Southwest Airlines Co. (NYSE:LUV) (the "Company") today reported its third quarter 2018 results:
Record third quarter net income of $615 million
Net income of $614 million, excluding special items1
Record third quarter earnings per diluted share of $1.08
Operating income of $798 million, or $796 million, excluding special items
Operating margin2 of 14.3 percent, and net margin3 of 11.0 percent
Operating cash flow of $1.3 billion, and free cash flow1 of $817 million
Returned $591 million to Shareholders through a combination of share repurchases and dividends
Return on invested capital (ROIC)1 pre-tax of 23.4 percent for the 12 months ended September 30, 2018, or 18.1 percent on an after-tax basis
Gary C. Kelly, Chairman of the Board and Chief Executive Officer, stated, "I want to congratulate our Employees on an excellent third quarter 2018 performance, resulting in record third quarter earnings per diluted share. The significant increase in our third quarter 2018 earnings per diluted share was driven by record third quarter operating revenues, lower federal income taxes, and a 4.8 percent year-over-year reduction in share count. Despite higher jet fuel prices and other cost pressures, we grew our third quarter 2018 net margin, year-over-year, which is a notable accomplishment.
"I am grateful to our People for their hard work and resilience, as we continue to consistently deliver stellar margins and returns. With these results, we accrued an additional $135 million in profitsharing for the benefit of our Employees and provided $591 million of share buybacks and dividends for our Shareholders.
"As we finish the year, our revenue momentum has continued into fourth quarter 2018, thus far. Unit revenue trends are stable and have recovered nicely from first half 2018. We are particularly pleased with the performance of our new revenue management tools. With our new reservation system in place since last year, we have more capabilities and are well-positioned to drive revenue growth. We expect $80 million to $90 million of year-over-year improvement in fourth quarter 2018 pre-tax results from these enhanced capabilities, which is in line with our annual 2018 pre-tax goal of $200 million.
"On the cost side, our third quarter 2018 unit cost performance was in line with our expectations. Our fuel hedge portfolio mitigated a significant portion of market jet fuel price increases, and we are pleased with the fuel hedge in place for both fourth quarter 2018 and annual 2019. Based on current trends, we continue to expect modest year-over-year inflation in our annual 2018 unit costs, excluding fuel and oil expense and profitsharing expense.
"Based on our second half 2018 revenue trends, we are well-positioned for year-over-year unit revenue growth in 2019, with easier year-over-year comparisons in first half. We also will continue to experience year-over-year unit cost inflation in 2019, excluding fuel and oil expense and profitsharing expense, of at least three percent, as we continue investing in and deploying new operations, technology, and airport infrastructure to support future growth. With the 2017 retirement of our Boeing 737-300 Classic fleet, launch of the 737 MAX, and implementation of our new reservation system, we continue with our efforts to modernize our fleet, optimize our network, and pursue additional revenue opportunities. Given our healthy revenue outlook, and despite expected cost increases, our 2019 goal is to expand margins year-over-year. We are refocusing our efforts to control costs and drive efficiency, and, as ever, we remain steadfast in our efforts to produce industry-leading margins and superior returns in excess of our cost of capital.
"For next year, Hawaii is our expansion focus, and we continue to expect 2019 available seat miles (ASMs, or capacity) to increase no more than five percent, year-over-year."
Revenue Results and Outlook
The Company's third quarter 2018 total operating revenues increased 5.1 percent, year-over-year, to a third quarter record $5.6 billion. Third quarter 2018 operating revenue per ASM (RASM, or unit revenues) increased 1.2 percent, year-over-year, driven largely by a passenger revenue yield increase of 2.3 percent, year-over-year, offset slightly by a load factor decline of 0.9 points, year-over-year, to 83.9 percent. Third quarter 2018 RASM also included an approximate one-half point year-over-year positive impact as a result of approximately 2,200 flight cancellations in third quarter 2018, due to thunderstorms and weather-related disruptions (the "weather cancellations").
Based on current bookings and yield trends, the Company expects fourth quarter 2018 RASM to increase in the one to two percent range, compared with fourth quarter 2017 RASM of 13.88 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 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 nine months ended September 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. The Company's third quarter 2018 year-over-year RASM increase included an approximate one point headwind from the change in the Rapid Rewards revenue recognition method as a result of the Company's adoption of the New Revenue Standard. The Company continues to expect an immaterial impact to its fourth quarter and annual 2018 year-over-year RASM trends as a result of the New Revenue Standard.
Cost Performance and Outlook
Third quarter 2018 total operating expenses increased 7.2 percent, year-over-year, to $4.8 billion. Total operating expenses per ASM (CASM, or unit costs) increased 3.1 percent, as compared with third quarter 2017. Excluding special items in both periods, third quarter 2018 total operating expenses increased 8.1 percent to $4.8 billion, or 4.1 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 nine months ended September 30, 2017, has been recast under the new standard to be comparable with current period results.
Third quarter 2018 economic fuel costs1 were $2.25 per gallon and included $.06 per gallon in premium expense and $.10 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. Third quarter 2018 ASMs per gallon, or fuel efficiency, improved 1.1 percent year-over-year, driven primarily by the retirement of the Classic fleet and the addition of more fuel-efficient 737-800 and 737 MAX 8 aircraft.
