Southwest Airlines Co. (NYSE: LUV) (the "Company") today reported its second quarter 2017 results:
- Net income of $746 million, diluted earnings per share of $1.23, operating income of $1.25 billion, and operating margin1 of 21.8 percent
- Excluding special items2, net income of $748 million, diluted earnings per share of $1.24, operating income of $1.21 billion, and operating margin3 of 21.1 percent
- Second quarter operating cash flow of $746 million and second quarter free cash flow2 of $195 million
- Returned $476 million to Shareholders through a combination of dividends and share repurchases
- Return on invested capital (ROIC)2 for 12 months ended June 30, 2017, of 27.5 percent
Gary C. Kelly, Chairman of the Board and Chief Executive Officer, stated, "We are very pleased to report another terrific quarter. As expected, we produced positive unit revenues compared with the strong year-ago performance. We had several notable achievements during second quarter, but the headline was the deployment of our new reservation system on May 9th. It was an historic milestone, the largest technology project in our history, and perhaps, one of the largest ever in the airline industry. The implementation was virtually flawless, although a new system is always challenging for the users. I want to thank all of our People who were involved in the development and deployment. It was superb. And, I want to thank all of our Frontline Employees for their hard work in learning and using their new system. The operations since May 9th have been superb, also. Once again, our Employees showcased their unmatched Hospitality and delivered a reliable product—a truly impressive achievement considering the record number of flights, Customers, and bags. Congratulations to our People and our Shareholders on a strong financial performance, which generated $202 million in profitsharing and $476 million in Shareholder returns."
Revenue Results and Outlook
The Company's total operating revenues increased 6.7 percent, year-over-year, to a quarterly record $5.7 billion, driven largely by quarterly record passenger revenues of $5.2 billion. Demand for Southwest's low fares remained strong, and the fare environment improved. The Company's second quarter load factor of 85.6 percent was a quarterly record performance, with passenger revenue yield increasing 1.5 percent, year-over-year. Operating unit revenues (RASM) also increased 1.5 percent, year-over-year. This included less than one point of temporary pressure attributable to the transition to the new reservation system. While the impact from the reservation system cutover is slightly greater than anticipated, adjustments are underway and expected to largely be implemented by the end of 2017.
Based on these trends and current bookings, the Company expects its third quarter 2017 year-over-year RASM growth to be approximately one percent, which includes an estimated year-over-year unfavorable impact from the transition to the new reservation system of approximately one point. The Company currently does not expect a significant unfavorable impact from the transition to the new reservation system beyond third quarter 2017. Third quarter 2017 year-over-year RASM comparisons also will be impacted by last July's technology outage and the timing of the July 4th holiday in 2017, which roughly offset on a unit basis. Mr. Kelly said, "Considering the complexities of implementing a new reservation system for a company of our size, as well as our significant industry outperformance last year, we are very pleased with our revenue performance, and our goal to grow annual 2017 unit revenues remains intact. We continue to expect the annual incremental benefits from the new reservation system capabilities to ramp up to an estimated $200 million in pretax profits in 2018."
