Southwest Airlines Co.
(unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of Southwest Airlines Co. (Company or Southwest) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The unaudited condensed consolidated financial statements for the interim periods ended September 30, 2010 and 2009 include all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. This includes all normal and recurring adjustments, b ut does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Financial results for the Company, and airlines in general, can be seasonal in nature. In many years, the Company’s revenues, as well as its operating income and net income, have been better in its second and third fiscal quarters than in its first and fourth fiscal quarters. Air travel is also significantly impacted by general economic conditions, the amount of disposable income available to consumers, unemployment levels, and corporate travel budgets. These and other factors, such as the price of jet fuel in some periods, the nature of the Company’s fuel hedging program, the periodic volatility of commodities used by the Company for hedging jet fuel, and the requirements related to hedge accounting, have created, and may continue to create, significant volatility in the Company’s results in certain fisc al periods. See Note 5 for further information on fuel and the Company’s hedging program. Operating results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ended December 31, 2010. For further information, refer to the consolidated financial statements and footnotes thereto included in the Southwest Airlines Co. Annual Report on Form 10-K for the year ended December 31, 2009.
2. MERGER AND RELATED MATTERS
On September 26, 2010, Southwest, AirTran Holdings, Inc. (“AirTran”), and Guadalupe Holdings Corp. (“Merger Sub”) entered into an Agreement and Plan of Merger (the “Merger Agreement”), providing for the acquisition of AirTran by Southwest. The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Merger Sub, a wholly owned subsidiary of Southwest formed for the sole purpose of effecting the merger, will be merged with and into AirTran, with AirTran continuing as the surviving corporation and as a wholly owned subsidiary of Southwest (the “Merger”). Immediately following the effective time of the Merger, AirTran will merge with and into a wholly owned limited liability company subsidiary of Southwest.
Subject to the terms and conditions of the Merger Agreement, which has been unanimously approved by the boards of directors of the respective parties, if the Merger is completed, each outstanding share of AirTran common stock will be converted into the right to receive 0.321 shares of Southwest common stock, which exchange ratio may be adjusted as discussed below, and $3.75 in cash, without interest. If the average closing price of Southwest common stock for the 20 consecutive trading day period ending on (and including) the third trading day prior to the closing of the Merger (the “Southwest Average Share Price”) is greater than $12.46, then the exchange ratio will be adjusted to equal $4.00 divided by the Southwest Average Share Price, rounded to the nearest thousandth. If the Southwest Average Share Price is l ess than $10.90, then, subject to the next sentence, the exchange ratio will be adjusted to equal $3.50 divided by the Southwest Average Share Price, rounded to the nearest thousandth. If the Southwest Average Share Price is less than $10.90, Southwest must deliver, at its election, an additional amount of cash, an additional number (or fraction) of shares of Southwest common stock, or a combination of both, such that, after giving effect to such election, the aggregate value of the Merger consideration is equal to $7.25. The exchange ratio adjustment mechanism provides at least $7.25 in value and up to $7.75 in value (based on the Southwest Average Share Price) per share of AirTran common stock.
Completion of the Merger is subject to certain conditions, including, among others: (i) adoption of the Merger Agreement by AirTran’s stockholders, (ii) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, (iii) receipt of any other material governmental consents and approvals required to consummate the Merger, (iv) the absence of any governmental order, law, or legal restraint prohibiting the consummation of the Merger, (v) the registration statement on Form S-4 used to register the Southwest common stock to be issued as consideration for the Merger having been declared effective by the Securities and Exchange Commission (the “SEC”), and (vi) authorization of the listing on the New York Stock Exchange of the shares of Southwest common stock to be issued to AirTran stockholders pursuant to the Merger. The obligation of each party to consummate the Merger is also conditioned upon the accuracy of the other party’s representations and warranties and the other party having performed in all material respects its obligations under the Merger Agreement.
Southwest and AirTran may mutually agree to terminate the Merger Agreement at any time prior to the effectiveness of the Merger. In addition, either party may terminate the Merger Agreement (i) if the Merger is not consummated on or before September 26, 2011 (subject to extension by mutual agreement of the parties), (ii) if the approval of AirTran’s stockholders is not obtained, (iii) in connection with certain competing transactions, and (iv) for certain other reasons, as set forth in the Merger Agreement. The Merger Agreement further provides that, upon termination of the Merger Agreement under specified circumstances, including termination of the Merger Agreement in connection with a competing transaction, AirTran may be required to pay to Southwest a termination fee of $39 million.
The foregoing description of the Merger Agreement is only a summary, does not purport to be complete and is qualified in its entirety by reference to the Merger Agreement, which is attached as Exhibit 2.1 to Southwest’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on September 27, 2010.
Southwest is expected to incur substantial expenses in connection with the Merger. While Southwest has assumed that a certain level of expenses would be incurred, there are many factors that could affect the total amount or the timing of the expenses, and many of the expenses that will be incurred are, by their nature, difficult to estimate. These expenses could, particularly in the near term, exceed the savings that the Company expects to achieve from the Merger and likely will result in the Company taking significant charges against earnings following the completion of the Merger. The amount and timing of such charges are currently uncertain.
3. ACCOUNTING CHANGES AND NEW ACCOUNTING PRONOUNCEMENTS
The Company had previously made changes in the estimated residual values of a limited number of owned 737-300 and 737-500 aircraft that had neared their retirement dates. During third quarter 2010, however, the Company changed the estimated residual values of its entire remaining fleet of owned 737-300 and 737-500 aircraft. Based on current and expected future market conditions related to these aircraft, the Company reduced the residual values of these aircraft from approximately 15 percent of original cost to approximately 10 percent of original cost. This determination was made due to the lack of buyers for these older aircraft, as many buyers of used aircraft prefer newer, more fuel efficient models, and the increase in the number of airlines retiring these older aircraft, which has effect ively “flooded” the market. As this reduction in residual value is considered a change in estimate, it has been accounted for on a prospective basis, and thus the Company will record additional depreciation expense over the remainder of the useful lives for each aircraft. The impact of this change on third quarter 2010 was an increase in depreciation expense of approximately $4 million, excluding the impact of profitsharing and income taxes ($2 million after the impact of profitsharing and taxes, with no impact on reported net income per share).
Effective January 1, 2010, the Company made a change in its accounting for frequent flyer benefits to begin accruing for partially earned frequent flyer awards as part of the Company’s incremental cost method of accounting for frequent flyer benefits. The term partial awards refers to credits earned by Customers for flights taken on Southwest Airlines that in the aggregate total less than 16, the number required to earn an award for free travel. Previously, the Company only accrued for fully earned frequent flyer awards. Although the prior policy is an acceptable method under accounting principles generally accepted in the United States, the Company believes accruing for partially earned awards is preferable to its former method because it is a better representation of the Company’s liability as awards are in the process of being earned since a portion of the partially earned awards will eventually turn into fully earned awards. Additionally, accruing for partially earned awards is more consistent with the Company’s accounting for fully earned awards, and it is consistent with the accounting policy used by several of the Company’s competitors that utilize the incremental cost approach to account for frequent flyer awards.
In accordance with accounting requirements associated with voluntary changes in accounting, the comparative unaudited Condensed Consolidated Balance Sheet as of December 31, 2009, was retrospectively adjusted in first quarter 2010 to apply the new method of accounting. The Company’s unaudited Condensed Consolidated Statement of Operations and unaudited Condensed Consolidated Statement of Cash Flows for the three and nine months ended September 30, 2009, were not retrospectively adjusted as the impact of this change in accounting for frequent flyer benefits was immaterial. In addition, this elective change in accounting did not have a material impact on the Company’s earnings or cash flows for the three and nine months ended September 30, 2010.
