UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2012
 
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to ________

Commission File No. 1-7259
 

 
Southwest Airlines Co.
(Exact name of registrant as specified in its charter)

TEXAS
74-1563240
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
P.O. Box 36611
 
Dallas, Texas
75235-1611
(Address of principal executive offices)
(Zip Code)

Registrant's telephone number, including area code:  (214) 792-4000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ  No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer þ
Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes ¨ No þ

 
Number of shares of Common Stock outstanding as of the close of business on October 24, 2012:  737,979,436
 

 
 
 

 

TABLE OF CONTENTS TO FORM 10-Q

Part I - FINANCIAL INFORMATION
 
Item 1. Financial Statements
   
Condensed Consolidated Balance Sheet as of September 30, 2012 and December 31, 2011
   
Condensed Consolidated Statement of Comprehensive Income (Loss) for the three and nine months ended September 30, 2012 and 2011
   
Condensed Consolidated Statement of Cash Flows for the three and nine months ended September 30, 2012 and 2011
   
Notes to Condensed Consolidated Financial Statements
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk
 
Item 4. Controls and Procedures
PART II – OTHER INFORMATION
 
Item 1. Legal Proceedings
 
Item 1A. Risk Factors
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
Item 3. Defaults Upon Senior Securities
 
Item 4. Mine Safety Disclosures
 
Item 5. Other Information
 
Item 6. Exhibits
SIGNATURES
EXHIBIT INDEX
 
 

 
2
 
 

 

SOUTHWEST AIRLINES CO.
FORM 10-Q
Part I – FINANCIAL INFORMATION

Item 1. Financial Statements
Southwest Airlines Co.
Condensed Consolidated Balance Sheet
 (in millions)
(unaudited)

   
September 30, 2012
   
December 31, 2011
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 1,168     $ 829  
Short-term investments
    2,067       2,315  
Accounts and other receivables
    430       299  
Inventories of parts and supplies, at cost
    544       401  
Deferred income taxes
    219       263  
Prepaid expenses and other current assets
    224       238  
Total current assets
    4,652       4,345  
                 
Property and equipment, at cost:
               
Flight equipment
    16,177       15,542  
Ground property and equipment
    2,671       2,423  
Deposits on flight equipment purchase contracts
    446       456  
      19,294       18,421  
Less allowance for depreciation and amortization
    6,722       6,294  
      12,572       12,127  
Goodwill
    970       970  
Other assets
    619       626  
    $ 18,813     $ 18,068  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Accounts payable
  $ 1,140     $ 1,057  
Accrued liabilities
    1,040       996  
Air traffic liability
    2,524       1,836  
Current maturities of long-term debt
    265       644  
Total current liabilities
    4,969       4,533  
                 
Long-term debt less current maturities
    2,961       3,107  
Deferred income taxes
    2,701       2,566  
Deferred gains from sale and leaseback of aircraft
    66       75  
Other noncurrent liabilities
    1,114       910  
Stockholders' equity:
               
Common stock
    808       808  
Capital in excess of par value
    1,228       1,222  
Retained earnings
    5,700       5,395  
Accumulated other comprehensive loss
    (125 )     (224 )
Treasury stock, at cost
    (609 )     (324 )
Total stockholders' equity
    7,002       6,877  
    $ 18,813     $ 18,068  
                 
                 
See accompanying notes.
 
 
 

 
3
 
 

 




Southwest Airlines Co.
Condensed Consolidated Statement of Comprehensive Income (Loss)
(in millions, except per share amounts)
(unaudited)



   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2012
   
2011
   
2012
   
2011
 
OPERATING REVENUES:
                       
Passenger
  $ 4,046     $ 4,034     $ 12,127     $ 10,875  
Freight
    39       35       118       103  
Other
    224       242       670       572  
Total operating revenues
    4,309       4,311       12,915       11,550  
                                 
OPERATING EXPENSES:
                               
Salaries, wages, and benefits
    1,189       1,146       3,552       3,226  
Fuel and oil
    1,528       1,586       4,615       4,150  
Maintenance materials and repairs
    300       272       862       717  
Aircraft rentals
    92       90       270       214  
Landing fees and other rentals
    278       257       791       705  
Depreciation and amortization
    217       191       620       523  
Acquisition and integration
    145       22       168       97  
Other operating expenses
    509       522       1,505       1,372  
Total operating expenses
    4,258       4,086       12,383       11,004  
                                 
OPERATING INCOME
    51       225       532       546  
                                 
OTHER EXPENSES (INCOME):
                               
Interest expense
    35       50       112       143  
Capitalized interest
    (5 )     (3 )     (16 )     (8 )
Interest income
    (2 )     (1 )     (5 )     (8 )
Other (gains) losses, net
    (10 )     405       (119 )     351  
Total other expenses (income)
    18       451       (28 )     478  
                                 
INCOME (LOSS) BEFORE INCOME TAXES
    33       (226 )     560       68  
PROVISION (BENEFIT) FOR INCOME TAXES
    17       (86 )     217       42  
                                 
NET INCOME (LOSS)
  $ 16     $ (140 )   $ 343     $ 26  
                                 
NET INCOME (LOSS) PER SHARE, BASIC
  $ .02     $ (.18 )   $ .45     $ .03  
                                 
NET INCOME (LOSS) PER SHARE, DILUTED
  $ .02     $ (.18 )   $ .45     $ .03  
                                 
COMPREHENSIVE INCOME (LOSS)
  $ 211     $ (546 )   $ 442     $ (225 )
                                 
WEIGHTED AVERAGE SHARES OUTSTANDING
                               
Basic
    739       792       756       773  
Diluted
    740       792       762       774  
                                 
Cash dividends declared per common share
  $ .0100     $ .0045     $ .0245     $ .0135  
                                 
See accompanying notes.
                 
