Financial Statement Analysis Southwest Airlines

Financial Statement Analysis

Southwest Airlines (the Company) prides itself as the nations low-fare, high Customer Satisfaction airline. The Company primarily serves shorthaul and mediumhaul city pairs, providing single-class air transportation, which targets business and leisure travelers. The Company was incorporated in Texas and commenced Customer Service in 1971, with three Boeing 737 aircraft serving three Texas cities -- Dallas, Houston, and San Antonio.

In 2006, the Company operated 481 Boeing 737 aircraft and serviced 63 airports in 32 states throughout the country. It continues to have one of the lowest operating cost structures in the domestic airline industry and consistently offers the lowest and simplest fares.

ASSESSMENT of 2006 FINANCIAL PERFORMANCE

Variance

2006 vs. 2005

2006 vs. 2004

Amount

OPERATING REVENUES

Passenger

B5-C5 # "#,##0" 1,471

E5/c5*100 # "0.00%" 20.21%

B5-D5 # "#,##0" 2,470

G5/d5*100 # "0.00%" 39.33%

Freight

B6-C6 1

E6/c6)*100 # "0.00%" 0.75%

B6-D6 17

G6/d6*100 # "0.00%" 14.53%

B7-C7 30

E7/c7*100 # "0.00%" 17.44%

B7-D7 69

G7/d7*100 # "0.00%" 51.88%

SUM (ABOVE) # "#,##0" 9,086

SUM (ABOVE) # "#,##0" 7,584

SUM (ABOVE) # "#,##0" 6,530

SUM (ABOVE) # "#,##0" 1,502

E8/c8*100 # "0.00%" 19.80%

SUM (ABOVE) # "#,##0" 2,556

G8/d8*100 # "0.00%" 39.14%

Amount in millions

For the past three years, operating revenues of the Southwest Airlines have continued to increase. Passenger revenues increased primarily due to an increase in capacity and in Revenue Passenger Mile (RPM) yield. Available Seat Mile (ASM) increased as a result of the net additions of 36 aircrafts in 2006 and 28 aircrafts in 2005. Average passenger fares increased 11.4% in 2005 and 5.8% in 2004, due to the strong demand for air travel and reduction of industry wide domestic capacity reductions.

Freight revenue in 2006 increased only by 1% compared its 14% increase in 2005. This is the result of the Company's decision to discontinue carrying mail for the U.S. Postal Service effective as of the end of the second quarter of 2006. However, this was offset by the higher rates charged for freight and cargo services.

Increase in other revenues for the past two years is due to higher commissions earned from Company sponsored programs with certain business partners such as the Chase® Visa Card and the increase in excess baggage charges in 2005.