On September 23, 2009, the Financial Accounting Standards Board (“FASB”) ratified ASU No. 2009-13 (formerly referred to as Emerging Issues Task Force Issue No. 08-1), “Revenue Arrangements with Multiple Deliverables.” ASU No. 2009-13 requires the allocation of consideration among separately identified deliverables contained within an arrangement, based on their related selling prices. The Company utilizes current accounting guidance, also titled “Revenue Arrangements with Multiple Deliverables,” in the timing of recognition of revenue associated with the sale of frequent flyer credits to business partners. Specifically, the Company applies the residual method, which is currently allowed, but which will be prohibited under ASU No. 2009-13. ASU No. 2009-13 will be effective for annual reporting periods beginning January 1, 2011; however, it will be effective only for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. The Company is currently evaluating the impact of ASU No. 2009-13 on its financial position, results of operations, cash flows, and disclosures.
In January 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-06, “Improving Disclosures about Fair Value Measurements” an amendment to Accounting Standards Codification Topic 820, “Fair Value Measurements and Disclosures.” This amendment requires an entity to: (i) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers, and (ii) present separate information for Level 3 activity pertaining to gross purchases, sales, issuances, and settlements. ASU No. 2010-06 is effective for the Company for interim and annual reporting periods beginning after December 15, 2009, with one new disclosure effective after December 15, 2010. The Company has adopted this ASU in full with respect to the interim periods ended September 30, 2010. See Note 10.
4. NET INCOME PER SHARE
The following table sets forth the computation of basic and diluted net income per share (in millions except per share amounts):
| | | Three months ended September 30, | | | Nine months ended September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| NUMERATOR: | | | | | | | | | | | | |
| Net income (loss) | | $ | 205 | | | $ | (16 | ) | | $ | 328 | | | $ | (16 | ) |
| | | | | | | | | | | | | | | | | |
| DENOMINATOR: | | | | | | | | | | | | | | | | |
| Weighted-average shares | | | | | | | | | | | | | | | | |
| outstanding, basic | | | 746 | | | | 742 | | | | 745 | | | | 741 | |
| Dilutive effect of Employee stock | | | | | | | | | | | | | | | | |
| options | | | 1 | | | | - | | | | 1 | | | | - | |
| Adjusted weighted-average shares | | | | | | | | | | | | | | | | |
| outstanding, diluted | | | 747 | | | | 742 | | | | 746 | | | | 741 | |
| | | | | | | | | | | | | | | | | |
| NET INCOME (LOSS) PER SHARE: | | | | | | | | | | | | | | | | |
| Basic | | $ | .27 | | | $ | (.02 | ) | | $ | .44 | | | $ | (.02 | ) |
| | | | | | | | | | | | | | | | | |
| Diluted | | $ | .27 | | | $ | (.02 | ) | | $ | .44 | | | $ | (.02 | ) |
| | | | | | | | | | | | | | | | | |
| Antidilutive stock options | | | | | | | | | | | | | | | | |
| excluded from calculations | | | 64 | | | | 81 | | | | 70 | | | | 80 | |
5. FINANCIAL DERIVATIVE INSTRUMENTS
Fuel Contracts
Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices. Furthermore, jet fuel and oil typically represents one of the largest operating expenses for airlines. The Company endeavors to acquire jet fuel at the lowest possible cost and to reduce volatility in operating expenses through its fuel hedging program. Because jet fuel is not widely traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel. However, the Company has found that financial derivative instruments in other commodities, such as crude oil, and refined products, such as heating oil and unleaded gasoline, can be useful in decreasing its exposure to jet fuel price volatility. The Company does not purchase or hold any financial derivative instruments for trading purposes.
The Company has used financial derivative instruments for both short-term and long-term time frames, and typically uses a mixture of purchased call options, collar structures (which include both a purchased call option and a sold put option), call spreads (which include a purchased call option and a sold call option), and fixed price swap agreements in its portfolio.
The Company evaluates its hedge volumes strictly from an “economic” standpoint and thus does not consider whether the hedges qualified or will qualify for special hedge accounting. The Company defines its “economic” hedge as the net volume of fuel derivative contracts held, including the impact of positions that have been offset through sold positions, regardless of whether those contracts qualify for hedge accounting. For third quarter 2010, the Company had fuel derivatives in place related to approximately 46 percent of its fuel consumption. As of September 30, 2010, the Company had fuel derivative instruments in place to provide coverage on a large portion of its fourth quarter 2010 estimated fuel consumption at varying price levels. The following table provides information about the Company’s volume of fuel hedging for fourth quarter 2010, as well as the years 2011 through 2014.
| | | | Fuel hedged as | |
| | | | of September 30, 2010 | |
| Period | | | (gallons in millions) | |
| | 4Q10 | | | | 108 | |
| | 2011 | | | | 865 | |
| | 2012 | | | | 887 | |
| | 2013 | | | | 750 | |
| | 2014 | | | | 700 | |
Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges. All derivatives designated as hedges that meet certain requirements are granted special hedge accounting treatment. Generally, utilizing the special hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective, as defined, are recorded in "Accumulated other comprehensive income (loss)” (“AOCI”) until the underlying jet fuel is consumed. See Note 6. The Company is exposed to the risk that periodic changes will not be effective, as defined, or that the derivatives will no longer qualify for special hedge accounting. Ineffectiveness, as defined, results when the change in the fair value of the der ivative instrument exceeds the change in the value of the Company’s expected future cash outlay to purchase and consume jet fuel. To the extent that the periodic changes in the fair value of the derivatives are not effective, that ineffectiveness is recorded to “Other (gains) losses, net” in the statement of operations. Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last period is recorded to “Other (gains) losses, net” in the statement of operations in the period of the change; however, any amounts previously recorded to AOCI would remain there until such time as the original forecasted transaction occurs, at which time these amounts would be reclassified to “Fuel and oil” expense. When the Company has sold derivative positions in order to effectively “close” or offset a derivative already held as part of its fuel derivative instrument portfoli o, any subsequent changes in fair value of those positions are marked to market through earnings. Likewise, any changes in fair value of those positions that were offset by entering into the sold positions are concurrently marked to market through earnings. However, any changes in value related to hedges that were deferred as part of AOCI while designated as a hedge would remain until the originally forecasted transaction occurs. In a situation where it becomes probable that a hedged forecasted transaction will not occur, any gains and/or losses that have been recorded to AOCI would be required to be immediately reclassified into earnings. The Company did not have any such situations occur during 2009 or the first nine months of 2010.
Ineffectiveness is inherent in hedging jet fuel with derivative positions based in other crude oil related commodities. Due to the volatility in markets for crude oil and related products, the Company is unable to predict the amount of ineffectiveness each period, including the loss of hedge accounting, which could be determined on a derivative by derivative basis or in the aggregate for a specific commodity. This may result, and has resulted, in increased volatility in the Company’s financial results. However, even though derivatives may not qualify for special hedge accounting, the Company continues to hold the instruments as management believes derivative instruments continue to afford the Company the opportunity to stabilize jet fuel costs.