 
 

 
4
 
 

 





Southwest Airlines Co.
Condensed Consolidated Statement of Cash Flows
(in millions)
(unaudited)


   
Three months ended
   
Nine months ended
 
   
September 30,
   
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
CASH FLOWS FROM OPERATING ACTIVITIES:
                       
Net income (loss)
  $ 16     $ (140 )   $ 343     $ 26  
Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities:
                               
Depreciation and amortization
    217       191       620       523  
Unrealized (gain) loss on fuel derivative instruments
    (16 )     393       (154 )     274  
Deferred income taxes
    82       (90 )     120       33  
Amortization of deferred gains on sale and leaseback of aircraft
    (3 )     (3 )     (9 )     (10 )
Changes in certain assets and liabilities:
                               
Accounts and other receivables
    (2 )     11       (107 )     (96 )
Other assets
    (74 )     (42 )     (164 )     (180 )
Accounts payable and accrued liabilities
    (187 )     (39 )     114       266  
Air traffic liability
    (5 )     (92 )     688       485  
Cash collateral received from (provided to) derivative counterparties
    252       (409 )     218       (429 )
Other, net
    184       2       164       93  
Net cash provided by (used in) operating activities
    464       (218 )     1,833       985  
                                 
CASH FLOWS FROM INVESTING ACTIVITIES:
                               
Payment to acquire AirTran, net of AirTran cash on hand
    -       -       -       (35 )
Payments for purchase of property and equipment, net
    (406 )     (276 )     (949 )     (548 )
Purchases of short-term investments
    (663 )     (1,525 )     (1,918 )     (4,788 )
Proceeds from sales of short-term investments
    775       1,664       2,192       4,414  
Other, net
    17       -       31       -  
Net cash used in investing activities
    (277 )     (137 )     (644 )     (957 )
                                 
CASH FLOWS FROM FINANCING ACTIVITIES:
                               
Proceeds from Employee stock plans
    5       4       22       35  
Proceeds from termination of interest rate derivative instrument
    -       -       -       76  
Payments of long-term debt and capital lease obligations
    (48 )     (48 )     (517 )     (110 )
Payments of convertible debt obligations
    -       -       -       (81 )
Payments of cash dividends
    (7 )     (3 )     (22 )     (14 )
Repurchase of common stock
    (50 )     (175 )     (325 )     (175 )
Other, net
    (2 )     (2 )     (8 )     (4 )
Net cash used in financing activities
    (102 )     (224 )     (850 )     (273 )
                                 
NET CHANGE IN CASH AND CASH EQUIVALENTS
    85       (579 )     339       (245 )
                                 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
    1,083       1,595       829       1,261  
                                 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
  $ 1,168     $ 1,016     $ 1,168     $ 1,016  

CASH PAYMENTS FOR:
                       
Interest, net of amount capitalized
  $ 39     $ 48     $ 119     $ 130  
Income taxes
  $ 2     $ -     $ 97     $ 5  
                                 
See accompanying notes.
                               
 
 

 
5
 
 

 





Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


1. BASIS OF PRESENTATION

The accompanying unaudited Condensed Consolidated Financial Statements of Southwest Airlines Co. and its subsidiaries (the “Company”) 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, 2012 and 2011 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 and elimination of significant intercompany transactions, but does not include all of the information and footnotes required by generally accepted accounting principles (“GAAP”) 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 financial results. 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, 2012 are not necessarily indicative of the results that may be expected for the year ended December 31, 2012. 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, 2011.

Certain prior period amounts have been reclassified to conform to the current presentation.  In the unaudited Condensed Consolidated Statement of Comprehensive Income (Loss) for the three and nine months ended September 30, 2011, the Company has reclassified $20 million and $46 million, respectively, from Other revenues to Passenger revenues associated with its sale of frequent flyer benefits from its co-branded Chase® Visa credit card.

2.  AIRTRAN ACQUISITION AND RELATED MATTERS
 
AirTran Holdings, Inc.
On May 2, 2011 (the “acquisition date”), the Company acquired all of the outstanding equity of AirTran Holdings, Inc. (“AirTran Holdings”), the former parent company of AirTran Airways, Inc. (“AirTran Airways”), in exchange for Southwest Airlines Co. common stock and cash.  Throughout this Form 10-Q, the Company makes reference to AirTran, which is meant to be inclusive of the following: (i) for periods prior to the acquisition date, AirTran Holdings and its subsidiaries, including, among others, AirTran Airways; and (ii) for periods on and after the acquisition date, AirTran Holdings, LLC, the successor to AirTran Holdings, and its subsidiaries, including among others, AirTran Airways.  AirTran Airways offers scheduled airline services, using Boeing 717-200 aircraft and Boeing 737-700 aircraft, throughout the United States and to select international locations.  In July 2012, the Company announced that the Boeing 717-200 aircraft will be transitioned out of the Company’s fleet over a three-year period beginning in August 2013.  See Note 8 for further information.  Approximately half of AirTran Airways’ flights originate or terminate at its largest base of operation in Atlanta, Georgia. AirTran Airways also serves a number of markets with non-stop service from smaller bases of operation in Baltimore, Maryland; Milwaukee, Wisconsin; and Orlando, Florida.

