extent, except for the potential for large swings in market prices for
fuel, changes in operating expenses for airlines are driven by changes in
capacity, or ASMs. The following presents Southwest’s operating expenses per ASM
for the nine months ended September 30, 2006 and 2005, followed by explanations
of changes on a per-ASM basis (in cents, except for percentages):
|
|
Nine
months ended September 30,
|
|
Per
ASM
|
|
Percent
|
|
|
|
2006
|
|
|
2005
|
|
Change
|
|
Change
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Salaries,
wages, and benefits
|
|
|
3.31
|
|
|
|
3.24
|
|
|
.07
|
|
|
2.2
|
|
Fuel
and oil
|
|
|
2.30
|
|
|
|
1.49
|
|
|
.81
|
|
|
54.4
|
|
Maintenance
materials
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
and
repairs
|
|
|
.50
|
|
|
|
.53
|
|
|
(.03
|
)
|
|
(5.7
|
)
|
Aircraft
rentals
|
|
|
.17
|
|
|
|
.19
|
|
|
(.02
|
)
|
|
(10.5
|
)
|
Landing
fees and other rentals
|
|
|
.54
|
|
|
|
.54
|
|
|
-
|
|
|
-
|
|
Depreciation
|
|
|
.55
|
|
|
|
.55
|
|
|
-
|
|
|
-
|
|
Other
operating expenses
|
|
|
1.43
|
|
|
|
1.36
|
|
|
.07
|
|
|
5.1
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
8.80
|
|
|
|
7.90
|
|
|
.90
|
|
|
11.4
|
|
Operating expenses per ASM were 8.80 cents, an 11.4 percent increase compared
to
7.90 cents for the nine months ended September 30, 2005. The majority of the
year-over-year CASM increase was due to higher
fuel costs, as the Company’s average cost per gallon of fuel increased 56.1
percent versus the prior year net of hedging. Excluding fuel, year-over-year
CASM increased 1.4 percent to 6.50 cents, primarily due to higher salaries
expense and higher Other
operating expenses. These were partially offset by lower maintenance costs
and
Aircraft rentals expense.
Salaries,
wages, and benefits expense per ASM increased 2.2 percent compared to the nine
months ended September 30, 2005. Approximately 45 percent of the increase was
due to higher wage rates. The majority of the remainder of the increase was
due
to higher profitsharing expense from the increase in Company profits available
for profitsharing. As explained in Note 2 to the unaudited condensed
consolidated financial statements, the Company adopted SFAS 123R, using the
modified retrospective method, effective January 1, 2006. As a result, prior
year results were retrospectively adjusted to include share-based compensation
expense, primarily associated with Employee stock options. Results for the
nine
months ended September 30, 2005, now include $57 million in share-based
compensation expense. For the nine months ended September 30, 2006, Salaries,
wages and benefits includes share-based compensation expense of $66 million.
The
inclusion of these amounts did not materially change the year-over-year
comparisons of salaries, wages and benefits on a per-ASM basis.
Fuel
and
oil expense per ASM increased 54.4 percent compared to the nine months ended
September 30, 2005, primarily due to a weaker hedge position held by the Company
in 2006 versus 2005, and higher market jet fuel prices. For the nine months
ended September 30, 2006, the Company was hedged at a lower percentage of
anticipated fuel consumption versus the prior year, and at higher average crude
oil-equivalent prices. The Company’s average fuel cost per gallon in the nine
months ended September 30, 2006 was $1.53, 56.1 percent higher than the same
period in 2005, including the effects of hedging activities. Fuel and oil
expense for the nine months ended September 30, 2006, are net of $515 million
in
hedging gains associated with the Company’s hedge program. Hedging gains
recorded in Fuel and oil expense for the nine months ended September 30, 2005,
were $627 million.