Variance

2006 vs. 2005

2006 vs. 2004

Amount

OPERATING EXPENSES

Salaries, wages & benefits

B5-C5 # "##0" 270

E5/c5)*100 # "0.00%" 9.71%

B5-D5 # "##0" 474

G5/d5*100 # "0.00%" 18.39%

Fuel and Oil

B6-C6 797

E6/c6)*100 # "0.00%" 59.43%

B6-D6 1,138

G6/d6*100 # "0.00%" 113.80%

Maintenance materials and repairs

B7-C7 22

E7/c7)*100 # "0.00%" 4.93%

B7-D7 -4

G7/d7*100 # "0.00%" -0.85%

Aircraft rentals

B8-C8 -5

E8/c8*100 # "0.00%" -3.07%

B8-D8 -21

G8/d8*100 # "0.00%" -11.73%

Landing fees and other rentals

B9-C9 41

E9/c9*100 # "0.00%" 9.03%

B9-D9 87

G9/d9*100 # "0.00%" 21.32%

Depreciation and Amortization

B10-C10 46

E10/c10*100 # "0.00%" 9.81%

B10-D10 84

G10/d10*100 # "0.00%" 19.49%

Other operating expenses

B11-C11 122

E11/c11*100 # "0.00%" 10.13%

B11-D11 268

G11/d11*100 # "0.00%" 25.33%

SUM (ABOVE) # "#,##0" 8,152

SUM (ABOVE) # "#,##0" 6,859

SUM (ABOVE) # "#,##0" 6,126

SUM (ABOVE) # "#,##0" 1,293

E12/B12 # "0.00%" 0.16%

SUM (ABOVE) # "#,##0" 2,026

G12/d12*100 # "0.00%" 33.07%

Amount in millions

Salaries, wages and benefits represents 37%, 41% and 42% of the Company's operating expenses in 2006, 2005 and 2004 respectively. Salaries, wages and benefits per ASM increased in 2006 by 6% while decreased in 2005 by 2.4%. Increase in 2006 is primarily due to the increase in average wage rates, which is mostly offset by productivity efforts that have enabled the Company to decrease headcount per aircraft from 74 in 2004 to 71 in 2005 and to 68 in 2006 while decrease in 2005 is due to a reduction in share-based compensation expense.

Fuel and Oil expense represents 26%, 20% and 16% of operating expenses in 2006, 2005 and 2004 respectively. It also continues to increase as average jet fuel cost increases as it is impacted by several political and economic factors. The Company's fuel hedge position in 2006 weakened compared to 2005, but it still managed to reduce its fuel and oil expense of $634 million.

Maintenance materials and repairs increase in 2006 due to additional aircrafts but maintenance materials and repairs per ASM have continued to decreased from 1.9% compared to 2005 and 16% compared to 2004, which is primarily due to decrease in repair events for aircraft engines.

Aircraft rentals have continued decrease over the past years due to additional acquisitions of aircrafts while landing fees and other rentals increase due to increase in operations, but have continue to remain flat per ASM at 0.53 cents.

Depreciation expense increases per total and per ASM in 2006 due to the additional 36 aircraft acquired by the Company, while in 2005 depreciation per ASM decreased due to retirement of the Company 737-200 fleet and all 737-200 remaining spare parts during the year.

Other operating expenses increased per total and per ASM in 2006 due to increase in credit card processing fee and also in 2005 due to increase in security fees in the form of $24 million retroactive assessment the Company received from the Transportation Security Administration.

Variance

2006 vs. 2005

2006 vs. 2004

Amount

OTHER INCOME (EXPENSES), NET

Interest expense

E5/c5)*100 # "0.00%" -4.92%

B5-D5 # "#0" -40

G5/d5*100 # "0.00%" 0.00%

Interest income

B6-C6 37

E6/c6)*100 # "0.00%" 78.72%

B6-D6 63

G6/d6*100 # "0.00%" 300.00%

Capitalized interest

B7-C7 12

E7/c7)*100 # "0.00%" 30.77%

B7-D7 12

G7/d7*100 # "0.00%" 30.77%

Other gains (losses), net

B8-C8 (241)

E8/c8*100 # "0.00%" -267.78%

B8-D8 (114)

G8/d8*100 # "0.00%" 308.11%

SUM (ABOVE) ($144)

E9/B9 # "0.00%" 1.38%

G9/d9*100 # "0.00%" 121.54%

Amount in millions

Interest expense increased in 2006 and 2005 due to increase in floating interest rates, since majority of the Company's long-term debt is at floating interest rates. Interest income in 2006 and 2005 continued to increase as rates earned on cash and investments increased in both years. Capitalized interest increased in 2006 as a result of higher 2006 progress payment balances for scheduled aircraft deliveries in the future and also due to higher interest rates.

In 2006, primarily due to the significant decrease in fair values of the Company's fuel derivative and the loss of hedge accounting for specific hedges, the Company recognized $101 million of net loss while in 2005 the Company recognized $110 million net gain on its hedging activities.