Accounting pronouncements pertaining to derivative instruments and hedging are complex with stringent requirements, including the documentation of a Company hedging strategy, statistical analysis to qualify a commodity for hedge accounting both on a historical and a prospective basis, and strict contemporaneous documentation that is required at the time each hedge is designated by the Company. As required, the Company assesses the effectiveness of each of its individual hedges on a quarterly basis. The Company also examines the effectiveness of its entire hedging program on a quarterly basis utilizing statistical analysis. This analysis involves utilizing regression and other statistical analyses that compare changes in the price of jet fuel to changes in the prices of the commodities used for hedging p urposes.
All cash flows associated with purchasing and selling derivatives are classified as operating cash flows in the unaudited Condensed Consolidated Statement of Cash Flows. The following table presents the location of all assets and liabilities associated with the Company’s hedging instruments within the unaudited Condensed Consolidated Balance Sheet:
| | | | Asset Derivatives | | | Liability Derivatives | |
| (in millions) | Balance Sheet Location | | Fair Value at 9/30/10 | | | Fair Value at 12/31/09 | | | Fair Value at 9/30/10 | | | Fair Value at 12/31/09 | |
| | | | | | | | | | | | | | |
| Derivatives designated as hedges | | | | | | | | | | | | | |
| Fuel derivative contracts (gross)* | Other assets | | $ | 623 | | | $ | - | | | $ | 160 | | | $ | - | |
| Fuel derivative contracts (gross)* | Accrued liabilities | | | 67 | | | | 122 | | | | 20 | | | | 4 | |
| Fuel derivative contracts (gross)* | Other deferred liabilities | | | 82 | | | | 225 | | | | 18 | | | | 10 | |
| Interest rate derivative contracts | Other assets | | | 114 | | | | 47 | | | | - | | | | - | |
| Interest rate derivative contracts | Other deferred liabilities | | | - | | | | - | | | | 23 | | | | 10 | |
| | | | | | | | | | | | | | | | | | |
| Total derivatives designated as hedges | | | $ | 886 | | | $ | 394 | | | $ | 221 | | | $ | 24 | |
| | | | | | | | | | | | | | | | | | |
| Derivatives not designated as hedges | | | | | | | | | | | | | | | | | |
| Fuel derivative contracts (gross)* | Other assets | | $ | 325 | | | $ | - | | | $ | 587 | | | $ | - | |
| Fuel derivative contracts (gross)* | Accrued liabilities | | | 37 | | | | 324 | | | | 184 | | | | 566 | |
| Fuel derivative contracts (gross)* | Other deferred liabilities | | | 33 | | | | 302 | | | | 284 | | | | 870 | |
| | | | | | | | | | | | | | | | | | |
| Total derivatives not designated as hedges | | | $ | 395 | | | $ | 626 | | | $ | 1,055 | | | $ | 1,436 | |
| | | | | | | | | | | | | | | | | | |
| Total derivatives | | | $ | 1,281 | | | $ | 1,020 | | | $ | 1,276 | | | $ | 1,460 | |
| * Does not include the impact of cash collateral deposits provided to counterparties. See discussion | | | | | |
| of credit risk and collateral following in this Note. | | | | | | | | | | | | | | | | |
In addition, the Company also had the following amounts associated with fuel derivative instruments and hedging activities in its unaudited Condensed Consolidated Balance Sheet:
| | Balance Sheet | | September 30, | | | December 31, | |
| (in millions) | Location | | 2010 | | | 2009 | |
| Cash collateral deposits provided | Offset against Other | | | | | | |
| to counterparty - noncurrent | deferred liabilities | | $ | 125 | | | $ | 238 | |
| Cash collateral deposits provided | Offset against Accrued | | | | | | | | |
| to counterparty - current | liabilities | | | - | | | | 92 | |
| Cash collateral deposits provided | | | | | | | | | |
| to counterparty - current | Accounts Receivable | | | 55 | | | | - | |
| Due to third parties for settled fuel contracts | Accrued liabilities | | | 18 | | | | 15 | |
| Net unrealized losses from fuel | Accumulated other | | | | | | | | |
| hedges, net of tax | comprehensive loss | | | 420 | | | | 580 | |
The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2010 and 2009:
| Derivatives in Cash Flow Hedging Relationships | | | | | | | | | | |
| | | Amount of (Gain) Loss Recognized in AOCI on Derivatives (effective portion) | | | Amount of (Gain) Loss Reclassified from AOCI into Income (effective portion)(a) | | | Amount of (Gain) Loss Recognized in Income on Derivatives (ineffective portion) (b) | |
| | | Three months ended September 30, | | | Three months ended September 30, | | | Three months ended September 30, | |
| (in millions) | | 2010 | | | 2009 | | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | | | | | | | |
| Fuel derivative | | | | | | | | | | | | | | | | | | |
| contracts | | $ | (122 | ) * | | $ | (40 | ) * | | $ | 77 | * | | $ | 101 | * | | $ | (24 | ) | | $ | (46 | ) |
| Interest rate | | | | | | | | | | | | | | | | | | | | | | | | |
| derivatives | | | 12 | * | | | 6 | * | | | - | | | | - | | | | - | | | | - | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total | | $ | (110 | ) | | $ | (34 | ) | | $ | 77 | | | $ | 101 | | | $ | (24 | ) | | $ | (46 | ) |
| * Net of tax | | | | | | | | | | | | | | | | | | | | | | | | |
| (a) Amounts related to fuel derivative contracts and interest rate derivatives are included in | |
| Fuel and oil and Interest expense, respectively. | | | | | | | | | | | | | |
| (b) Amounts are included in Other (gains) losses, net. | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Derivatives in Cash Flow Hedging Relationships | | | | | | | | | | | | | |
| | | Amount of (Gain) Loss Recognized in AOCI on Derivatives (effective portion) | | | Amount of (Gain) Loss Reclassified from AOCI into Income (effective portion)(a) | | | Amount of (Gain) Loss Recognized in Income on Derivatives (ineffective portion) (b) | |
| | | Nine months ended September 30, | | | Nine months ended September 30, | | | Nine months ended September 30, | |
(in millions) | | | 2010 | | | | 2009 | | | | 2010 | | | | 2009 | | | | 2010 | | | | 2009 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Fuel derivative | | | | | | | | | | | | | | | | | | | | | | | | |
| contracts | | $ | 66 | * | | $ | (85 | ) * | | $ | 226 | * | | $ | 307 | * | | $ | 26 | | | $ | (55 | ) |
| Interest rate | | | | | | | | | | | | | | | | | | | | | | | | |
| derivatives | | | 34 | * | | | (19 | ) | | | - | | | | - | | | | - | | | | - | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total | | $ | 100 | | | $ | (104 | ) | | $ | 226 | | | $ | 307 | | | $ | 26 | | | $ | (55 | ) |
| * Net of tax | | | | | | | | | | | | | | | | | | | | | | | | |
| (a) Amounts related to fuel derivative contracts and interest rate derivatives are included in | |
| Fuel and oil and Interest expense, respectively. | | | | | | | | | | | | | |
| (b) Amounts are included in Other (gains) losses, net. | | | | | | | | | | | | | |
| Derivatives not in Cash Flow Hedging Relationships |
| | | Amount of (Gain) Loss Recognized in Income on Derivatives | | |
| | | Three months ended September 30, | | Location of (Gain) Loss Recognized in Income |
| (in millions) | | 2010 | | | 2009 | | on Derivatives |
| | | | | | | | |
| Fuel derivative contracts | | $ | (26 | ) | | $ | 7 | | Other (gains) losses, net |
| | | | | | | | | | |
| | | | | | | | | | |
| Derivatives not in Cash Flow Hedging Relationships |
| | | Amount of (Gain) Loss Recognized in Income on Derivatives | | |
| | | Nine months ended September 30, | | Location of (Gain) Loss Recognized in Income |
| (in millions) | | | 2010 | | | | 2009 | | on Derivatives |
| | | | | | | | | | |
| Fuel derivative contracts | | $ | 13 | | | $ | (57 | ) | Other (gains) losses, net |
The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during third quarter 2010 and 2009 of $37 million and $35 million, respectively, and during the nine months ended September 30, 2010 and 2009 of $98 million and $104 million, respectively. These amounts are excluded from the Company’s measurement of effectiveness for related hedges and are included as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Operations.