Maintenance
materials and repairs per ASM decreased 5.7 percent compared to the nine months
ended September 30, 2005 primarily due to a decrease in repair costs for
airframes. Also, as discussed in Note 2 to the unaudited condensed consolidated
financial statements, the Company changed its method of accounting for planned
airframe maintenance on its 737-300 and 737-500 aircraft in first quarter 2006.
As a result, in first quarter 2006, prior year Maintenance materials and repairs
expense was retrospectively adjusted to conform to the Company’s present method
of accounting for airframe maintenance.
Aircraft
rentals per ASM decreased 10.5 percent compared to the nine months ended
September 30, 2005. The majority of the decrease per ASM was due to the
renegotiation of several aircraft leases that resulted in both lower lease
rates
and the reclassification of four aircraft from operating leases to capital
leases. Expense associated with capital lease aircraft is recorded as
depreciation. In addition, all of the aircraft acquired in 2005 and 2006 are
owned by the Company.
Other
operating expenses per ASM increased 5.1 percent compared to the nine months
ended September 30, 2005. Approximately forty percent of the increase was due
to
higher
credit card fees associated with the increase in revenues, and another
forty
percent was due to higher security fees assessed by the Transportation Security
Administration.
Other
Interest
expense increased $11 million, or 12.4 percent compared to the nine months
ended
September 30, 2005. The majority of the increase was due to an increase in
interest rates, due to the fact that most of the Company’s long-term debt is at
floating rates. See Notes 5 and 7
to the
unaudited condensed consolidated financial statements for more
information.
Capitalized
interest increased $10 million, or 35.7 percent compared to the prior year,
also
primarily due to an increase in interest rates.
Interest
income increased by $31 million, or 100.0 percent, primarily due to an increase
in rates earned on cash and investments.
Other
(gains) losses, net primarily includes amounts recorded in accordance with
the
Company’s hedging activities and SFAS 133. During the nine months ended
September 30, 2006, the Company recognized approximately $37 million of expense
related to amounts excluded from the Company's measurements of hedge
effectiveness. Also in 2006, the
Company recognized approximately $37 million of net losses in Other (gains)
losses, net, related to the ineffectiveness of its hedges and the loss of hedge
accounting for certain fuel derivatives. Of this net total, approximately $18
million was unrealized, mark-to-market losses in the fair value of derivatives
due to the discontinuation of hedge accounting for certain contracts that will
settle in future periods and $22 million was losses related to unrealized
ineffectiveness from hedges designated for future periods.
These
were partially offset by $3 million in ineffectiveness
and mark-to-market gains related to contracts that settled during the nine
months ended September 30, 2006. See
Note 5
to the unaudited condensed consolidated financial statements for more
information on the Company’s hedging activities.
In the
nine months ended September 30, 2005, the Company recognized approximately
$26
million of expense related to amounts excluded from the Company's measurements
of hedge effectiveness and $134 million in income related to the ineffectiveness
of its hedges
and the
loss of hedge accounting for certain fuel derivatives. Of
this
$134 million, approximately $88 million of the additional income was unrealized,
mark-to-market changes in the fair value of derivatives due to the
discontinuation of hedge accounting for certain contracts that will settle
in
future periods, $20 million was gains related to unrealized ineffectiveness
from
hedges designated for future periods, and $26 million was ineffectiveness and
mark-to-market gains related to contracts that settled during the nine months
ended September 30, 2005.
The
Company’s effective tax rate decreased to 35.9 percent for the nine months ended
September 30, 2006, from 37.9 percent in the same period of 2005. The decrease
in the 2006 rate is primarily due to a 2006 $13 million net reduction related
to
a revision in the State of Texas franchise tax law enacted during second quarter
2006.
Liquidity
and Capital Resources
Net
cash
provided by operating activities was $1.3 billion for the nine months ended
September 30, 2006, compared to $2.1 billion in the same prior year period.
