Southwest reports second quarter net profit of $733 million

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Southwest Airlines Company reported its second quarter 2018 results:

Gary C. Kelly, Chairman of the Board and Chief Executive Officer, stated, “Despite higher fuel prices and the expected effects from the Flight 1380 accident, we delivered solid financial results, including record earnings per share for second quarter 2018. I am especially proud of the heroic efforts of our People to address and overcome the challenges resulting from the accident.

The revenue effects of the accident reduced second quarter 2018 passenger revenues by $100 million. We expect the revenue impact from this headwind to be temporary and subside in third quarter 2018 and are encouraged by the solid rebound in demand. Separately, we deployed additional revenue management tools and techniques during second quarter 2018, and we continue to expect to generate incremental improvements in pre-tax results of $200 million this year from the investment in our new reservation system. Our second half 2018 flight schedule is better optimized, and our Rapid Rewards Program and other ancillary products continue to perform very well.

“Excluding fuel, first half 2018 cost inflation was modest. We are pleased with our second quarter 2018 cost performance, which came in below expectation, mostly due to timing. We expect higher unit costs as we move into second half 2018, due largely to shifting spending from first half 2018. With the completion of major revenue initiatives over the last several years, we will refocus our efforts to control costs and drive efficiency, especially in light of higher fuel prices.

“Our expected year-over-year 2018 available seat mile (ASMs, or capacity) growth remains in the low four percent range, which is approximately one point lower than our original capacity growth plan, resulting from adjustments made to mitigate higher fuel prices and near-term unit revenue pressures. Our suboptimal flight schedule headwinds begin to abate next month and are not expected to have a material impact on fourth quarter 2018. As we look ahead to 2019, Hawaii remains our expansion focus, and our goal is to begin selling tickets later this year.”

Revenue Results and Outlook
The Company’s second quarter 2018 total operating revenues increased 0.2 percent to $5.7 billion, and decreased 3.0 percent on a unit basis, as compared with second quarter 2017. Second quarter 2018 passenger revenues decreased 0.4 percent, with a 0.9 point decline in load factor to 84.7 percent, and a passenger revenue yield decline of 2.5 percent, year-over-year. The decline in passenger revenues was due largely to the effects following the Flight 1380 accident, which had an approximate $100 million impact to second quarter 2018 passenger revenues. Second quarter 2018 other revenues increased 10.4 percent to $340 million driven largely by a strong performance of the Company’s Rapid Rewards Program.

Based on current bookings and yield trends, passenger revenues are continuing to recover post-accident. The Company expects third quarter 2018 year-over-year operating revenue per available seat mile (RASM, or unit revenues) to be a significant improvement over second quarter 2018 and in the range of down one percent to up one percent, compared with third quarter 2017 RASM of 13.58 cents, as recast in accordance with Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (or the “New Revenue Standard”). The Company’s outlook for third quarter 2018 includes an estimated one-half point impact to RASM due to temporarily lower passenger yields from an aggressive May 2018 fare sale for June through October 2018 travel, which was offered in conjunction with the Company’s broad marketing efforts following the accident. Third quarter 2018 year-over-year RASM trends also include an approximate one-half point headwind due to the Company’s suboptimal schedule from the accelerated retirement of its Boeing 737-300 (Classic) fleet, as well as an approximate one point headwind from the change in the Rapid Rewards revenue recognition as a result of the Company’s adoption of the New Revenue Standard. The headwinds to third quarter 2018 revenue from the Flight 1380 accident, the Company’s suboptimal schedule, and the impact from the adoption of the New Revenue Standard are not expected to be material to year-over-year RASM trends for fourth quarter 2018.

The Company adopted the New Revenue Standard effective January 1, 2018, and utilized the full retrospective method of adoption allowed by the standard. As such, results for the three and six months ended June 30, 2017, have been recast under the new standard in order to be comparable with current period results in the accompanying unaudited Condensed Consolidated Statement of Income.

Cost Performance and Outlook
Second quarter 2018 total operating expenses increased 5.6 percent, to $4.8 billion. Total operating expenses per available seat mile (CASM, or unit costs) increased 2.3 percent, as compared with second quarter 2017. Excluding special items in both periods, second quarter 2018 total operating expenses increased 4.9 percent to $4.8 billion, or 1.5 percent on a unit basis, year-over-year.