Expenses related to the AirTran acquisition
The Company is expected to continue to incur substantial integration and transition expenses in connection with the AirTran acquisition, including the necessary costs associated with integrating the operations of the two companies. While the Company has assumed that a certain level of expenses will be incurred, there are many factors that could affect the total amount or the timing of these 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 financial benefits that the Company expects to achieve from the AirTran acquisition and could continue to result in the Company taking significant charges against earnings during the integration process. The Company incurred consolidated acquisition and integration-related costs for the three months ended September 30, 2012 and 2011 of $145 million and $22 million, respectively, and for the nine months ended September 30, 2012 and 2011 of $168 million and $97 million, respectively, primarily consisting of costs associated with the lease and sublease of AirTran’s Boeing 717-200 fleet, consulting, flight crew training, seniority integration, technology, and facility integration expenses. In the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income (Loss), these costs are classified as Acquisition and integration expenses.  Also, see Note 8 for further information regarding the Boeing 717-200 lease/sublease transaction.
 
 
 
6
 

 

 
3.   ACCOUNTING CHANGES AND NEW ACCOUNTING PRONOUNCEMENTS

During first quarter 2012, the Company changed the estimated retirement dates of several 737-300 and 737-500 aircraft based on revisions in the Company’s fleet plan.  This change, which was accounted for on a prospective basis, resulted in an acceleration of depreciation expense, since the majority of these aircraft had previously been expected to retire in periods beyond 2012, but were now expected to be retired during 2012.  For the nine months ended September 30, 2012, the impact of this change was an increase in depreciation expense of approximately $28 million, excluding the impact of profitsharing and income taxes ($15 million after the impact of profitsharing and taxes, with a $.02 decrease in both basic and diluted net income per share).  The impact of this change for the three months ended September 30, 2012, was not significant. 

During third quarter 2012, the Company changed the estimated residual values of its entire fleet of owned 737-300 and 737-500 aircraft.  This change was based on an agreement entered into during July 2012, pursuant to which the Company will lease or sublease certain aircraft to a third party, and the resulting impact this transaction will have on how the Company manages the ultimate retirement of its owned 737-300 and 737-500 aircraft.  See Note 8 for further information on the lease/sublease transaction.  Based on the expected retirement dates and current and expected future market conditions related to its owned 737-300 and 737-500 aircraft, the Company reduced the residual values of these aircraft from approximately ten percent of original cost to approximately two percent of original cost.  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 2012 was an increase in depreciation expense of approximately $20 million, excluding the impact of profitsharing and income taxes ($10 million after the impact of profitsharing and taxes, with a $.01 decrease in both basic and diluted net income per share).

On December 16, 2011, the Financial Accounting Standards Board ratified Accounting Standards Update (“ASU”) No. 2011-11, “Disclosures about Offsetting Assets and Liabilities.” The new disclosure requirements mandate that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position, as well as instruments and transactions subject to an agreement similar to a master netting arrangement. In addition, the standard requires disclosure of collateral received and posted in connection with master netting agreements or similar arrangements. This ASU is effective for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. This ASU will not have a material effect on the Company’s financial position or results of operations, but will change the Company’s disclosure policies for financial derivative instruments. The Company plans to adopt this ASU for the interim period ending March 31, 2013.
 
 
 
7
 

 

 
4.  NET INCOME (LOSS) PER SHARE

The following table sets forth the computation of basic and diluted net income (loss) per share (in millions except per share amounts):

   
Three months ended
   
Nine months ended
 
   
September 30,
   
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
NUMERATOR:
                       
Net income (loss)
  $ 16     $ (140 )   $ 343     $ 26  
Incremental income effect of
                               
interest on 5.25% convertible notes
    -       -       2       -  
Net income (loss) after assumed conversion
  $ 16     $ (140 )   $ 345     $ 26  
                                 
DENOMINATOR:
                               
Weighted-average shares
                               
outstanding, basic
    739       792       756       773  
Dilutive effect of Employee stock options
                               
and restricted stock units
    1       -       -       1  
Dilutive effect of 5.25% convertible notes
    -       -       6       -  
Adjusted weighted-average shares
                               
outstanding, diluted
    740       792       762       774  
                                 
NET INCOME (LOSS) PER SHARE:
                               
Basic
  $ .02     $ (.18 )   $ .45     $ .03  
                                 
Diluted
  $ .02     $ (.18 )   $ .45     $ .03  
                                 
Potentially dilutive amounts
                               
excluded from calculations:
                               
Stock options and restricted stock units
    32       48       40       48  
5.25% convertible notes
    6       6       -       6  
 
 
 
 
8
 

 
 
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 represent 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 West Texas Intermediate (“WTI”) crude oil, Brent 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 primarily 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 have qualified or will qualify for 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.  The level at which the Company is hedged for a particular period is also dependent on current market prices for that period as well as the types of derivative instruments held and the strike prices of those instruments.

For the three months ended September 30, 2012, the Company had fuel derivatives in place for approximately 59 million gallons, or 12 percent, of its fuel consumption.  As of September 30, 2012, the Company had fuel derivative instruments in place to provide coverage on a portion of its remaining 2012 estimated fuel consumption. The following table provides information about the Company’s volume of fuel hedging for the years 2012 through 2016 on an “economic” basis considering current market prices:

   
Fuel hedged as of
   
   
September 30, 2012
 
Hedged commodity type
Period (by year)
 
(gallons in millions)(a)
 
as of September 30, 2012
Remainder of 2012
 
 130 
 
WTI crude oil
2013 
 
 183 
 
WTI crude and Brent crude oil
2014 
 
 1,171 
 
WTI crude and Brent crude oil
2015 
 
 609 
 
WTI crude and Brent crude oil
2016 
 
 454 
 
Brent crude oil
         
(a) The Company determines gallons hedged based on market prices and forward curves as of September 30, 2012.  Due to the types of derivatives utilized by the Company, these volumes may vary significantly as market prices fluctuate.

Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges.  Generally, utilizing hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective are recorded in Accumulated other comprehensive income (loss) (“AOCI”) until the underlying jet fuel is consumed.  See Note 6.  To the extent that the periodic changes in the fair value of the derivatives are ineffective, the ineffective portion is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income (Loss).  Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income (Loss) 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. 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 2011 or during the nine months ended September 30, 2012.

All cash flows associated with purchasing and selling fuel derivatives are classified as Other 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 derivative instruments within the unaudited Condensed Consolidated Balance Sheet:
 
 

 
9
 
 

 





Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)



       
Asset derivatives
   
Liability derivatives
 
Balance Sheet
 
Fair value at
 
Fair value at
 
Fair value at
 
Fair value at
(in millions)
 location
 
09/30/12
 
12/31/11
 
09/30/12
 
12/31/11
Derivatives designated as hedges*
                         
Fuel derivative contracts (gross)
Other current assets
 
$
 27 
 
$
 17 
 
$
 - 
 
$
 - 
Fuel derivative contracts (gross)
Other assets
   
 296 
   
 542 
   
 20 
   
 107 
Fuel derivative contracts (gross)
Accrued liabilities
   
 21 
   
 97 
   
 2 
   
 8 
Fuel derivative contracts (gross)
Other noncurrent liabilities
   
 - 
   
 93 
   
 - 
   
 24 
Interest rate derivative contracts
Other assets
   
 71 
   
 64 
   
 - 
   
 - 
Interest rate derivative contracts
Accrued liabilities
   
 - 
   
 2 
   
 - 
   
 - 
Interest rate derivative contracts
Other noncurrent liabilities
   
 - 
   
 - 
   
 132 
   
 132 
                           
Total derivatives designated as hedges
 
$
 415 
 
$
 815 
 
$
 154 
 
$
 271 
                           
Derivatives not designated as hedges*
                         
Fuel derivative contracts (gross)
Other current assets
 
$
 255 
 
$
 124 
 
$
 215 
 
$
 58 
Fuel derivative contracts (gross)
Other assets
   
 405 
   
 26 
   
 513 
   
 272 
Fuel derivative contracts (gross)
Accrued liabilities
   
 158 
   
 326 
   
 279 
   
 687 
Fuel derivative contracts (gross)
Other noncurrent liabilities
   
 - 
   
 9 
   
 - 
   
 122 
                           
Total derivatives not designated as hedges
   
$
 818 
 
$
 485 
 
$
 1,007 
 
$
 1,139 
                           
Total derivatives
   
$
 1,233 
 
$
 1,300 
 
$
 1,161 
 
$
 1,410 
                           
* Represents the position of each trade before consideration of offsetting positions with each counterparty and does not include the impact of cash collateral deposits provided to or received from 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:
 
 

 
10
 
 

 





Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)



     
Balance Sheet
 
September 30,
 
December 31,
(in millions)
 
location
 
2012 
 
2011 
Cash collateral deposits provided
 
Offset against Other
           
 
to counterparties - noncurrent
 
noncurrent liabilities
 
$
 - 
 
$
 41 
Cash collateral deposits provided
 
Offset against Accrued
           
 
to counterparties - current
 
liabilities
   
 13 
   
 185 
Due to third parties for fuel contracts
 
Accrued liabilities
   
 8 
   
 21 
Receivable from third parties for
 
Accounts and other
           
 
fuel contracts - current
 
receivables
   
 - 
   
 3 
Receivable from third parties for
               
 
fuel contracts - noncurrent
 
Other assets
   
 54 
   
 - 
 
 
The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Comprehensive Income (Loss) for the three and nine months ended September 30, 2012 and 2011:
 
 
Derivatives in cash flow hedging relationships
 
   
(Gain) loss
   
(Gain) loss
 
(Gain) loss
   
recognized in AOCI on
   
reclassified from AOCI
 
recognized in income
   
derivatives (effective
   
into income (effective
 
on derivatives
   
portion)
   
 portion)(a)
   
(ineffective portion)(b)
   
Three months ended
 
Three months ended
 
Three months ended
   
September 30,
 
September 30,
 
September 30,
(in millions)
2012 
 
2011 
 
2012 
 
2011 
 
2012 
 
2011 
                                     
Fuel derivative
                                 
 
contracts
$
 (167)
*
$
 417 
*
$
 25 
*
$
 45 
*
$
 4 
 
$
 85 
Interest rate
                                 
 
derivatives
 
 3 
*
 
 30 
*
 
 - 
   
 - 
   
 - 
   
 - 
                                     
Total
$
 (164)
 
$
 447 
 
$
 25 
 
$
 45 
 
$
 4 
 
$
 85 
                                     
*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.
 
 
 
 
11
 

 

 
Derivatives in cash flow hedging relationships
 
   
(Gain) loss
   
(Gain) loss
 
(Gain) loss
   
recognized in AOCI on
   
reclassified from AOCI
 
recognized in income
   
derivatives (effective
   
into income (effective
 
on derivatives
   
portion)
   
 portion)(a)
   
(ineffective portion)(b)
   
Nine months ended
 
Nine months ended
 
Nine months ended
   
September 30,
 
September 30,
 
September 30,
(in millions)
2012 
 
2011 
 
2012 
 
2011 
 
2012 
 
2011 
                                     
Fuel derivative
                                 
 
contracts
$
 (24)
*
$
 297 
*
$
 76 
*
$
 78 
*
$
 44 
 
$
 127 
Interest rate
                                 
 
derivatives
 
 5 
*
 
 34 
*
 
 - 
   
 - 
   
 - 
   
 - 
                                     
Total
$
 (19)
 
$
 331 
 
$
 76 
 
$
 78 
 
$
 44 
 
$
 127 
                                     
*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
 
                   
   
(Gain) loss
     
   
recognized in income on
     
   
  derivatives
     
   
Three months ended
 
Location of (gain) loss
 
   
September 30,
 
recognized in income
 
(in millions)
 