The
operating cash flows in both years were largely impacted by
fluctuations in counterparty deposits associated with the Company’s fuel hedging
program. There was a decrease in counterparty deposits of $270 million for
the
nine months ended September 30, 2006, versus an increase of $865 million during
the nine months ended September 30, 2005. The decrease in these deposits during
2006 has been due to the decline in fair value of the Company’s fuel derivative
portfolio from $1.7 billion at December 31, 2005, to $1.3 billion at September
30, 2006. The increase during 2005 was primarily due to a large increase in
the
fair value of the Company’s fuel derivative instruments, as a result of
escalating energy prices during the first nine months of 2005. Cash flows from
operating activities for the nine months ended September 30, 2006, were also
driven by the $319 million increase in Air traffic liability, as a result of
seasonal bookings for future travel, and the $442 million in net income. See
Item 3, and Notes 5 and 8 to the unaudited condensed consolidated financial
statements. Net
cash
provided by operating activities is primarily used to finance capital
expenditures.
Net
cash
flows used in investing activities during the nine months ended September 30,
2006, totaled $1.1 billion compared to $876 million in 2005. Investing
activities in both years consisted primarily of payments for new 737-700
aircraft delivered to the Company and progress payments for future aircraft
deliveries. In addition, investing activities for both periods was impacted
by
changes in the balance of the Company’s short-term investments, namely auction
rate securities. During the nine months ended September 30, 2006 and 2005,
the
Company’s short-term investments increased by $103 million and decreased by $72
million, respectively.
Net
cash
used in financing activities during the nine months ended September 30, 2006,
was $468 million compared to $169 million generated from financing activities
for the same period in 2005. During the nine months ended September 30, 2006,
the Company repurchased $600 million of its Common Stock and redeemed $137
million of its debt on scheduled maturity dates. These outflows were partially
offset by $226 million received from the exercise of Employee stock options.
In
the prior year, the Company generated $300 million from the February 2005
issuance of senior unsecured Notes due 2017. This was partially offset by cash
used to redeem $100 million senior unsecured 8% Notes, $36 million used to
repay
other long-term and capital lease obligations, and to repurchase $55 million
of
the Company’s Common Stock.
Contractual
Obligations and Contingent Liabilities and Commitments
Southwest
has contractual obligations and commitments primarily for future purchases
of
aircraft, payment of debt, and lease
arrangements. Through the first nine months of 2006, the Company purchased
29
new 737-700 aircraft from Boeing and one used aircraft from a third-party.
As of
October 19, 2006, Southwest has firm orders and options to purchase Boeing
737-700 aircraft as follows:
|
|
The
Boeing Company
|
|
|
|
|
|
|
|
|
|
|
|
Purchase
|
|
Previously
|
|
|
|
|
|
Firm
|
|
Options
|
|
Rights
|
|
Owned
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2006
|
|
|
34
|
|
|
|
|
|
|
|
|
2
|
*
|
|
36
|
**
|
2007
|
|
|
37
|
|
|
|
|
|
|
|
|
|
|
|
37
|
|
2008
|
|
|
29
|
|
|
5
|
|
|
|
|
|
|
|
|
34
|
|
2009
|
|
|
18
|
|
|
18
|
|
|
|
|
|
|
|
|
36
|
|
2010
|
|
|
10
|
|
|
32
|
|
|
|
|
|
|
|
|
42
|
|
2011
|
|
|
10
|
|
|
30
|
|
|
|
|
|
|
|
|
40
|
|
2012
|
|
|
10
|
|
|
30
|
|
|
|
|
|
|
|
|
40
|
|
2008-2014
|
|
|
-
|
|
|
-
|
|
|
54
|
|
|
|
|
|
54
|
|
|
|
|
148
|
|
|
115
|
|
|
54
|
|
|
2
|
|
|
319
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
*
Acquired one 737-700 during third quarter 2006 and have signed
an
agreement
|
to
acquire an additional 737-700 during the fourth quarter
2006
|
|
|
|
**Includes
thirty aircraft delivered in first nine months of 2006
|
|
|
|
|
The
following table details information on the 475 aircraft in the Company’s fleet