Overall Assessment on Financial Performance

Variance

2006 vs. 2005

2006 vs. 2004

Amount

Revenues

B5-C5 # "##0" 1502

E5/c5)*100 # "0.00%" 19.80%

B5-D5 # "##0" 2556

G5/d5*100 # "0.00%" 39.14%

Operating expenses

B6-C6 (1,293)

E6/c6)*100 # "0.00%" 18.85%

B6-D6 (2,026)

G6/d6*100 # "0.00%" 33.07%

Operating income

B7-C7 209

E7/c7)*100 # "0.00%" 28.83%

B7-D7 530

G7/d7*100 # "0.00%" 131.19%

Other income (expenses), net

B8-C8 (198)

E8/c8*100 # "0.00%" -366.67%

B8-D8 (79)

G8/d8*100 # "0.00%" 121.54%

Income before income taxes

B9-C9 11

E9/c9*100 # "0.00%" 1.41%

B9-D9 451

G9/d9*100 # "0.00%" 133.04%

Provision for income taxes

B10-C10 4

E10/c10*100 # "0.00%" -1.36%

B10-D10 (167)

G10/d10*100 # "0.00%" 134.68%

NET INCOME

B11-C11 # "#0" 15

E11/B11 # "0.00%" 0.03%

SUM (ABOVE) # "##0" 284

G11/d11*100 # "0.00%" 132.09%

Amount in millions

Total revenues increased as revenue passengers carried increased due to new two destinations opened during 2006, the Denver and Washington Dulles and due to the passage of the Wright Amendment Reform Act in October 2006. Also average passenger fare increased from $93.68 in 2005 to $104.40 in 2006 to meet continues increase in jet fuel cost and to utilize increased demand on air travel as a result of the industry wide domestic capacity reductions.

Operating expenses primarily increased due to increase in jet fuel prices while other expenses increased due to the loss on hedging activities.

The Company continues to report its 34th consecutive year of profitability which is due to its continuous effort to provide excellent customer service while maintaining its low fare brand and continuing to enter effective fuel hedge programs.

MOST IMPORTANT FACTORS AFFECTING the COMPANY'S CURRENT PERFORMANCE

Key success factors in the airline industry as identified by Dr. Richard Mc. Cabe are as follows: (1) Attracting customers; (2) managing its fleet; (3) managing its people, and (4) managing its finances. The Company has done well in all four respects over the years, which is evidenced by its consecutive 34 years of profitability.

Attracting customers. Two factors of measurement are used with regard to these factors, first is the attractiveness of the airline's service and the other is the effectiveness of the airline's promotional expenditures. The Company commits itself in keeping their customers happy. Managers monitor how employees are treating their customers' everyday. Based on the statistics published in the Department of Transportation, the Company had the highest customer's satisfaction and best on time performance ranking of all major airlines during 2006. They also offers the lowest fares in the industry, which have paved way to what is called the "Southwest Effect," wherein number of flights increases in a new market (route) to which the Company enters.

Managing its fleet. This pertains to the optimization of an Airline's major assets, which is its airplanes, which is measure by its load factor, which is that percentage of an airplane's sets that are sold and actually filled at departure. The Company's load factor continues to increase from 69.5% in 2004, to 70.7% in 2005 to 73.1% in 2006. The Company is able to maximize its fleet by reducing its ground time (the amount of time planes spend on the ground at airports). Most airlines have an hour ground time compared to the Company's 15-20 minute ground time.

Managing People. Fortune magazine ranks the Company as one of the top 100 best companies to work for. The Company boasts of treating their employees like their customers, this has given the Company with the image and reputation of giving its customers the great value with their money. The dedication of its employees to provide customers with great satisfaction has been a powerful competitive weapon for the Company as its management claims.

Even with the rising labor cost, the Company has never laid off anyone in their 35 years of operations, which promotes a good management to employee relationship.

Managing its finances. The Company is the nations leading low fare brand and it also boast of its continuous financial success for the past 34 years, even amidst chaotic turmoil such as the 9/11 terrorist attack and raising fuel cost. The Company has well-known for its cost reduction strategies. For its ticketless travel options, which has eliminate the commission expense to be paid to travel agents, to standardizing the airplanes it uses, which reduces cost of maintenance, fleet managements and pilot training and to its best fuel hedging programs.

SUGGESTED FINANCIAL STRATEGIES for the NEXT FIVE YEARS

Many have criticized the Company for its soft domestic revenue trends. Rapid ratings have identified the Company's significant weaknesses in its leveraging rates and its sales performance. The Company's commitment to offer low fares in the expected rising ex-fuel CASM (cost per available seat mile) have cause some financial analyst to rate the Company as underperforming.