The fair value of the derivative instruments, depending on the type of instrument, was determined by the use of present value methods or standard option value models with assumptions about commodity prices based on those observed in underlying markets. Included in the Company’s total net unrealized losses from fuel hedges as of September 30, 2010, are approximately $196 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2010. In addition, as of September 30, 2010, the Company had already recognized cumulative net losses due to ineffectiveness and derivatives that do not qualify for hedge accounting totaling $80 million, net of taxes. These net losses were recognized in third quarter 2010 and prior periods, and are reflected in “Retained earnings” as of September 30, 2010, but the underlying derivative instruments will not expire/settle until fourth quarter 2010 or future years.
Interest rate swaps
The Company is party to certain interest rate swap agreements that are accounted for as either fair value hedges or cash flow hedges, as defined in the applicable accounting guidance for derivative instruments and hedging. The interest rate swap agreements accounted for as fair value hedges qualify for the “shortcut” method of accounting for hedges, which dictates that the hedges are assumed to be perfectly effective, and, thus, there is no ineffectiveness to be recorded in earnings. For the Company’s interest rate swap agreements accounted for as cash flow hedges, ineffectiveness is required to be measured each reporting period. The ineffectiveness associated with these hedges for all periods presented was not material.
Credit risk and collateral
The Company’s credit exposure related to fuel derivative instruments is represented by the fair value of contracts with a net positive fair value to the Company at the reporting date. These outstanding instruments expose the Company to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company has not experienced any significant credit loss as a result of counterparty nonperformance in the past. To manage credit risk, the Company selects and will periodically review counterparties based on credit ratings, limits its exposure to a single counterparty, and monitors the market position of the fuel hedging program and its relative market position with each counterparty. At September 30, 2010, the Company had agreements with all of its active cou nterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount or credit ratings fall below certain levels. The Company also had agreements with counterparties in which cash deposits and/or pledged aircraft are required to be posted whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of September 30, 2010, at which such postings are triggered:
| | | | Counterparty (CP) | | | | | | | |
| | | | | A | | | | B | | | | C | | | | D | | | | E | | | Other | | | Total | |
| (in millions) | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Fair value of fuel derivatives | | $ | 5 | | | $ | (265 | ) | | $ | (22 | ) | | $ | 41 | | | $ | 154 | | | $ | 1 | * | | $ | (86 | ) |
| Cash collateral held by CP | | | 55 | | | | 125 | | | | - | | | | - | | | | - | | | | - | | | | 180 | |
| Aircraft collateral pledged to CP | | | - | | | | 165 | | | | - | | | | - | | | | - | | | | - | | | | 165 | |
| If credit rating is investment | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| grade, fair value of fuel | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| derivative level at which: | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Cash is provided to CP | | 0 to (300) | | | 0 to (125) | | | >(75) | | | >(75) | | | >(75) | | | | | | | | | |
| | | | or >(700) | | | or >(535) | | | | | | | | | | | | | | | | | | | | | |
| Cash is received from CP | | >40 | | | >150 | | | >200 *** | | | >125 *** | | | >250 | | | | | | | | | |
| Aircraft is pledged to CP | | (300) to (700) | | | (125) to (535) | | | | N/A | | | | N/A | | | | N/A | | | | | | | | | |
| If credit rating is non-investment | | | | | | | | | | | | | | | | | | | | | | | | | |
grade, fair value of fuel derivative level at which: | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Cash is provided to CP | | 0 to (300) | | | 0 to (125) | | | | ** | | | | ** | | | | ** | | | | | | | | | |
| | | | or >(700) | | | or >(535) | | | | | | | | | | | | | | | | | | | | | |
| Cash is received from CP | | | ** | | | | ** | | | | ** | | | | ** | | | | ** | | | | | | | | | |
| Aircraft is pledged to CP | | (300) to (700) | | | (125) to (535) | | | | N/A | | | | N/A | | | | N/A | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| * Sum of counterparties with fair value of fuel derivatives <$5M and no risk of the Company posting collateral. | | | | | | | | | |
| ** Cash collateral is provided at 100 percent of fair value of fuel derivative contracts. | | | | | | | | | | | | | |
| *** Thresholds may vary based on changes in credit ratings within investment grade. | | | | | | | | | | | | | |
The Company also has agreements with each of its counterparties associated with its outstanding interest rate swap agreements in which cash collateral may be required based on the fair value of outstanding derivative instruments, as well as the Company’s and its counterparty’s credit ratings. As of September 30, 2010, no cash collateral had been provided to or received from counterparties associated with the Company’s interest rate derivatives. If the Company’s credit rating had been below investment grade as of September 30, 2010, it would have been required to provide $24 million in cash collateral to one counterparty based on its outstanding net liability derivative position with that counterparty. The outstanding interest rate net derivative positions with all other counterpa rties at September 30, 2010 were assets to the Company.
Applicable accounting provisions require an entity to select a policy of how it records the offset rights to reclaim cash collateral associated with the related derivative fair value of the assets or liabilities of such derivative instruments. Entities may either select a “net” or a “gross” presentation. The Company has elected to present its cash collateral utilizing a net presentation, in which cash collateral amounts held or provided have been netted against the fair value of outstanding derivative instruments.
6. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) includes changes in the fair value of certain financial derivative instruments, which qualify for hedge accounting, unrealized gains and losses on certain investments, and actuarial gains/losses arising from the Company’s postretirement benefit obligation. The differences between net income (loss) and comprehensive income (loss) for the three and nine months ended September 30, 2010 and 2009, were as follows:
| | | Three months ended September 30, | |
| (In millions) | | 2010 | | | 2009 | |
| | | | | | | |
| Net income/(Loss) | | $ | 205 | | | $ | (16 | ) |
| Unrealized gain on fuel derivative instruments, | | | | | | | | |
| net of deferred taxes of $124 and $37 | | | 199 | | | | 61 | |
| Unrealized loss on interest rate swaps, | | | | | | | | |
| net of deferred taxes of ($7) and ($4) | | | (12 | ) | | | (6 | ) |
| Other, net of deferred taxes of $1 and $18 | | | 1 | | | | 27 | |
| Total other comprehensive income/(loss) | | | 188 | | | | 82 | |
| | | | | | | | | |
| Comprehensive income | | $ | 393 | | | $ | 66 | |
| | | | | | | | | |
| | | | | | | | | |
| | | Nine months ended September 30, | |
| (In millions) | | | 2010 | | | | 2009 | |
| | | | | | | | | |
| Net income/(Loss) | | $ | 328 | | | $ | (16 | ) |
| Unrealized gain on derivative instruments, | | | | | | | | |
| net of deferred taxes of $100 and $137 | | | 160 | | | | 222 | |
| Unrealized gain/(loss) on interest rate swaps, | | | | | | | | |
| net of deferred taxes of ($21) and $12 | | | (34 | ) | | | 20 | |
| Other, net of deferred taxes of $0 and $18 | | | (1 | ) | | | 27 | |
| Total other comprehensive income/(loss) | | | 125 | | | | 269 | |
| | | | | | | | | |
| Comprehensive income | | $ | 453 | | | $ | 253 | |
A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three and nine months ended September 30, 2010 and 2009:
| | | Fuel | | | Interest | | | | | | Accumulated other | |
| | | hedge | | | rate | | | | | | comprehensive | |
| (In millions) | | derivatives | | | derivatives | | | Other | | | income (loss) | |
| Balance at June 30, 2010 | | $ | (619 | ) | | $ | (41 | ) | | $ | 19 | | | $ | (641 | ) |
| Changes in fair value | | | 122 | | | | (12 | ) | | | 1 | | | | 111 | |
| Reclassification to earnings | | | 77 | | | | - | | | | - | | | | 77 | |
| Balance at September 30, 2010 | | $ | (420 | ) | | $ | (53 | ) | | $ | 20 | | | $ | (453 | ) |
| | | | | | | | | | | | | | | | | |
| | | Fuel | | | Interest | | | | | | | Accumulated other | |
| | | hedge | | | rate | | | | | | | comprehensive | |
| (In millions) | | derivatives | | | derivatives | | | Other | | | income (loss) | |
| Balance at December 31, 2009 | | $ | (580 | ) | | $ | (19 | ) | | $ | 21 | | | $ | (578 | ) |
| Changes in fair value | | | (66 | ) | | | (34 | ) | | | (1 | ) | | | (101 | ) |
| Reclassification to earnings | | | 226 | | | | - | | | | - | | | | 226 | |
| Balance at September 30, 2010 | | $ | (420 | ) | | $ | (53 | ) | | $ | 20 | | | $ | (453 | ) |
7. ACCRUED LIABILITIES
| | | September 30, | | | December 31, | |
| (In millions) | | 2010 | | | 2009 | |
| | | | | | | |
| Retirement plans | | $ | 132 | | | $ | 46 | |
| Aircraft rentals | | | 75 | | | | 112 | |
| Vacation pay | | | 201 | | | | 190 | |
| Advances and deposits | | | 29 | | | | 32 | |
| Fuel derivative contracts | | | 100 | | | | 32 | |
| Workers compensation | | | 130 | | | | 130 | |
| Other | | | 277 | | | | 187 | |
| Accrued liabilities | | $ | 944 | | | $ | 729 | |
8. DIVIDENDS
During the three month periods ended September 30, June 30, and March 31, 2010, dividends of $.0045 per share were declared on the 746 million shares, 746 million shares, and 744 million shares of Common Stock then outstanding, respectively. During the three month periods ended September 30, June 30, and March 31, 2009, dividends of $.0045 per share were declared on the 742 million shares, 741 million shares, and 740 million shares of Common Stock then outstanding, respectively.
9. COMMITMENTS AND CONTINGENCIES
Various purported class action lawsuits have been filed by stockholders of AirTran that challenge the proposed acquisition of AirTran by the Company.
On September 28, 2010, Frederick Leonelli filed a purported class action lawsuit on behalf of himself and similarly situated stockholders of AirTran in the First Judicial District Court of the State of Nevada for Carson City against AirTran, Robert L. Fornaro, AirTran’s Chairman, President and Chief Executive Officer, Arne G. Haak, AirTran’s Senior Vice President of Finance, Treasurer and Chief Financial Officer, each member of the AirTran board of directors, Southwest and Merger Sub (the “Leonelli complaint”). The Leonelli complaint generally alleges that the consideration to be received by AirTran’s stockholders in the Merger is unfair and inadequate and that the AirTran officers and directors named as defendants (the “ind ividual AirTran defendants”) breached their fiduciary duties by approving the Merger Agreement through an unfair and flawed process and by approving certain deal protection mechanisms contained in the Merger Agreement. The Leonelli complaint further alleges that AirTran, Southwest and Merger Sub aided and abetted the individual AirTran defendants in the breach of their fiduciary duties to AirTran’s stockholders. The Leonelli complaint seeks injunctive relief: (i) enjoining the defendants from consummating the Merger unless AirTran adopts and implements a procedure or process to obtain the highest possible price for AirTran’s stockholders and discloses all material information to AirTran’s stockholders, (ii) directing the individual AirTran defendants to exercise their fiduciary duties to obtain a transaction that is in the best interests of AirTran’s stockholders, (iii) rescinding, to the extent already implemented, the Merger Agreement, including the deal protection devices tha t may preclude premium competing bids for AirTran, (iv) awarding plaintiff’s costs and disbursements of the action, including reasonable attorneys’ and experts’ fees, and (v) granting such other and further equitable relief as the court may deem just and proper. The lawsuit is in a preliminary stage.
On September 28, 2010, Frank Frohman filed a second purported AirTran shareholder class action lawsuit in the same court and against the same defendants (other than Mr. Haak) as in the Leonelli complaint. The allegations in the Frohman lawsuit, as well as the relief requested, are generally the same as those set forth in the Leonelli complaint. The lawsuit is also in a preliminary stage.
On October 8, 2010, Douglas Church filed another purported AirTran shareholder class action lawsuit in the District Court of Clark County, Nevada against the same defendants (other than Mr. Haak) as in the Leonelli complaint. The allegations set forth in the Church lawsuit, as well as the relief requested, are generally the same as those set forth in the Leonelli complaint with one addition. The Church complaint additionally alleges, as part of its breach of fiduciary duty claim, that the individual AirTran defendants (other than Mr. Haak) received greater benefits under the Merger Agreement than other AirTran shareholders. The lawsuit is also in a preliminary stage.
Four purported AirTran shareholder class action lawsuits have also been filed in the Circuit Court of the Ninth Judicial Circuit in and for Orange County, Florida. Harry Hoffner filed a purported class action lawsuit on behalf of himself and similarly situated AirTran stockholders on September 30, 2010 against the same defendants (other than Mr. Haak and Merger Sub) as in the Leonelli complaint. This was followed by lawsuits filed by Robert Debardelan on October 8, 2010, Thomas A. Rosenberger on October 12, 2010, and Robert Loretitsch on October 15, 2010 (collectively the “Florida actions”) against the same defendants plus Merger Sub. The allegations in the Florida actions, as well as the relief requested, are also generally the same as those set forth in the Leonelli complaint. The Florida actions are also in th eir preliminary stages. On October 12, 2010, Mr. Rosenberger filed a motion to transfer and consolidate the Hoffner, Debardelan, and Rosenberger actions and appoint Mr. Rosenberger as lead plaintiff and his attorneys as lead plaintiffs’ counsel. A counter motion to transfer and consolidate and for the appointment of lead plaintiff and lead plaintiffs’ counsel was filed by Messrs. Hoffner and Debardelan on October 19, 2010. Those motions are currently pending.
Southwest believes that each of the above described lawsuits is without merit.