Based on the Company's existing fuel derivative contracts and market prices as of October 19, 2018, fourth quarter 2018 economic fuel costs are estimated to be in the range of $2.30 to $2.35 per gallon4, including $.07 per gallon in premium expense and an estimated $.14 per gallon in favorable cash settlements from fuel derivative contracts, compared with $2.16 per gallon in fourth quarter 2017, as recast, which included $.07 per gallon in premium expense and $.19 per gallon in unfavorable cash settlements from fuel derivative contracts. As of October 19, 2018, the fair market value of the Company's fuel derivative contracts settling in fourth quarter 2018 was an asset of approximately $82 million, and the fair market value of the hedge portfolio settling in 2019 and beyond was an asset of approximately $521 million.
Based on the Company's existing fuel derivative contracts and market prices as of October 19, 2018, annual 2019 economic fuel costs are estimated to be in the range of $2.35 to $2.40 per gallon4, including $.04 per gallon in premium expense and an estimated $.08 per gallon in favorable cash settlements from fuel derivative contracts. 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, third quarter 2018 operating expenses increased 7.0 percent, as compared with third quarter 2017. Third quarter 2018 profitsharing expense was $135 million, as compared with $127 million in third quarter 2017. Excluding fuel and oil expense, profitsharing expense, and special items, third quarter 2018 operating expenses also increased 7.0 percent, or 3.0 percent on a unit basis, year-over-year. This increase was due primarily to shifting of spending from first half 2018 into third quarter 2018, higher maintenance and advertising expenses, and a nearly one-point year-over-year negative impact as a result of the third quarter 2018 weather cancellations.
Based on current cost trends, the Company estimates fourth quarter 2018 CASM, excluding fuel and oil expense and profitsharing expense, to be flat to up one percent, compared with fourth quarter 2017's 8.82 cents, as recast, which excluded fuel and oil expense, profitsharing expense, and special items. The Company continues to estimate 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.
Third Quarter Results
Third quarter 2018 net income was a third quarter record $615 million, or a record third quarter $1.08 per diluted share, compared with third quarter 2017 net income of $528 million, or $.88 per diluted share. Excluding special items, third quarter 2018 net income was $614 million, or a third quarter record $1.08 per diluted share, compared with third quarter 2017 net income of $554 million, or $.93 per diluted share, and compared with First Call third quarter 2018 consensus estimate of $1.06 per diluted share.
The Company estimates its effective tax rate to be approximately 23 percent for annual 2018. For annual 2019, the Company estimates its effective tax rate to be approximately 23.5 percent.
Liquidity and Capital Deployment
As of September 30, 2018, the Company had approximately $3.8 billion in cash and short-term investments, and a fully available unsecured revolving credit line of $1 billion. Net cash provided by operations during third quarter 2018 was $1.3 billion, capital expenditures were $454 million, and free cash flow was $817 million. The Company repaid $98 million in debt and capital lease obligations during third quarter 2018, and expects to repay approximately $87 million in debt and capital lease obligations during fourth quarter 2018.
During third quarter 2018, the Company returned $591 million to its Shareholders through the repurchase of $500 million in common stock and the payment of $91 million in dividends. The Company repurchased 8.2 million shares of common stock pursuant to a $500 million accelerated share repurchase program (ASR) launched during third quarter 2018 and completed earlier this month. The Company's third quarter ASR completed the remaining $350 million of its previous $2.0 billion share repurchase program that had been authorized by its Board of Directors in May 2017, and initiated the $2.0 billion share repurchase program authorized by its Board of Directors in May 2018. The Company has $1.85 billion remaining under its current authorization.
For the nine months ended September 30, 2018, net cash provided by operations was approximately $3.9 billion. Capital expenditures, including net proceeds from assets constructed for others, were approximately $1.3 billion, and free cash flow was $2.6 billion. This enabled the Company to return approximately $1.8 billion to Shareholders through the repurchase of $1.5 billion in common stock and the payment of $332 million in dividends.
The Company continues to estimate its annual 2018 capital expenditures to be in the $2.0 to $2.1 billion range. For annual 2019, capital expenditures are expected to be similar to 2018 levels.
Fleet and Capacity
The Company ended third quarter 2018 with 742 aircraft in its fleet. This reflects the third quarter delivery of five new 737-800s and seven new 737 MAX 8s. The Company continues to expect 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 now expects its annual 2018 year-over-year ASM growth to be approximately four percent, slightly lower than previously expected, due primarily to the third quarter 2018 weather cancellations. The Company now expects fourth quarter 2018 year-over-year ASM growth to be in the 6.0 to 6.5 percent range.
Awards and Recognitions
Ranked #2 on the list of Top-Rated Workplaces in 2018 by Indeed
Ranked among the Best Airline Rewards Programs by U.S. News & World Report
Named a Best Employer for Women 2018 by Forbes
Among Forbes's list of America's Best Employers for New Graduates 2018
Named the Best Airline for Family Travel by The Points Guy