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SOUTHWEST AIRLINES CO.
ANNUAL REPORT PROJECT
MICHAEL HSUN
BUS 210-00A
http://southwest.investorroom.com/download/2012+Annual+Report.PDF
Introduction
CEO: Gary C. Kelly
Headquarters: Dallas, TX
Ending date of latest fiscal year: Dec 30, 2012
Southwest Airlines provides scheduled air transportation services in the United States. It is the third largest airline in the United States by passenger carriage and operates using a low cost, point-to-point transit model.
97 destinations across 41 states, and six international Central American countries.
Audit Report
Independent Auditors:
Ernst & Young LLP of Dallas, Texas
The financial statements presented fairly the
consolidated financial position, results of
operations, and cash flows of Southwest
Airlines Co. in conformity with US generally
accepted accounting principles.
Stock Market Information
Most recent closing price: $13.86
52 week range: $8.45 to $14.56
Dividend per share (last quarter): $0.04
As of June 18, 2013
Stock Market Information
Recommendation: HOLD
Significant cost creep:
Unit costs 30% higher than low fare competitor-leader Allegiant
Industry high labor costs
Revenue growth lagging behind peers
Missed 15% ROIC target for 2012
Long term outlook seeks cost synergies from AirTran acquisition and development of new, ancillary revenue streams (i.e. checked baggage fees)
Strong capacity growth (more than doubled since 2000)
Income Statement
• The above format is in a single-step format
• While revenues and corresponding net income are increasing
strongly, a fall in operations income suggests that the company’s
operational costs are increasing
(In Millions) 2012 2011
Gross profit 8,438 7,792
Income from operations 623 693
Net income 421 178
Balance Sheet
• Assets grew primarily through an increase in flight equipment
(aircraft)
• Liabilities grew by approximately the same amount through an
increase in air traffic liability.
• Stockholders’ equity decreased slightly to remain approximately the
same
(In Millions) Assets = Liabilities + Stockholders’ Equity
2012 18,596 11,604 6,692
2011 18,068 11,191 6,877
Statement of Cash Flows
• Cash flows from operations are significantly higher than net income
• The company is growing through investing activities, especially through recent
purchases of new flight equipment (aircraft)
• The company’s two primary sources of financing are proceeds from employee
stock plans and proceeds from the termination of interest rate derivative
instrument
• Cash has increased by approximately $2 billion in the last two years
(In Millions) 2012 2011
Operating Activities 2,064 1,356
Investing Activities (833) (1,022)
Financing Activities (947) (766)
Accounting Policies
Revenue recognition: Tickets sold are initially deferred as Air traffic
liability. Passenger revenue is recognized when transportation is
provided. The Company estimates the amount of tickets that expire
unused and recognizes such amounts in Passenger
Accounts and other receivables: Accounts and other receivables are
carried at cost. They primarily consist of amounts due from credit card
companies associated with sales of tickets for future travel, amounts
due from business partners in the Company’s frequent flyer programs,
and amounts due from counterparties associated with fuel derivative
instruments that have settled.
Accounting Policies
Inventories: Inventories consist primarily of aircraft fuel, flight equipment expendable parts, materials, and supplies. All of these items are carried at average cost, less an allowance for obsolescence. These items are generally charged to expense when issued for use.
Short-term and noncurrent investments: Short-term investments consist of investments with original maturities of greater than three months but less than twelve months when purchased. These are primarily short-term securities issued by the U.S. Government and certificates of deposit issued by domestic banks. All of these investments are classified as available-for-sale securities and are stated at fair value, which approximates cost.
Property and equipment: Property and equipment is stated at cost. Depreciation is provided by the straight-line method to estimated residual values over periods generally ranging from 23 to 25 years for flight equipment and 5 to 30 years for ground property and equipment once the asset is placed in service.
Topics of Notes to Financial Statements
Cash and cash equivalents
Short-term and noncurrent
investments
Accounts and other receivables
Inventories
Property and equipment
Aircraft and engine maintenance
Goodwill and intangible assets
Revenue recognition
Frequent flyer programs
Advertising
Share-based Employee
compensation
Financial derivative instruments
Software capitalization
Income taxes
Concentration risk
Financial Analysis
Liquidity Ratios
Liquidity Ratio Formula 2012 2011
Working capital CA – CL 4,227 – 4,650 =
(423)
4,345 – 4,533 =
(188)
Current ratio CA/CL 4,227/4,650
= 0.92
4,345/4,533
= 0.96
Receivables
turnover
Net
Sales/Averag
e AR
17,088/[(332 +
299)/2] = 54.2
15,658/[(195 +
299)/2] = 63.4
Average days’
sales
uncollected
Days/Receiv
ables
turnover
366/54.2 = 6.75 365/63.4 = 5.76
Inventory
turnover
COGS/Avera
ge Inv.