2012 
 
2011 
 
on derivatives
 
Fuel derivative contracts
 
$
 (32)
 
$
 284 
 
Other (gains) losses, net
 

Derivatives not in cash flow hedging relationships
 
                   
   
(Gain) loss
     
   
recognized in income on
     
   
  derivatives
     
   
Nine months ended
 
Location of (gain) loss
 
   
September 30,
 
recognized in income
 
(in millions)
 
2012 
 
2011 
 
on derivatives
 
Fuel derivative contracts
 
$
 (200)
 
$
 129 
 
Other (gains) losses, net
 
 
 
 
 
12
 

 

 
The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended September 30, 2012 and 2011 of $15 million and $36 million, respectively, and the nine months ended September 30, 2012 and 2011 of $33 million and $93 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 Comprehensive Income (Loss).

The fair values of the derivative instruments, depending on the type of instrument, were determined by the use of present value methods or option value models with assumptions about commodity prices based on those observed in underlying markets or provided by third parties.  Included in the Company’s cumulative net unrealized losses from fuel hedges as of September 30, 2012, were approximately $87 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2012.  In addition, as of September 30, 2012, the Company had already recognized cumulative net gains due to ineffectiveness and derivatives that did not qualify for hedge accounting treatment totaling $30 million, net of taxes.  These net gains were recognized during the three months ended September 30, 2012 and prior periods, and are reflected in Retained earnings as of September 30, 2012, but the underlying derivative instruments will not expire/settle until fourth quarter 2012 or future periods.

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 at each reporting period.  The ineffectiveness associated with all of the Company’s, including AirTran’s, interest rate cash flow hedges for all periods presented was not material.
 
 
Credit risk and collateral
Credit exposure related to fuel derivative instruments is represented by the fair value of contracts that are an asset to the Company at the reporting date.  At such times, 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 periodically reviews counterparties based on credit ratings, limits its exposure with respect to each counterparty, and monitors the market position of the fuel hedging program and its relative market position with each counterparty.  At September 30, 2012, the Company had agreements with all of its active counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount based on the counterparty credit rating.  The Company also had agreements with counterparties in which cash deposits, letters of credit, 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, 2012, at which such postings are triggered:
 
 
 
 
13
 

 
 
 
   
Counterparty (CP)
           
   
A
   
B
   
C
   
D
   
E
   
Other(a)
   
Total
(in millions)
                                       
Fair value of fuel derivatives
$
(9)
 
$
 
$
(17)
 
$
 
$
121 
 
$
36 
 
$
 133 
Cash collateral held (by) CP
 
 - 
   
 (13)
   
 - 
   
 - 
   
 - 
   
 - 
   
 (13)
Aircraft collateral pledged to CP
 
 - 
   
 - 
   
 - 
   
 - 
   
 - 
   
 - 
   
 - 
Letters of credit (LC)
 
 - 
   
 - 
   
 - 
   
 - 
   
 - 
   
 - 
   
 - 
   Option to substitute LC for aircraft
 
(340) to
   
>(125)(d)
   
N/A
   
N/A
   
N/A
           
   
(740)(d)
                                   
                                         
   Option to substitute LC for cash
 
N/A
   
N/A
   
(100) to
   
N/A
   
>(50)(e)
           
               
(150)(e)
                       
If credit rating is investment
                                       
grade, fair value of fuel
                                       
derivative level at which:
                                       
   Cash is provided to CP
 
(40) to (340)
   
0 to (125)
   
>(50)
   
>(75)
   
>(50)
           
   
or >(740)
   
or >(625)
                             
   Cash is received from CP
 
>75
   
>150
   
>125(c)
   
>125(c)
   
>250
           
   Aircraft or cash can be pledged
                                       
     to CP as collateral
 
(340) to
   
(125) to
   
N/A
   
N/A
   
N/A
           
   
(740)(d)
   
(625)(d)
                             
If credit rating is non-investment
                                       
grade, fair value of fuel derivative
                                       
level at which:
                                       
   Cash is provided to CP
 
(40) to (340)
   
0 to (125)
   
(b)
   
(b)
   
(b)
           
   
or >(740)
   
or >(625)
                             
   Cash is received from CP
 
(b)
   
(b)
   
(b)
   
(b)
   
(b)
           
   Aircraft can be pledged to CP
                                       
     as collateral
 
(340) to
   
(125) to
   
N/A
   
N/A
   
N/A
           
   
(740)
   
(625)
                             
                                         
(a) Individual counterparties with fair value of fuel derivatives <$20 million.
(b) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.
(c) Thresholds may vary based on changes in credit ratings within investment grade.
(d) The Company has the option of providing cash, letters of credit, or pledging aircraft as collateral. No letters of credit or aircraft were pledged as collateral with such counterparties as of September 30, 2012.
(e) The Company has the option of providing cash or letters of credit as collateral. No letters of credit were pledged as collateral with such counterparties as of September 30, 2012.

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, 2012, $67 million had been provided to one counterparty associated with interest rate derivatives based on the Company’s outstanding net liability derivative position with that counterparty.  In addition, in connection with interest rate swaps entered into by AirTran, $24 million had been provided to one counterparty at September 30, 2012, as a result of a net liability derivative position with that counterparty. The outstanding interest rate net derivative positions with all other counterparties at September 30, 2012, were not material.
 
Applicable accounting provisions require an entity to select a policy for how it presents the offset rights to reclaim cash collateral associated with the fair value of the related derivative assets or liabilities. In the accompanying unaudited Condensed Consolidated Balance Sheet, 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.
 