The Company is from time to time subject to various legal proceedings and claims arising in the ordinary course of business, including, but not limited to, examinations by the Internal Revenue Service (IRS). The Company's management does not expect that the outcome in any of its currently ongoing legal proceedings or the outcome of any proposed adjustments presented to date by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow.
During 2008, the City of Dallas approved the Love Field Modernization Program (LFMP), a project to reconstruct Dallas Love Field (Airport) with modern, convenient air travel facilities. Pursuant to a Program Development Agreement (PDA) with the City of Dallas, the Company is managing this project, and major construction has commenced during 2010, with completion scheduled for the second half of 2014. Although subject to change, at the current time the project is expected to include the renovation of the Airport airline terminals and complete replacement of gate facilities with a new 20-gate facility, including infrastructure, systems and equipment, aircraft parking apron, fueling system, roadways and terminal curbside, baggage handling systems, passenger loading bridges and support systems, and other supporting in frastructure.
The PDA authorizes reimbursement to the Company of up to $75 million for certain early LFMP expenditures the Company has incurred and will incur from April 25, 2008 until the issuance of bonds that will be used as funding for ongoing construction. The source of such reimbursement will be the proceeds of those bonds. As of September 30, 2010, the Company had spent a total of $70 million of its own funds on a portion of the LFMP project, which funds are considered eligible for reimbursement. The Company has classified this amount as “Ground property and equipment” in its unaudited Condensed Consolidated Balance Sheet.
The Company has agreed to manage the majority of the LFMP project, and as a result, will be evaluating its ongoing accounting requirements in consideration of accounting guidance provided for lessees involved in asset construction, which can, depending on the specific facts and circumstances, require the lessee to report an asset and corresponding obligation for the cost of the project on the Company’s balance sheet. As of the current time, the Company has not yet made a final determination of its accounting for the LFMP. It is currently expected that bonds being utilized to finance a portion of the LFMP will be issued during fourth quarter 2010, subject to market conditions, at which time the Company will be able to finalize its conclusions regarding its ongoing accounting treatment for the LFMP. The Company will guar anty principal and interest payments on the bonds.
10. FAIR VALUE MEASUREMENTS
Accounting standards pertaining to fair value measurements establish a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.
As of September 30, 2010, the Company held certain items that are required to be measured at fair value on a recurring basis. These included cash equivalents, short-term investments (primarily treasury bills and certificates of deposit), certain noncurrent investments, interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities. The majority of short-term investments consist of instruments classified as Level 1. However, certificates of deposit are classified as Level 2, due to the fact that the fair value for these instruments is determined utilizing observable inputs in non-active markets. Noncurrent investments consist of certain auction rate securities, primarily those collate ralized by student loan portfolios, which are guaranteed by the U.S. Government. Other available-for-sale securities primarily consist of investments associated with the Company’s excess benefit plan.
The Company’s fuel and interest rate derivative instruments consist of over-the-counter (OTC) contracts, which are not traded on a public exchange. Fuel derivative instruments include both swaps as well as different types of option contracts, whereas interest rate derivatives consist of swap agreements. See Note 5 for further information on the Company’s derivative instruments and hedging activities. The fair values of swap contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized these swap contracts as Level 2. The Company determines the value of option contracts utilizing a standard option pricing model based on inputs that are either readily available in public markets, can be derived from information available in publicly quoted markets, or are quoted by financial institutions that trade these contracts. Because certain of the inputs used to determine the fair value of option contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as Level 3. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds.
The Company’s investments associated with its excess benefit plan consist of mutual funds that are publicly traded and for which market prices are readily available. This plan is a deferred compensation plan designed to hold Employee contributions in excess of limits established by Section 415 of the Internal Revenue Code. This plan is funded through qualifying Employee contributions and it impacts the Company’s earnings through changes in the fair value of plan assets.
All of the Company’s auction rate security instruments, totaling $92 million at September 30, 2010, are classified as available for sale securities and are reflected at estimated fair value in the unaudited Condensed Consolidated Balance Sheet. In periods when an auction process successfully took place every 30-35 days, quoted market prices would be readily available, which would qualify the securities as Level 1. However, due to events in credit markets beginning during first quarter 2008, the auction events for most of these instruments failed, and, therefore, the Company has subsequently determined the estimated fair values of these securities utilizing a discounted cash flow analysis or other type of valuation model. The Company has performed, and routinely updates, a valuation for each of its auction rate security instruments, considering, among other items, the collateralization underlying the security investments, the expected future cash flows, including the final maturity, associated with the securities, and estimates of the next time the security is expected to have a successful auction or return to full par value.
In association with its estimate of fair value as of September 30, 2010, the Company has recorded a temporary unrealized decline in fair value of $18 million, with an offsetting entry to AOCI. The Company continues to believe that this decline in fair value is due entirely to market liquidity issues, because the underlying assets for the majority of these auction rate securities held by the Company are almost entirely backed by the U.S. Government. In addition, these auction rate securities represented an immaterial portion of the Company’s total cash, cash equivalent, and investment balance at September 30, 2010. The range of maturities for the Company’s auction rate securities are from 8 years to 37 years. Considering the relative insignificance of these securi ties in comparison to the Company’s liquid assets and other sources of liquidity, the Company has no current intention of selling these securities nor does it expect to be required to sell these securities before a recovery in their cost basis. At the time of the first failed auctions during first quarter 2008, the Company held a total of $463 million in auction rate securities and, since that time, has been able to sell $353 million of these instruments at par value.
The Company remains in discussions with its remaining counterparties to determine whether mutually agreeable decisions can be reached regarding the effective repurchase of its remaining auction rate securities. The Company has continued to earn interest on virtually all of its outstanding auction rate security instruments. Any future fluctuation in fair value related to these instruments that the Company deems to be temporary, including any recoveries of previous temporary write-downs, would be recorded to AOCI. If the Company determines that any future valuation adjustment was other than temporary, it would record a charge to earnings as appropriate.