13,399/[(469 +
401)/2] = 30.8
12,237/[(401 +
243)/2] = 38.0
Financial Analysis
Liquidity Ratios
Liquidity Ratio Formula 2012 2011
Average days’
inventory on hand
Days/Inventory
turnover
366/30.8 = 11.9 365/38.0 =
9.61
Operating cycle Days inventory
+ Days sales –
Days payable
11.9 + 6.75 –
12.4 = 6.25
9.61 + 5.76 –
13.6 = 1.77
Payables turnover COGS/Average
AP
13,399/[(1107+
1057)/2] = 12.4
12,237/[(1057
+739)/2] =
13.6
Average days’
payables
Days/Payables
turnover
366/12.4 = 29.5 365/13.6 =
26.8
Financial Analysis
Liquidity Ratios
Although working capital and the current
ratio is declining, Southwest has over $1B in
cash which decreases the risk of non-
payment to creditors
Operating cycle increased significantly, but
Southwest is still self-financing
Overall liquidity remains strong, bolstered
particularly by a strong cash position
Financial Analysis
Profitability Ratios
(In Millions) Formula 2012 2011
Profit margin Net
income/Reven
ue
421/17,088 =
2.46%
178/15,658= 1.14%
Asset
turnover
Revenue/Aver
age Total
Assets
17,088/[(18,596 +
18,068)/2] = 0.93
15,658/[(18,068 +
15,463)/2] = 0.93
Return on
assets
Net
Income/Avera
ge Total
Assets
421/[(18,596 +
18,068)/2] =
2.30%
178/[(18,068 +
15,463)/2] = 1.06%
Return on
equity
Net
Income/Avera
ge Total SHE
421/[(6,992 +
6,887)/2] = 6.07%
178/[(6,887 +
6,237)/2] = 2.71%
Financial Analysis
Profitability Ratios
Profit margin improved slightly, marking 40
consecutive years of profits – an outlier in
the airline industry
Asset turnover, a measure of revenue
generation efficiency, remained flat, but high
compared to its competitors
ROA and ROE improved significantly, helped
by ongoing AirTran acquisition synergies
Financial Analysis
Market Strength Ratios
(In Millions) Formula 2012 2011
Price/earnings per
share
Price per
share/EPS
10.24/0.56 =
18.3
8.56/0.23 =
37.2
Dividend yield Annual
dividends per
share/PPS
.0345/10.24
= .337%
.0180/8.56 =
.210%
Financial Analysis
Market Strength Ratios
• P/E Ratio has declined significantly; no
longer overvalued
• Southwest nearly doubled its dividend in
2012 on the back of improved profitability
and operating metrics
• Dividend growth is expected to continue, as
demonstrated with the recent 2013
announcement of a quadrupling the regular
quarterly dividend to $0.04
Financial Analysis
Solvency Ratios
(In Millions) Formula 2012 2011
Debt to equity Total
Liabilities/Total
Equity
11,604/6,992 =
1.65
11,191/6,887 =
1.62
Financing gap Operating
Cycle > Days
Payable
6.25 < 29.5 =
Self-financing
1.77 < 26.8 =
Self-financing
Financial Analysis
Solvency Ratios
A debt to equity ratio greater than one
indicates that creditors control the company
Low interest rates in recent years have
allowed Southwest to increase its debt to
equity ratio without jeopardizing the
company’s financial health
Southwest is self-financing; no financing gap
exists
Industry & Company Plans
In the last decade, the US airline industry has
undergone an unprecedented period of
restructuring and consolidation. Today, airlines
are returning to profitability and the industry
has stabilized into a sustainable one. (http://www.bloomberg.com/news/2013-06-02/u-s-carriers-ready-to-go-
on-attack-after-mergers-iata-predicts.html)
Among the four legacy carriers that remain
(United, Delta, American, and Southwest),
Southwest is extremely well positioned to
capture market share and demand for low-cost
travel.
Industry & Company Plans
Southwest is currently in the process of acquiring AirTran Airways which will make it the biggest low-cost carrier in North America when complete. The scale and network of the combined carriers will solidify its position as the world’s third largest airline by passenger carriage.
In addition, Southwest is beginning to foray into international markets. International passenger growth of 4.7% versus 3.1% for domestic passengers last year signal widespread opportunities for future growth in international markets. (FAA Aerospace Forecast Fiscal Years 2012-2032)
Industry & Company Plans
Southwest has indicated that in light of industry
consolidation, it no longer aims to offer the
lowest fares, but rather become the dominant
carrier on the routes it serves. The industry as
a whole is limiting passenger carriage growth
in favor of stronger yields and sustainable
airfares.
http://www.southwestonereport.com/2012/
http://business.time.com/2013/03/26/southw
est-airlines-were-not-really-about-cheap-
flights-anymore/
Executive Summary
The airline industry has witnessed a
remarkable structural shift in the last decade.
Consolidation has led to sustainable pricing,
greater efficiency, and stronger route
optimization.
Southwest has benefited, and will continue
benefit strongly from these developments. Its
consistently profitable business model and
strong management practices will continue to
uphold and strengthen its competitiveness.
Executive Summary
Southwest is highly efficient at managing capital. Extra cash is used to buyback shares and expand capacity while taking advantage of favorable fuel hedging contracts and attractively-priced acquisitions (most notably, the AirTran acquisition).
Airline bankruptcies in the last decade have allowed legacy carriers to renegotiate labor contracts and lower labor costs. But Southwest has not had the opportunity to renegotiate and restructure its labor contracts, whose costs are now among the highest in the industry.
Executive Summary
In addition, Southwest has been slow to
expand into international markets where
competitors such as JetBlue have thrived.
After missing its 15% ROIC target for 2012, a
conservative management has largely failed in
efforts to keep Southwest a formidable
competitor.
Despite these concerns, Southwest’s strong
financial position will allow it to grow and invest
in a restructured industry.