Cost Performance and Outlook
Second quarter 2017 total operating expenses increased 9.4 percent to $4.5 billion, or 4.1 percent on a unit basis, as compared with second quarter 2016. During second quarter 2017, the Company recorded lease termination costs of $8 million (before profitsharing and taxes) as a result of the acquisition of two of its Boeing 737-300 (Classic) aircraft previously under operating leases. Second quarter 2016 operating expenses included a $21 million impairment charge (before profitsharing and taxes) for the intangible assets associated with the Company's Newark Liberty International Airport slots4 as a result of the Federal Aviation Administration (FAA) announcement in April 2016 that Newark would be designated as a Level 2 schedule-facilitated airport. Excluding special items in both periods, total operating expenses increased 10.1 percent to $4.5 billion, or 4.7 percent on a unit basis, year-over-year. Second quarter 2017 economic fuel costs2 were $1.93 per gallon, including $0.32 per gallon in unfavorable cash settlements from fuel derivative contracts, compared with $1.81 per gallon in second quarter 2016, which included $0.42 per gallon in unfavorable cash settlements from fuel derivative contracts. Based on the Company's existing fuel derivative contracts and market prices as of July 21, 2017, third quarter 2017 economic fuel costs are estimated to be in the $1.95 to $2.00 per gallon range5. As of July 21, 2017, the fair market value of the Company's fuel derivative contracts settling during the second half of 2017 was a net liability of approximately $361 million, and the fair market value of the hedge portfolio settling in 2018, 2019, and 2020 combined, was a net asset of approximately $103 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 2017 operating expenses increased 9.8 percent, as compared with second quarter 2016. Second quarter 2017 profitsharing expense was $202 million, compared with an all-time quarterly record $206 million in second quarter 2016. Excluding fuel and oil expense, special items, and profitsharing expense, second quarter 2017 operating expenses increased 10.6 percent, or 5.3 percent on a unit basis, year-over-year. Approximately two-thirds of this unit cost increase was associated with the significant snap-up in wage rates due to Flight Attendant and Pilot amended collective-bargaining agreements that became effective in fourth quarter 2016. One-time implementation costs related to several significant technology projects, including the successful implementation of the Company's new reservation system in May, also contributed to the second quarter 2017 year-over-year cost increase.
Based on current cost trends, the Company estimates third quarter 2017 unit costs, excluding fuel and oil expense, special items, and profitsharing expense, will increase in the two to three percent range, year-over-year6. As of July 25, 2017, the scheduled grounding of the Company's remaining Classic aircraft in third quarter 2017 included 21 leases that are being retired prior to the end of their lease terms. Therefore, the Company expects to record a charge of approximately $60 million, primarily related to the remaining lease payments due as of the cease-use date. Additional charges could be recorded in third quarter 2017 associated with certain lease return requirements that may have to be performed on such aircraft prior to their return to the lessor; however, the Company does not expect the charges to be significant. The Company expects these grounding-related charges will be considered special items. The Company continues to expect the accelerated retirement of its Classic aircraft in 2017 to produce significant incremental cost savings and improved pretax profits of at least $200 million, cumulatively, by the end of 2020.
The Company expects fourth quarter 2017 unit costs to be in line with year-ago levels, excluding fuel and oil expense, special items, and profitsharing expense, due to tailwinds associated with the retirement of its Classic fleet by the end of the third quarter, the lapse of the step-up in wage rates from labor collective-bargaining agreements ratified in 2016, and the wind-down of temporary costs associated with the implementation of the new reservation system6.
Second Quarter Results
Second quarter 2017 operating income was $1.25 billion, compared with $1.28 billion in second quarter 2016. Excluding special items, second quarter 2017 operating income was $1.21 billion, compared with $1.27 billion in second quarter 2016.
Other expenses in second quarter 2017 were $80 million, compared with other income of $28 million in second quarter 2016. The $108 million difference resulted primarily from $74 million in other losses recognized in second quarter 2017, compared with $43 million in other gains recognized in second quarter 2016. In both periods, these gains and 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, other losses were $34 million in second quarter 2017, compared with other losses of $48 million in second quarter 2016, primarily attributable to the premium costs associated with the Company's fuel derivative contracts. Third quarter 2017 premium costs related to fuel derivative contracts are currently estimated to be approximately $35 million, compared with $34 million in third quarter 2016. Net interest expense in second quarter 2017 was $6 million, compared with $15 million in second quarter 2016.
Second quarter 2017 net income was $746 million, or $1.23 per diluted share, compared with second quarter 2016 net income of $820 million, or a quarterly record $1.28 per diluted share. Excluding special items, second quarter 2017 net income was $748 million, or a quarterly record $1.24 per diluted share, compared with second quarter 2016 net income of $757 million, or $1.19 per diluted share, and compared with First Call second quarter 2017 consensus estimate of $1.20 per diluted share.