The following items are measured at fair value on a recurring basis at September 30, 2010 and December 31, 2009:
| | | | | | Fair Value Measurements at Reporting Date Using | |
| | | | | | Quoted Prices in Active Markets for Identical Assets | | | | | | Significant Unobservable Inputs | |
| | | | | | Significant Other | |
| | | | | | Observable Inputs | |
| Description | | September 30, 2010 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
| Assets | | (in millions) | |
| Cash equivalents | | $ | 1,031 | | | $ | 1,031 | | | $ | - | | | $ | - | |
| Short-term investments: | | | | | | | | | | | | | | | | |
| Treasury bills | | | 2,089 | | | | 2,089 | | | | - | | | | - | |
| Certificates of deposit | | | 260 | | | | 260 | | | | - | | | | - | |
| Noncurrent investments (a) | | | 92 | | | | - | | | | - | | | | 92 | |
| Interest rate derivatives (see Note 5) | | | 114 | | | | - | | | | 114 | | | | - | |
| Fuel derivatives: | | | | | | | | | | | | | | | | |
| Swap contracts (b) | | | 28 | | | | - | | | | 28 | | | | - | |
| Option contracts (b) | | | 192 | | | | - | | | | - | | | | 192 | |
| Swap contracts (c) | | | 232 | | | | - | | | | 232 | | | | - | |
| Option contracts (c) | | | 716 | | | | - | | | | - | | | | 716 | |
| Other available-for-sale securities | | | 39 | | | | 31 | | | | - | | | | 8 | |
| Total assets | | $ | 4,793 | | | $ | 3,411 | | | $ | 374 | | | $ | 1,008 | |
| | | | | | | | | | | | | | | | | |
| Liabilities | | | | | | | | | | | | | | | | |
| Fuel derivatives: | | | | | | | | | | | | | | | | |
| Swap contracts (b) | | $ | (306 | ) | | $ | - | | | $ | (306 | ) | | $ | - | |
| Option contracts (b) | | | (201 | ) | | | - | | | | - | | | | (201 | ) |
| Swap contracts (c) | | | (427 | ) | | | - | | | | (427 | ) | | | - | |
| Option contracts (c) | | | (320 | ) | | | - | | | | - | | | | (320 | ) |
| Interest rate derivatives (see Note 5) | | | (23 | ) | | | - | | | | (23 | ) | | | - | |
| Total liabilities | | $ | (1,277 | ) | | $ | - | | | $ | (756 | ) | | $ | (521 | ) |
| (a) Auction rate securities included in "Other assets" in the unaudited Condensed | | | | | | | | | |
| Consolidated Balance Sheet. | | | | | | | | | | | | | | | | |
| (b) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net liability, | | | | | |
| and are also net of $125 million in cash collateral provided to counterparties. See Note 5. | | | | | |
| (c) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net asset. See Note 5. | |
| | | | | | Fair Value Measurements at Reporting Date Using | |
| | | | | | Quoted Prices in | | | | | | Significant | |
| | | | | | Active Markets for | | | Significant Other | | | Unobservable | |
| | | | | | Identical Assets | | | Observable Inputs | | | Inputs | |
| Description | | December 31, 2009 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
| Assets | | (in millions) | |
| Cash equivalents | | $ | 1,114 | | | $ | 1,114 | | | $ | - | | | $ | - | |
| Short-term investments | | | | | | | | | | | | | | | | |
| Treasury bills | | | 1,279 | | | | 1,279 | | | | - | | | | - | |
| Certificates of deposit | | | 125 | | | | 125 | | | | - | | | | - | |
| Auction rate securities | | | 75 | | | | - | | | | - | | | | 75 | |
| Noncurrent investments (a) | | | 99 | | | | - | | | | - | | | | 99 | |
| Interest rate derivatives | | | 47 | | | | - | | | | 47 | | | | - | |
| Fuel derivatives (b) | | | | | | | | | | | | | | | | |
| Swap contracts | | | 373 | | | | - | | | | 373 | | | | - | |
| Option contracts | | | 848 | | | | - | | | | - | | | | 848 | |
| Other available-for-sale securities | | | 38 | | | | 30 | | | | - | | | | 8 | |
| Total assets | | $ | 3,998 | | | $ | 2,548 | | | $ | 420 | | | $ | 1,030 | |
| | | | | | | | | | | | | | | | | |
| Liabilities | | | | | | | | | | | | | | | | |
| Fuel derivatives (b) | | | | | | | | | | | | | | | | |
| Swap contracts | | $ | (990 | ) | | $ | - | | | $ | (990 | ) | | $ | - | |
| Option contracts | | | (708 | ) | | | - | | | | - | | | | (708 | ) |
| Interest rate derivatives | | | (10 | ) | | | - | | | | (10 | ) | | | - | |
| Total liabilities | | $ | (1,708 | ) | | $ | - | | | $ | (1,000 | ) | | $ | (708 | ) |
| (a) Auction rate securities included in "Other assets" in the unaudited Condensed Consolidated Balance Sheet. | |
| (b) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net liability, | | | | | |
| and are also net of $330 million in cash collateral provided to counterparties. | | | | | | | | | |
Investments in certificates of deposit have been reclassified from Level 1 to Level 2 in the above tables, but the Company had no transfers of assets or liabilities between any of the above levels during the nine months ended September 30, 2010. The following tables present the Company’s activity for items measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2010:
| | | Fair Value Measurements Using Significant | |
| | | Unobservable Inputs (Level 3) | |
| | | Fuel | | | Auction Rate | | | Other | | | | |
| (in millions) | | Derivatives | | | Securities | | | Securities | | | Total | |
| Balance at June 30, 2010 | | $ | 46 | | | $ | 105 | | | $ | 8 | | | $ | 159 | |
| Total gains or (losses) (realized or unrealized) | | | | | | | | | | | | | | | | |
| Included in earnings | | | 164 | | | | - | | | | - | | | | 164 | |
| Included in other comprehensive income | | | 180 | | | | (1 | ) | | | - | | | | 179 | |
| Purchases | | | 7 | | | | - | | | | - | | | | 7 | |
| Sales | | | (30 | ) | | | (12 | ) | | | - | | | | (42 | ) |
| Settlements | | | 20 | | | | - | | | | - | | | | 20 | |
| Balance at September 30, 2010 | | $ | 387 | | | $ | 92 | (a) | | $ | 8 | | | $ | 487 | |
| | | | | | | | | | | | | | | | | |
| The amount of total gains or (losses) for the | | | | | | | | | | | | | | | | |
| period included in earnings attributable to the | | | | | | | | | | | | | | | | |
| change in unrealized gains or losses relating to | | | | | | | | | | | | | | | | |
| �� assets still held at September 30, 2010 | | $ | 166 | | | $ | - | | | $ | - | | | $ | 166 | |
| | | | | | | | | | | | | | | | | |
| (a) Included in "Other assets" in the unaudited Condensed Consolidated Balance Sheet. | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | Fair Value Measurements Using Significant | |
| | | Unobservable Inputs (Level 3) | |
| | | Fuel | | | Auction Rate | | | Other | | | | | |
| (in millions) | | Derivatives | | | Securities | | | Securities | | | Total | |
| Balance at December 31, 2009 | | $ | 140 | | | $ | 174 | | | $ | 8 | | | $ | 322 | |
| Total gains or (losses) (realized or unrealized) | | | | | | | | | | | | | | | | |
| Included in earnings | | | (84 | ) | | | - | | | | - | | | | (84 | ) |
| Included in other comprehensive income | | | (93 | ) | | | (1 | ) | | | - | | | | (94 | ) |
| Purchases | | | 525 | | | | - | | | | - | | | | 525 | |
| Sales | | | (126 | ) | | | (81 | ) | | | - | | | | (207 | ) |
| Settlements | | | 25 | | | | - | | | | - | | | | 25 | |
| Balance at September 30, 2010 | | $ | 387 | | | $ | 92 | (a) | | $ | 8 | | | $ | 487 | |
| | | | | | | | | | | | | | | | | |
| The amount of total gains or (losses) for the | | | | | | | | | | | | | | | | |
| period included in earnings attributable to the | | | | | | | | | | | | | | | | |
| change in unrealized gains or losses relating to | | | | | | | | | | | | | | | | |
| assets still held at September 30, 2010 | | $ | (53 | ) | | $ | - | | | $ | - | | | $ | (53 | ) |
| | | | | | | | | | | | | | | | | |
| (a) Included in "Other assets" in the unaudited Condensed Consolidated Balance Sheet. | | | | | | | | |
All settlements from fuel derivative contracts that are deemed “effective” are included in “Fuel and oil” expense in the period the underlying fuel is consumed in operations. Any “ineffectiveness” associated with hedges, including amounts that settled in the current period (realized), and amounts that will settle in future periods (unrealized), is recorded in earnings immediately, as a component of “Other (gains) losses, net.” See Note 5 for further information on hedging.
