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.