as of September 30, 2006:
|
|
|
|
Average
|
|
Number
|
|
Number
|
|
Number
|
|
737
Type
|
|
Seats
|
|
Age
(Yrs)
|
|
of
Aircraft
|
|
Owned
|
|
Leased
|
|
|
|
|
|
|
|
|
|
|
|
|
|
-300
|
|
|
137
|
|
|
15.4
|
|
|
194
|
|
|
112
|
|
|
82
|
|
-500
|
|
|
122
|
|
|
15.4
|
|
|
25
|
|
|
16
|
|
|
9
|
|
-700
|
|
|
137
|
|
|
3.9
|
|
|
256
|
|
|
254
|
|
|
2
|
|
TOTALS
|
|
|
|
|
|
9.2
|
|
|
475
|
|
|
382
|
|
|
93
|
|
The Company has the option, which must be exercised two years prior to the
contractual delivery date, to substitute -600s or -800s for the -700s. Based
on
the above delivery schedule, aggregate funding needed for firm aircraft
commitments was approximately $3.3 billion, subject to adjustments for
inflation, due as follows: $256 million remaining in 2006, $996 million in
2007,
$744 million in 2008, $467 million in 2009, $341 million in 2010, and $499
million thereafter.
The
Company has various options available to meet its capital and operating
commitments, including cash on hand and short term investments at September
30,
2006, of $2.3 billion, internally generated funds, and the Company’s fully
available $600 million revolving credit facility. The Company will also consider
various borrowing or leasing options to maximize earnings and supplement cash
requirements.
In
January 2006, the Company’s Board of Directors authorized the repurchase of up
to $300 million of the Company’s Common Stock. Repurchases were made in
accordance with applicable securities laws in the open market or in private
transactions from time to time, depending on market conditions. This program
was
completed during second quarter 2006, resulting in the repurchase of 17.8
million shares. In May 2006, the Company’s Board of Directors authorized an
additional $300 million repurchase program. In July 2006, the Company also
completed this program, resulting in the repurchase of 18.7 million shares.
See
Item 2 of Part II of this filing for further information on these two repurchase
programs.
During
both the first quarter 2006 and second quarter 2006, the Company redeemed $29
million two-year notes on their respective maturity dates of February 24, 2006,
and April 28, 2006. See Note 7 to the unaudited condensed consolidated financial
statements.
The
Company currently has outstanding shelf registrations for the issuance of up
to
$1.3 billion in public debt securities and pass-through certificates, which
it
may utilize for aircraft financings or other purposes in the future.
Forward
looking statements
Some
statements in this Form 10-Q (or otherwise made by the Company or on the
Company’s behalf from time to time in other reports, filings with the Securities
and Exchange Commission, news releases, conferences, World Wide Web postings
or
otherwise) which are not historical facts may be “forward-looking statements”
within the meaning of Section 21E of the Securities Exchange Act of 1934 and
the
Private Securities Litigation Reform Act of 1995. Forward-looking statements
include statements about Southwest’s estimates, expectations, beliefs,
intentions, or strategies for the future, and the assumptions underlying these
forward-looking statements. Southwest uses the words "anticipates," "believes,"
"estimates," "expects," "intends," "forecasts," "may," "will," "should," and
similar expressions to identify these forward-looking statements.
Forward-looking statements involve risks and uncertainties that could cause
actual results to differ materially from historical experience or the Company’s
present expectations. Factors that could cause these differences include, but
are not limited to those set forth under Item 1A. - Risk Factors in our Annual
Report on Form 10-K for the year ended December 31, 2005.
Caution
should be taken not to place undue reliance on the Company’s forward-looking
statements, which represent the Company’s views only as of the date this report
is filed. The Company undertakes no obligation to update publicly or revise
any
forward-looking statement, whether as a result of new information, future events
or otherwise.
Item
3.