 
 
 
14
 

 

 
6.      COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) includes changes in the fair value of certain financial derivative instruments that 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 and Comprehensive income (loss) for the three and nine months ended September 30, 2012 and 2011 were as follows:

   
Three months ended September 30,
 
(in millions)
 
2012
   
2011
 
NET INCOME (LOSS)
  $ 16     $ (140 )
                 
Unrealized gain (loss) on fuel derivative instruments, net of
               
deferred taxes of $120 and ($233)
    192       (372 )
Unrealized loss on interest rate derivative instruments, net of
               
deferred taxes of ($2) and ($19)
    (3 )     (30 )
Other, net of deferred taxes of $3 and ($3)
    6       (4 )
Total other comprehensive income (loss)
  $ 195     $ (406 )
                 
COMPREHENSIVE INCOME (LOSS)
  $ 211     $ (546 )
                 
                 

   
Nine months ended September 30,
 
(in millions)
 
2012
   
2011
 
NET INCOME
  $ 343     $ 26  
                 
Unrealized gain (loss) on fuel derivative instruments, net of
               
deferred taxes of $63 and ($137)
    100       (219 )
Unrealized loss on interest rate derivative instruments, net of
               
deferred taxes of ($3) and ($22)
    (5 )     (34 )
Other, net of deferred taxes of $2 and $1
    4       2  
Total other comprehensive income (loss)
  $ 99     $ (251 )
                 
COMPREHENSIVE INCOME (LOSS)
  $ 442     $ (225 )
                 
                 

A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three and nine months ended September 30, 2012:

                       
Accumulated other
     
Fuel
 
Interest rate
       
comprehensive
(in millions)
 
derivatives
 
derivatives
 
Other
 
income (loss)
Balance at June 30, 2012
 
$
 (275)
 
$
 (68)
 
$
 23 
 
$
 (320)
 
Changes in fair value
   
 167 
   
 (3)
   
 6 
   
 170 
 
Reclassification to earnings
   
 25 
   
 - 
   
 - 
   
 25 
Balance at September 30, 2012
 
$
 (83)
 
$
 (71)
 
$
 29 
 
$
 (125)

                       
Accumulated other
     
Fuel
 
Interest rate
       
comprehensive
(in millions)
 
derivatives
 
derivatives
 
Other
 
income (loss)
Balance at December 31, 2011
 
$
 (183)
 
$
 (66)
 
$
 25 
 
$
 (224)
 
Changes in fair value
   
 24 
   
 (5)
   
 4 
   
 23 
 
Reclassification to earnings
   
 76 
   
 - 
   
 - 
   
 76 
Balance at September 30, 2012
 
$
 (83)
 
$
 (71)
 
$
 29 
 
$
 (125)

 
 
15
 

 

 
7.  OTHER ASSETS AND LIABILITIES

   
September 30,
   
December 31,
 
(in millions)
 
2012
   
2011
 
Derivative contracts
  $ 294     $ 253  
Intangible assets
    144       155  
Non-current investments
    42       97  
Other
    139       121  
Other assets
  $ 619     $ 626  

   
September 30,
   
December 31,
 
(in millions)
 
2012
   
2011
 
Retirement plans
  $ 114     $ 110  
Aircraft rentals
    105       57  
Vacation pay
    263       248  
Health
    60       56  
Derivative contracts
    90       85  
Workers compensation
    155       162  
Accrued taxes
    61       68  
Other
    192       210  
Accrued liabilities
  $ 1,040     $ 996  
                 

   
September 30,
   
December 31,
 
(in millions)
 
2012
   
2011
 
Postretirement obligation
  $ 116     $ 107  
Non-current lease-related obligations
    419       311  
Airport construction obligation
    304       202  
Other
    275       290  
Other non-current liabilities
  $ 1,114     $ 910  
                 
                 
 
 
 
 
16
 

 

 
8.  LEASES

On July 9, 2012, the Company signed an agreement with Delta Air Lines, Inc. (“Delta”) and Boeing Capital Corp. to lease or sublease all 88 of AirTran’s Boeing 717-200 aircraft (“B717s”) to Delta, with the first delivery expected to occur in August 2013, at a rate of approximately three B717s per month.  A total of 78 of the B717s are on operating lease, eight are owned, and two are currently classified as capital leases.

The B717s add complexity to the Company’s operations, as Southwest Airlines has historically operated an all-Boeing 737 fleet.  From a fleet management perspective, the transition of approximately three B717s per month to Delta beginning in August 2013 allows the Company to minimize the impact of this transaction on operations, as the B717 capacity lost will be replaced through the capacity gained as a result of the Company’s modification of the retirement dates for a portion of its 737-300 and 737-500 aircraft, and its receipt of new 737 deliveries from Boeing, or other used 737s that could be acquired.

The Company will lease and/or sublease all 88 of the B717s to Delta at agreed-upon lease rates.  In addition, the Company will pay the majority of the costs to convert the aircraft to the Delta livery and perform certain maintenance checks prior to the delivery of each aircraft.  The agreement to pay these conversion and maintenance costs is a “lease incentive” under applicable accounting guidance.  The sublease terms for the 78 B717s currently on operating lease and the two B717s currently classified as capital leases coincide with the Company’s remaining lease terms for these aircraft from the original lessor, which range from approximately six years to approximately twelve years.  The lease terms for the eight B717s that are owned by the Company are for a period of seven years, after which Delta will have the option to purchase the aircraft at the then-prevailing market value.  The Company will account for the lease and sublease transactions with Delta as operating leases, except for the two aircraft classified by the Company as capital leases.  The sublease of these two aircraft will be accounted for as direct financing leases.  There are no contingent payments and no significant residual value conditions associated with the transaction.