Effective January 1, 2018, the Company early adopted ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities. The new standard eliminated ineffectiveness for all derivatives designated in a hedge for accounting purposes, as well as changed the Company’s classification of premium expense associated with fuel hedges from Other (gains) and losses, net, to Fuel and oil expense within the unaudited Condensed Consolidated Statement of Income. As such, the classification of premium expense for the three and six months ended June 30, 2017, has been recast under the new standard to be comparable with current period results.

Second quarter 2018 economic fuel costs3 were $2.21 per gallon, including $.06 per gallon in premium expense and $.08 per gallon in favorable cash settlements from fuel derivative contracts, compared with $1.99 per gallon in second quarter 2017, as recast, which included $.06 per gallon in premium expense and $.32 per gallon in unfavorable cash settlements from fuel derivative contracts. Second quarter 2018 ASMs per gallon, or fuel efficiency, improved 1.7 percent year-over-year, driven primarily by the retirement of the Boeing 737-300 (Classic) fleet and the addition of the more fuel-efficient 737-800 and 737 MAX 8 aircraft.

Based on the Company’s existing fuel derivative contracts and market prices as of July 20, 2018, third quarter 2018 economic fuel costs are estimated to be approximately $2.25 per gallon6, including $.06 per gallon in premium expense and an estimated $.07 per gallon in favorable cash settlements from fuel derivative contracts, compared with $2.07 per gallon in third quarter 2017, as recast, which included $.06 per gallon in premium expense and $.31 per gallon in unfavorable cash settlements from fuel derivative contracts. As of July 20, 2018, the fair market value of the Company’s fuel derivative contracts for the remainder of 2018 was a net asset of approximately $108 million, and the fair market value of the hedge portfolio settling in 2019 and beyond was a net asset of approximately $345 million. Additional information regarding the Company’s fuel derivative contracts is included in the accompanying tables.

Excluding fuel and oil expense and special items in both periods, second quarter 2018 operating expenses increased 2.4 percent, as compared with second quarter 2017. Second quarter 2018 profitsharing expense was $166 million, as compared with $202 million in second quarter 2017. Excluding fuel and oil expense, profitsharing expense, and special items, second quarter 2018 operating expenses increased 3.7 percent, or 0.4 percent on a unit basis, year-over-year. The Company’s second quarter 2018 cost performance was better-than-expected due largely to shifting of certain expenses from second quarter into second half 2018.

Based on current cost trends, the Company estimates third quarter 2018 CASM, excluding fuel and oil expense and profitsharing expense, to increase in the two to three percent range, compared with third quarter 2017’s 8.22 cents, as recast, which excluded fuel and oil expense, profitsharing expense, and special items. The Company’s second half 2018 year-over-year increase includes approximately $30 million of costs, primarily advertising and technology expenses, shifting from first half 2018 into second half 2018, in addition to higher maintenance and advertising expenses. Due primarily to a two-point reduction in its fourth quarter 2018 ASM growth, the Company now estimates annual 2018 CASM, excluding fuel and oil expense and profitsharing expense, to be flat to up one percent, compared with annual 2017’s 8.47 cents, as recast, which excluded fuel and oil expense, profitsharing expense, and special items.

Last month, the Company reached a Tentative Agreement with the Aircraft Mechanics Fraternal Association (AMFA), which represents the Company’s 2,400 Employees in the Aircraft Mechanics and Related Employees workgroup. The estimated cost impact of this tentative collective-bargaining agreement is included in the Company’s third quarter and annual 2018 guidance.

Second Quarter Results
Second quarter 2018 operating income was $972 million, compared with $1.2 billion in second quarter 2017. Excluding special items, second quarter 2018 operating income was $967 million, compared with $1.2 billion in second quarter 2017.

Other expenses in second quarter 2018 were $12 million, compared with $50 million in second quarter 2017. The $38 million difference resulted primarily from $4 million in other losses recognized in second quarter 2018, compared with $44 million in second quarter 2017. In second quarter 2017, these losses included ineffectiveness and unrealized mark-to-market amounts associated with a portion of the Company’s fuel hedge portfolio, which are special items. Excluding these special items related to fuel hedging, other losses were $4 million in second quarter 2018, compared with $3 million in second quarter 2017. Net interest expense in second quarter 2018 was $8 million, compared with $6 million in second quarter 2017.