Quantitative and Qualitative Disclosures About Market
Risk
As
discussed in Note 5 to the unaudited condensed consolidated financial
statements, the Company utilizes financial derivative instruments to hedge
its
exposure to material increases in jet fuel prices. During the first six months
of 2006, the fair values of the Company’s fuel derivative contracts increased
significantly, and then in third quarter 2006 decreased in value significantly,
due to the volatility in forward prices for commodities used by the Company
for
hedging jet fuel. At September 30, 2006, the estimated gross fair value of
outstanding contracts was $1.3 billion, compared to $1.7 billion at December
31,
2005.
Outstanding
financial derivative instruments expose the Company to credit loss in the event
of nonperformance by the counterparties to the agreements. However, the Company
does not expect any of the counterparties to fail to meet their obligations.
The
credit exposure related to these financial instruments is represented by the
fair value of contracts with a positive fair value at the reporting date. To
manage credit risk, the Company selects and periodically reviews counterparties
based on credit ratings, limits its exposure to a single counterparty, and
monitors the market position of the program and its relative market position
with each counterparty. At September 30, 2006, the Company had agreements with
seven counterparties containing early termination rights and/or bilateral
collateral provisions whereby security is required if market risk exposure
exceeds a specified threshold amount or credit ratings fall below certain
levels. At September 30, 2006, the Company held $680 million in fuel derivative
related cash collateral deposits under these bilateral collateral provisions.
These collateral deposits serve to decrease, but not totally eliminate, the
credit risk associated with the Company’s hedging program. The cash deposits,
which can have a significant impact on the Company’s cash balance, are included
in Accrued liabilities on the unaudited Condensed Consolidated Balance Sheet.
Cash flows as of and for a particular operating period are included as Operating
cash flows in the unaudited Condensed Consolidated Statement of Cash Flows.
See
also Note 8 to the unaudited condensed consolidated financial statements.
See
Item
7A “Quantitative and Qualitative Disclosures About Market Risk” in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2005 and Note 5
to
the unaudited condensed consolidated financial statements for further
information about Market Risk.
Disclosure
Controls and Procedures
The
Company maintains disclosure controls and procedures designed to ensure that
it
is able to collect the information it is required to disclose in the reports
it
files with the Securities and Exchange Commission (SEC), and to process,
summarize and disclose this information within the time periods specified in
the
rules of the SEC. Based on an evaluation of the Company’s disclosure controls
and procedures as of the end of the period covered by this report conducted
by
the Company’s management, with the participation of the Chief Executive and
Chief Financial Officers, the Chief Executive and Chief Financial Officers
believe that these controls and procedures are effective to ensure that the
Company is able to collect, process, and disclose the information it is required
to disclose in the reports it files with the SEC within the required time
periods.
Internal
Control over Financial Reporting
There
were no changes in the Company’s internal control over financial reporting (as
defined in Rules 13(a)-15(f) and 15(d)-15(f) under the Exchange Act) during
the
fiscal quarter ended September 30, 2006, that have materially affected, or
are
reasonably likely to materially affect, the Company’s internal control over
financial reporting.
The
Company is subject to various legal proceedings and claims arising in the
ordinary course of business, including, but not limited to, examinations by
the
Internal Revenue Service (IRS). The IRS regularly examines the Company’s federal
income tax returns and, in the course thereof, proposes adjustments to the
Company’s federal income tax liability reported on such returns. It is the
Company’s practice to vigorously contest those proposed adjustments it deems
lacking of merit.
The
Company's management does not expect that the outcome in any of its currently
ongoing legal proceedings or the outcome of any proposed adjustments presented
to date by the IRS, individually or collectively, will have a material adverse
effect on the Company's financial condition, results of operations or cash
flow.
There
have been no material changes to the factors disclosed in Item 1A. Risk Factors
in our Annual Report on Form 10-K for the year ended December 31,
2005.