The accounting for this transaction is based on the guidance provided for lease transactions.  For the components of this transaction finalized in third quarter 2012 and with respect to which the lease inception has been deemed to occur, the Company recorded a charge of approximately $137 million during third quarter 2012.  The charge represents the remaining estimated cost, at the scheduled date of delivery of each B717 to Delta (including the conversion, maintenance, and other contractual costs to be incurred), of the Company’s lease of the 78 B717s that are currently accounted for as operating leases, net of the future sublease income from Delta and the remaining unfavorable aircraft lease liability established as of the acquisition date.  The charges recorded by the Company for this transaction are included as a component of Acquisition and integration costs in the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income (Loss) and are included as a component of Other, net in Cash flows from operating activities in the Company’s unaudited Condensed Consolidated Statement of Cash Flows, and the corresponding liability for this transaction is included as a component of Other noncurrent liabilities in the Company’s unaudited Condensed Consolidated Balance Sheet.  See Note 2 for further information on the Company’s Acquisition and integration costs.  The Company may also incur other costs associated with this transaction, such as contract termination costs with certain aircraft maintenance vendors.  Two of these vendor maintenance contracts have stated termination penalties totaling approximately $106 million if the Company were to terminate such contracts; however, termination of these contracts has not occurred and any charges would only be recorded at the time of contract termination or at the time any associated charges become probable and estimable.

The effect of this transaction on the Company’s future expected contractual obligations and commitments related to operating leases is to reduce such amounts by: $5 million in 2013, $48 million in 2014, $88 million in 2015, $106 million in 2016, $106 million in 2017, and $345 million thereafter.

 
 
17
 

 

 
9. COMMITMENTS AND CONTINGENCIES

Commitments
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, and the Love Field Airport Modernization Corporation (or “LFAMC,” a Texas non-profit “local government corporation” established by the City to act on the City’s behalf to facilitate the development of the LFMP), the Company is managing this project.  Major construction commenced during 2010, with completion of the project scheduled for the second half of 2014.  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 infrastructure.

It is currently expected that the total amount spent on the LFMP project will be approximately $519 million.  Although the City of Dallas has received commitments from various sources that are expected to fund portions of the LFMP project, including the Federal Aviation Administration (“FAA”), the Transportation Security Administration, and the City’s Aviation Fund, the majority of the funds used are expected to be from the issuance of bonds.  During fourth quarter 2010, $310 million of such bonds were issued by the LFAMC, and the Company has guaranteed principal and interest payments on the bonds.  An additional tranche of such bonds totaling $146 million was issued during second quarter 2012, and the Company has guaranteed the principal and interest payments on these bonds as well. The Company currently expects that as a result of the funding commitments from the above mentioned sources and the bonds that have been issued thus far, no further bond issuances will be required to complete the LFMP project.

The Company has agreed to manage the majority of the LFMP project and, as a result, has evaluated its ongoing accounting requirements in consideration of accounting guidance provided for lessees involved in asset construction.  The Company has recorded and will continue to record an asset and corresponding obligation for the cost of the LFMP project as the construction of the facility occurs.  As of September 30, 2012, the Company had recorded LFMP construction costs of $304 million, classified as both an asset as a component of Ground property and equipment and a corresponding liability as a component of Other non-current liabilities in its unaudited Condensed Consolidated Balance Sheet.  Upon completion of the LFMP project, the Company expects to begin depreciating the assets over their estimated useful lives, and reduce the corresponding liabilities primarily through the Company’s airport rental payments to the City of Dallas.

The Company also has contractual purchase commitments associated with scheduled aircraft acquisitions from Boeing. During the second quarter 2012, the Company revised its future aircraft delivery schedule to defer 30 firm deliveries from Boeing, originally scheduled for delivery in 2013 and 2014, to 2017 and 2018, resulting in a reduction in the Company’s expected capital expenditures totaling approximately $1 billion from 2012 through 2014. However, this deferral did not result in a net change in the total future purchase commitments with Boeing by the Company.

Contingencies
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 IRS.  The Company's management does not expect that the outcome in any of its currently ongoing legal proceedings or the outcome of any adjustments presented by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow.
 
 
 
 
18
 

 

 
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, 2012, 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, commercial paper, and certificates of deposit), certain noncurrent investments, interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities.  The majority of the Company’s short-term investments consist of instruments classified as Level 1.  However, the Company has certificates of deposit and commercial paper that 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 collateralized 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 swaps, as well as different types of option contracts, whereas interest rate derivatives consist solely 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’s Treasury Group, which reports to the Chief Financial Officer, determines the value of option contracts utilizing an 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 provided by financial institutions that trade these contracts. The option pricing model used by the Company is an industry standard model for valuing options and is the same model used by the broker/dealer community (i.e., the Company’s counterparties). The inputs to this option pricing model are the option strike price, underlying price, risk free rate of interest, time to expiration, and volatility. Because certain 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. Volatility information is obtained from external sources, but is analyzed by the Company for reasonableness and compared to similar information received from other external sources. The fair value of option contracts considers both the intrinsic value and any remaining time value associated with those derivatives that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model, on a monthly basis, the Company compares its option valuations to third party valuations. If any significant differences were to be noted, they would be researched in order to determine the reason. However, historically, no significant differences have been noted. 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 non-qualified deferred compensation plan designed to hold Employee contributions in excess of limits established by Section 415 of the Internal Revenue Code of 1986, as amended.  Payments under this plan are made based on the participant’s distribution election and plan balance. Assets related to the funded portion of the deferred compensation plan are held in a rabbi trust and the Company remains liable to these participants for the unfunded portion of the plan. The Company records changes in the fair value of the liability and the asset in the Company’s earnings.