Second quarter 2018 net income was $733 million, or a second quarter record $1.27 per diluted share, compared with second quarter 2017 net income of $743 million, or $1.23 per diluted share. Excluding special items, second quarter 2018 net income was $729 million, or a second quarter record $1.26 per diluted share, compared with second quarter 2017 net income of $745 million, or $1.23 per diluted share, and compared with First Call second quarter 2018 consensus estimate of $1.22 per diluted share.

The Company estimates its effective tax rate to be approximately 23.5 percent for third quarter and annual 2018.

Liquidity and Capital Deployment
As of June 30, 2018, the Company had approximately $3.7 billion in cash and short-term investments, and a fully available unsecured revolving credit line of $1 billion. Net cash provided by operations during second quarter 2018 was $1.6 billion, capital expenditures were $521 million, and free cash flow was $1.1 billion. The Company repaid $75 million in debt and capital lease obligations during second quarter 2018, and expects to repay approximately $179 million in debt and capital lease obligations during the remainder of 2018.

During second quarter 2018, the Company returned $593 million to its Shareholders through the repurchase of $500 million in common stock and the payment of $93 million in dividends. The Company repurchased $500 million in common stock pursuant to an accelerated share repurchase (ASR) program launched during second quarter and received approximately 7.0 million shares, representing an estimated 75 percent of the shares expected to be repurchased under that ASR program. The ASR program is scheduled to terminate no later than July 31, 2018. On May 16, 2018, the Company’s Board of Directors approved a 28 percent increase in the Company’s quarterly dividend to $.16, or $.64 annually, and authorized a new $2.0 billionshare repurchase program upon the completion of the remaining $350 million under the May 2017 $2.0 billion share repurchase authorization.

For the six months ended June 30, 2018, net cash provided by operations was approximately $2.6 billion, capital expenditures were approximately $929 million, and free cash flow was $1.8 billion. This enabled the Company to return approximately $1.2 billion to Shareholders through the repurchase of $1.0 billion in common stock and the payment of $240 million in dividends.

The Company continues to estimate its annual 2018 capital expenditures to be in the $2.0 to $2.1 billion range.

Fleet and Capacity
The Company ended second quarter with 730 aircraft in its fleet. This reflects the second quarter 2018 delivery of 12 new 737-800s and 2 new 737 MAX 8s.

The Company expects to end 2018 with 751 aircraft in its fleet based on the current aircraft delivery schedule. Additional information regarding the Company’s aircraft delivery schedule is included in the accompanying tables.

The Company continues to expect its 2018 year-over-year ASM growth to be in the low four percent range, with third quarter 2018 year-over-year ASM growth in the 4.5 to 5 percent range and fourth quarter 2018 year-over-year ASM growth in the 6.5 to 7 percent range.

1Net margin is calculated as net income divided by operating revenues.
2Operating margin is calculated as operating income divided by operating revenues.
3See Note Regarding Use of Non-GAAP Financial Measures for additional information on special items, free cash flow, and ROIC. In addition, information regarding special items, ROIC, and economic results is included in the accompanying reconciliation tables.
4Net margin, excluding special items, is calculated as net income, excluding special items, divided by operating revenues. See Note Regarding Use of Non-GAAP Financial Measures. In addition, information regarding special items is included in the accompanying reconciliation tables.
5Operating margin, excluding special items, is calculated as operating income, excluding special items, divided by operating revenues. See Note Regarding Use of Non-GAAP Financial Measures. In addition, information regarding special items is included in the accompanying reconciliation tables.
6Based on the Company’s existing fuel derivative contracts and market prices as of July 20, 2018, third quarter 2018 fuel costs per gallon on a GAAP and economic basis are both estimated to be approximately $2.25. See Note Regarding Use of Non-GAAP Financial Measures.

Top Copyright Photo (all others by Southwest): Southwest Airlines Boeing 737-7H4 WL N705SW (msn 27839) (Shark Week 30th – Hammerhead) SNA (Michael B. Ing). Image: 942895.

Southwest aircraft slide show:

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