Item
2. Unregistered
Sales of Equity Securities and Use of Proceeds
(c)
Issuer
Purchases of Equity Securities (1)
|
|
(a)
|
|
(b)
|
|
(c)
|
|
(d)
|
|
|
|
|
|
|
|
Total
number of
|
|
Maximum
dollar
|
|
|
|
|
|
|
|
shares
purchased
|
|
value
that may
|
|
|
|
Total
number
|
|
Average
|
|
as
part of publicly
|
|
yet
be purchased
|
|
|
|
of
shares
|
|
price
paid
|
|
announced
plans
|
|
under
the plans
|
|
Period
|
|
purchased
|
|
per
share
|
|
or
programs
|
|
or
programs
|
|
|
|
|
|
|
|
|
|
|
|
July
1, 2006 through July 31, 2006
|
|
|
5,952,700
|
|
$
|
16.50
|
|
|
5,952,700
|
|
$
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
August
1, 2006 through August 31, 2006
|
|
|
-
|
|
$
|
-
|
|
|
-
|
|
$
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September
1, 2006 through September 30, 2006
|
|
|
-
|
|
$
|
-
|
|
|
-
|
|
$
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
(2)
|
|
|
5,952,700
|
|
|
|
|
|
5,952,700
|
|
|
|
|
(1)
In
January 2006, the Company announced a program for the repurchase of up to $300
million of the Company’s Common Stock. This program was completed during second
quarter 2006, resulting in the purchase of 17.8 million shares. In May 2006,
the
Company announced a second program for the repurchase of up to $300 million
of
the Company’s Common Stock. This program was completed in July 2006, resulting
in the purchase of 18.7 million shares. Repurchases for both programs were
made
in accordance with applicable securities laws in the open market or in private
transactions from time to time, depending on market conditions.
(2)
All
shares were purchased pursuant to the publicly announced programs.
Item
3. Defaults
upon Senior Securities
None
Item
4. Submission
of Matters to a Vote of Security Holders
None
None
a) Exhibits
|
10.1
|
Supplemental
Agreement Nos. 49 and 50 to Purchase Agreement No. 1810, dated
January
|
|
|
19,
1994 between The Boeing Company and Southwest.
|
|
|
Pursuant
to 17 CFR 240.24b-2, confidential information has been
omitted
|
|
|
and
has been filed separately with the Securities and Exchange
Commission
|
|
|
pursuant
to a Confidential Treatment Application filed with the
|
|
|
Commission.
|
|
31.1
|
Rule
13a-14(a) Certification of Chief Executive Officer
|
|
31.2
|
Rule
13a-14(a) Certification of Chief Financial Officer
|
|
32.1
|
Section
1350 Certifications of Chief Executive Officer and Chief
Financial
|
|
|
Officer
|
Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant
has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
|
SOUTHWEST
AIRLINES CO.
|
|
|
|
October
20, 2006
|
By
|
/s/
Laura Wright
|
|
|
|
|
|
Laura
Wright
|
|
|
Chief
Financial Officer
|
|
|
(Principal
Financial and
|
|
|
Accounting
Officer)
|
|
|
|
Exhibit
No.
|
|
Description
|
Exhibit
10.1
|
-
|
Supplemental
Agreement Nos. 49 and 50 to Purchase Agreement No.
1810,
|
|
|
dated
January 19, 1994 between The Boeing Company and
|
|
|
Southwest.
|
|
|
Pursuant
to 17 CFR 240.24b-2, confidential information has been
|
|
|
omitted
and has been filed separately with the Securities and
|
|
|
Exchange
Commission pursuant to a Confidential Treatment
|
|
|
Application
filed with the Commission.
|
Exhibit
31.1
|
-
|
Rule
13a-14(a) Certification of Chief Executive Officer
|
Exhibit 31.2
|
-
|
Rule
13a-14(a) Certification of Chief Financial Officer
|
Exhibit
32.1
|
-
|
Section
1350 Certifications of Chief Executive Officer and
Chief
|
|
|
Financial
Officer
|