Liquidity and Capital Deployment
As of June 30, 2017, the Company had approximately $3.2 billion in cash and short-term investments, and a fully available unsecured revolving credit line of $1 billion. During the second quarter, Moody's Investors Service upgraded the Company's senior unsecured debt to A3 from Baa1. Net cash provided by operations during second quarter 2017 was $746 million, capital expenditures were $551 million, and free cash flow was $195 million2. The Company repaid $59 million in debt and capital lease obligations during second quarter 2017, and expects to repay approximately $136 million in debt and capital lease obligations during the remainder of 2017. In second quarter 2017, the Company funded the $586 million ProfitSharing award associated with its 2016 results.
During second quarter 2017, the Company returned $476 million to its Shareholders through the payment of $76 million in dividends and the repurchase of 6.6 million shares in common stock for $400 million, which completed its previous $2.0 billion share repurchase program. The common stock repurchased was pursuant to an accelerated share repurchase program launched during second quarter 2017 and completed this month. On May 17, 2017, the Company's Board of Directors authorized a new $2.0 billion share repurchase program, along with a 25 percent increase in the Company's quarterly dividend. The Company has the full $2.0 billion remaining under its May 2017 share repurchase authorization.
For the six months ended June 30, 2017, net cash provided by operations was $2.4 billion, capital expenditures were $965 million, and free cash flow was $1.4 billion2. This enabled the Company to return $1.1 billion to Shareholders through the repurchase of $950 million in common stock, pursuant to its previous $2.0 billion share repurchase program, and the payment of $199 million in dividends.
Fleet and Capacity
The Company ended second quarter 2017 with 735 aircraft in its fleet. This reflects the second quarter 2017 delivery of 13 new Boeing 737-800s and 5 pre-owned Boeing 737-700s, as well as the retirement of 10 Classic aircraft. During the second quarter, the Company also added three pre-owned 737-700 aircraft to its fleet order book to be delivered this year for 2018 service. Subsequent to June 30, 2017, the Company added one additional pre-owned 737-700 aircraft to its fleet order book to be delivered this year for 2018 service. With the addition of these four pre-owned 737-700 aircraft to its order book, the Company deferred its four remaining 737-800 options in 2018 and converted them to four Boeing 737 MAX 8 options, two in 2021 and two in 2022. As of July 25, 2017, there were 67 Classic aircraft remaining in the Company's fleet that it intends to retire by the end of third quarter 2017. Total aircraft, net of all Classic retirements, is expected to decline to 707 by year-end 2017 and grow to 750 aircraft by year-end 2018, as previously announced.
The Company currently expects its third quarter 2017 available seat miles (ASMs) to increase in the four to five percent range and its fourth quarter 2017 ASMs to increase in the one to two percent range, compared with the same year-ago periods. While the Company has not finalized its 2018 capacity plans, it currently estimates year-over-year ASM growth to be less than four percent in the first half of 2018, and its full year 2018 ASM growth to be less than its 2016 year-over-year ASM growth of 5.7 percent. Additional information regarding the Company's aircraft delivery schedule is included in the accompanying tables.
The Company continues to fine tune its network and introduce new markets that not only strengthen its Customer brand appeal, but also support its revenue and profitability targets. In late April, the Company began international service daily between San Diego and San Jose del Cabo/Los Cabos, Mexico. In June, the Company consolidated its Ohio operations and launched service to Cincinnati/Northern Kentucky International Airport. The same day, the Company also launched service to Grand Cayman from Ft. Lauderdale-Hollywood International Airport (FLL). Additionally, the Company has announced plans to concentrate its service to Cuba in Havana and will cease operations at Varadero and Santa Clara in September. In November, the Company expects to begin international nonstop service weekly from both Nashville and St. Louis to Cancun (CUN), as well as daily service between Providenciales, Turks & Caicos and FLL beginning in the same month, all subject to requisite governmental approvals. And just this morning, the Company published a flight schedule extension through April 6, 2018, which includes new international service weekly between Indianapolis and CUN that is expected to begin in March 2018 and is also subject to governmental approvals.