Any gains and losses (realized and unrealized) related to other investments are reported in “Other operating expenses,” and were immaterial for the three and nine months ended September 30, 2010, and 2009.
The carrying amounts and estimated fair values of the Company’s long-term debt at September 30, 2010, are contained in the below table. The estimated fair values of the Company’s publicly held long-term debt were based on quoted market prices.
| (In millions) | | Carrying value | | | Estimated fair value | |
| 10.5% Notes due 2011 | | $ | 395 | | | $ | 432 | |
| Term Loan Agreement due 2020 - 5.223% | | | 599 | | | | 551 | |
| Term Loan Agreement due 2019 - 6.64% | | | 320 | | | | 333 | |
| Term Loan Agreement due 2019 - 6.84% | | | 115 | | | | 125 | |
| French Credit Agreements due 2012 | | | 17 | | | | 17 | |
| 6.5% Notes due 2012 | | | 367 | | | | 390 | |
| 5.25% Notes due 2014 | | | 306 | | | | 332 | |
| 5.75% Notes due 2016 | | | 277 | | | | 302 | |
| 5.125% Notes due 2017 | | | 240 | | | | 254 | |
| French Credit Agreements due 2017 | | | 77 | | | | 77 | |
| Pass Through Certificates due 2022 | | | 444 | | | | 455 | |
| 7.375% Debentures due 2027 | | | 71 | | | | 80 | |
11. EARLY RETIREMENT OFFER
On April 16, 2009, the Company announced Freedom ’09, a one-time voluntary early retirement program offered to eligible Employees, in which the Company offered cash bonuses, medical/dental coverage for a specified period of time, and travel privileges based on work group and years of service. The purpose of this voluntary initiative and other initiatives was to right-size headcount in conjunction with the Company’s decision to reduce its capacity by approximately five percent in 2009, and to reduce costs. Virtually all of the Company’s Employees hired before March 31, 2008, were eligible to participate in the program. Participants’ last day of work primarily fell between July 31, 2009, and April 15, 2010 , as assigned by the Company based on the operational needs of particular work locations and departments, determined on an individual-by-individual basis. A total of 1,404 Employees elected to participate in Freedom ‘09. In accordance with accounting guidance for voluntary termination benefits, the Company recorded total costs of approximately $66 million during the third quarter of 2009 upon acceptance of the retirement offer by Employees—all of which was reflected in salaries, wages, and benefits. The Company had no material remaining liability recorded for Freedom ’09 at September 30, 2010.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Relevant Southwest comparative operating statistics for the three and nine months ended September 30, 2010 and 2009 are as follows:
| | | Three months ended September 30, | | | | |
| | | 2010 | | | 2009 | | | Change | |
| Revenue passengers carried | | | 22,879,097 | | | | 22,375,593 | | | | 2.3 | % |
| Enplaned passengers | | | 27,814,896 | | | | 26,396,360 | | | | 5.4 | % |
| Revenue passenger miles (RPMs) (000s) | | | 20,673,082 | | | | 19,706,579 | | | | 4.9 | % |
| Available seat miles (ASMs) (000s) | | | 25,557,692 | | | | 24,771,016 | | | | 3.2 | % |
| Load factor | | | 80.9 | % | | | 79.6 | % | | 1.3 pts | |
| Average length of passenger haul (miles) | | | 904 | | | | 881 | | | | 2.6 | % |
| Average aircraft stage length (miles) | | | 653 | | | | 640 | | | | 2.0 | % |
| Trips flown | | | 287,200 | | | | 283,663 | | | | 1.2 | % |
| Average passenger fare | | $ | 132.53 | | | $ | 113.95 | | | | 16.3 | % |
| Passenger revenue yield per RPM (cents) | | | 14.67 | | | | 12.94 | | | | 13.4 | % |
| Operating revenue per ASM | | | 12.49 | | | | 10.76 | | | | 16.1 | % |
| Passenger revenue per ASM | | | 11.86 | | | | 10.29 | | | | 15.3 | % |
| Operating expenses per ASM (cents) | | | 11.10 | | | | 10.67 | | | | 4.0 | % |
| Operating expenses per ASM, excluding fuel (cents) (1) | | | 7.47 | | | | 7.34 | | | | 1.8 | % |
| Fuel costs per gallon, including fuel tax | | $ | 2.47 | | | $ | 2.27 | | | | 8.8 | % |
| Fuel costs per gallon, including fuel tax, economic | | $ | 2.38 | | | $ | 2.13 | | | | 11.7 | % |
| Fuel consumed, in gallons (millions) | | | 375 | | | | 363 | | | | 3.3 | % |
| Active fulltime equivalent Employees | | | 34,836 | | | | 34,806 | | | | 0.1 | % |
| Aircraft in service at period-end* | | | 547 | | | | 545 | | | | 0.4 | % |
| | | | | | | | | | | | | |
| | | Nine months ended September 30, | | | | | |
| | | | 2010 | | | | 2009 | | | Change | |
| Revenue passengers carried | | | 65,739,354 | | | | 64,811,451 | | | | 1.4 | % |
| Enplaned passengers | | | 79,063,561 | | | | 75,951,788 | | | | 4.1 | % |
| Revenue passenger miles (RPMs) (000s) | | | 58,041,024 | | | | 56,281,687 | | | | 3.1 | % |
| Available seat miles (ASMs) (000s) | | | 73,648,997 | | | | 74,495,618 | | | | (1.1 | )% |
| Load factor | | | 78.8 | % | | | 75.6 | % | | 3.2 pts | |
| Average length of passenger haul (miles) | | | 883 | | | | 868 | | | | 1.7 | % |
| Average aircraft stage length (miles) | | | 646 | | | | 641 | | | | 0.8 | % |
| Trips flown | | | 836,314 | | | | 852,371 | | | | (1.9 | )% |
| Average passenger fare | | $ | 129.97 | | | $ | 112.76 | | | | 15.3 | % |
| Passenger revenue yield per RPM (cents) | | | 14.72 | | | | 12.98 | | | | 13.4 | % |
| Operating revenue per ASM | | | 12.21 | | | | 10.25 | | | | 19.1 | % |
| Passenger revenue per ASM | | | 11.60 | | | | 9.81 | | | | 18.2 | % |
| Operating expenses per ASM (cents) | | | 11.16 | | | | 10.13 | | | | 10.2 | % |
| Operating expenses per ASM, excluding fuel (cents) (1) | | | 7.52 | | | | 7.11 | | | | 5.8 | % |
| Fuel costs per gallon, including fuel tax | | $ | 2.48 | | | $ | 2.07 | | | | 19.8 | % |
| Fuel costs per gallon, including fuel tax, economic | | $ | 2.36 | | | $ | 1.89 | | | | 24.9 | % |
| Fuel consumed, in gallons (millions) | | | 1,075 | | | | 1,083 | | | | (0.7 | )% |
| Active fulltime equivalent Employees | | | 34,836 | | | | 34,806 | | | | 0.1 | % |
| Aircraft in service at period-end* | | | 547 | | | | 545 | | | | 0.4 | % |
| | | | | | | | | | | | | |
| * Excludes aircraft that have been removed from service and are in storage, held for sale, or for return to the lessor. | |
| (1) See the following reconciliation of GAAP to non-GAAP financial measures. | | | | | | | |
Reconciliation of Reported Amounts to non-GAAP Financial Measures (unaudited) (in millions, except per share and per ASM amounts)