All of the Company’s auction rate security instruments, totaling $37 million at September 30, 2012, 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 these remaining instruments failed, and have continued to fail through the current period.  Therefore, the Company’s Treasury Group determines the estimated fair values of these securities utilizing a discounted cash flow analysis.  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, estimates of the next time the security is expected to have a successful auction or return to full par value, forecasted reset rates based on the London Interbank Offered Rate (“LIBOR”) or the issuer’s net loan rate, and a counterparty credit spread.  To validate the reasonableness of the Company’s discounted cash flow analyses, the Company compares its valuations to third party valuations on a quarterly basis.

In association with its estimate of fair value related to auction rate security instruments as of September 30, 2012, the Company has previously recorded a temporary unrealized decline in fair value of $13 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 currently rated investment grade by Moody’s, Standard and Poor’s, and Fitch and are almost entirely backed by the U.S. Government. The range of maturities for the Company’s auction rate securities are from 6 years to 35 years. Considering the relative insignificance of these securities 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 $413 million of these instruments at par value.
 

 

19
 
 

 





Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)



The following tables present the Company’s assets and liabilities that are measured at fair value on a recurring basis at September 30, 2012 and December 31, 2011:
 

           
Fair value measurements at reporting date using:
           
Quoted prices in
 
Significant
 
Significant
           
active markets
 
other observable
 
unobservable
           
for identical assets
 
inputs
 
inputs
Description
 
September 30, 2012
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
                       
 
Cash equivalents (a)
 
$
 986 
 
$
 986 
 
$
 - 
 
$
 - 
 
Commercial paper
   
 160 
   
 - 
   
 160 
   
 - 
 
Certificates of deposit
   
 22 
   
 - 
   
 22 
   
 - 
Short-term investments:
                       
 
Treasury bills
   
 1,824 
   
 1,824 
   
 - 
   
 - 
 
Certificates of deposit
   
 243 
   
 - 
   
 243 
   
 - 
Noncurrent investments (b)
                       
 
Auction rate securities
   
 37 
   
 - 
   
 - 
   
 37 
Interest rate derivatives (see Note 5)
   
 71 
   
 - 
   
 71 
   
 - 
Fuel derivatives:
                       
 
Swap contracts (c)
   
 87 
   
 - 
   
 87 
   
 - 
 
Option contracts (c)
   
 896 
   
 - 
   
 - 
   
 896 
 
Swap contracts (d)
   
 66 
   
 - 
   
 66 
   
 - 
 
Option contracts (d)
   
 113 
   
 - 
   
 - 
   
 113 
Other available-for-sale securities
   
 50 
   
 45 
   
 - 
   
 5 
Total assets
 
$
 4,555 
 
$
 2,855 
 
$
 649 
 
$
 1,051 
                           
Liabilities
                       
Fuel derivatives:
                       
 
Swap contracts (c)
 
$
 (32)
 
$
 - 
 
$
 (32)
 
$
 - 
 
Option contracts (c)
   
 (716)
   
 - 
   
 - 
   
 (716)
 
Swap contracts (d)
   
 (212)
   
 - 
   
 (212)
   
 - 
 
Option contracts (d)
   
 (69)
   
 - 
   
 - 
   
 (69)
Interest rate derivatives (see Note 5)
   
 (132)
   
 - 
   
 (132)
   
 - 
Deferred compensation
   
 (134)
   
 (134)
   
 - 
   
 - 
Total liabilities
 
$
 (1,295)
 
$
 (134)
 
$
 (376)
 
$
 (785)
                           
                           
(a) Cash equivalents are primarily composed of money market investments.
(b) Noncurrent investments are included in Other assets in the unaudited Condensed Consolidated Balance Sheet.
(c) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net asset, and are also net of cash collateral received from counterparties.  See Note 5.
(d) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net liability, and are also net of cash collateral provided to counterparties.  See Note 5.
 
 

 
20
 
 

 





Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)



           
Fair value measurements at reporting date using:
           
Quoted prices in
 
Significant
 
Significant
           
active markets
 
other observable
 
unobservable
           
for identical assets
 
inputs
 
inputs
Description
 
December 31, 2011
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
                       
 
Cash equivalents (a)
 
$
 774 
 
$
 774 
 
$
 - 
 
$
 - 
 
Commercial paper
   
 48 
   
 - 
   
 48 
   
 - 
 
Certificates of deposit
   
 7 
   
 - 
   
 7 
   
 - 
Short-term investments:
                       
 
Treasury bills
   
 2,014 
   
 2,014 
   
 - 
   
 - 
 
Certificates of deposit
   
 221 
   
 - 
   
 221 
   
 - 
 
Commercial paper
   
 80 
   
 - 
   
 80 
   
 - 
Noncurrent investments (b)
                       
 
Auction rate securities
   
 67 
   
 - 
   
 - 
   
 67 
 
Certificates of deposit
   
 25 
   
 - 
   
 25 
   
 - 
Interest rate derivatives (see Note 5)
   
 66 
   
 - 
   
 66 
   
 - 
Fuel derivatives:
                       
 
Option contracts (c)
   
 709 
   
 - 
   
 - 
   
 709 
 
Swap contracts (d)
   
 180 
   
 - 
   
 180 
   
 - 
 
Option contracts (d)
   
 345 
   
 - 
   
 - 
   
 345 
Other available-for-sale securities
   
 43 
   
 38 
   
 - 
   
 5 
Total assets
 
$
 4,579 
 
$
 2,826 
 
$
 627 
 
$
 1,126 
                           
Liabilities
                       
Fuel derivatives:
                       
 
Swap contracts (c)
 
$
 (65)
 
$
 - 
 
$
 (65)
 
$
 - 
 
Option contracts (c)
   
 (371)
   
 - 
   
 - 
   
 (371)
 
Swap contracts (d)