form10q.htm

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 June 30, 2010
 
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 July 27, 2010: 745,946,155

 

 

SOUTHWEST AIRLINES CO.

TABLE OF CONTENTS TO FORM 10-Q


Part I- FINANCIAL INFORMATION
Item 1. 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. (Removed and Reserved)
Item 5. Other Information
Item 6. Exhibits
SIGNATURES
EXHIBIT INDEX


 

 
Table of Contents


SOUTHWEST AIRLINES CO.
FORM 10-Q
Part I - FINANCIAL INFORMATION
Item 1. Financial Statements
Southwest Airlines Co.
Condensed Consolidated Balance Sheet
(in millions)
(unaudited)
 
 

   
June 30, 2010
   
December 31, 2009
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 989     $ 1,114  
Short-term investments
    2,135       1,479  
Accounts and other receivables
    277       169  
Inventories of parts and supplies, at cost
    226       221  
Deferred income taxes
    252       291  
Prepaid expenses and other current assets
    92       84  
Total current assets
    3,971       3,358  
                 
Property and equipment, at cost:
               
Flight equipment
    13,923       13,719  
Ground property and equipment
    2,024       1,922  
Deposits on flight equipment purchase contracts
    235       247  
      16,182       15,888  
Less allowance for depreciation and amortization
    5,555       5,254  
      10,627       10,634  
Other assets
    389       277  
    $ 14,987     $ 14,269  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Accounts payable
  $ 787     $ 732  
Accrued liabilities
    942       729  
Air traffic liability
    1,486       1,044  
Current maturities of long-term debt
    123       190  
Total current liabilities
    3,338       2,695  
                 
Long-term debt less current maturities
    3,324       3,325  
Deferred income taxes
    2,192       2,200  
Deferred gains from sale and leaseback of aircraft
    95       102  
Other non-current liabilities
    490       493  
Stockholders' equity:
               
Common stock
    808       808  
Capital in excess of par value
    1,221       1,216  
Retained earnings
    5,075       4,971  
Accumulated other comprehensive loss
    (641 )     (578 )
Treasury stock, at cost
    (915 )     (963 )
Total stockholders' equity
    5,548       5,454  
    $ 14,987     $ 14,269  
                 
See accompanying notes.
               




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


 
   
Three months ended June 30,
   
Six months ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
OPERATING REVENUES:
                       
Passenger
  $ 3,016     $ 2,506     $ 5,511     $ 4,758  
Freight
    33       29       63       58  
Other
    119       81       224       156  
Total operating revenues
    3,168       2,616       5,798       4,972  
OPERATING EXPENSES:
                               
Salaries, wages, and benefits
    946       863       1,810       1,699  
Fuel and oil
    933       726       1,754       1,423  
Maintenance materials and repairs
    194       190       360       373  
Aircraft rentals
    45       47       92       93  
Landing fees and other rentals
    206       179       396       345  
Depreciation and amortization
    154       150       308       300  
Other operating expenses
    327       338       661       666  
Total operating expenses
    2,805       2,493       5,381       4,899  
OPERATING INCOME
    363       123       417       73  
OTHER EXPENSES (INCOME):
                               
Interest expense
    42       47       83       92  
Capitalized interest
    (5 )     (5 )     (10 )     (11 )
Interest income
    (4 )     (3 )     (6 )     (8 )
Other (gains) losses, net
    146       (23 )     150       -  
Total other expenses
    179       16       217       73  
                                 
INCOME BEFORE INCOME TAXES
    184       107       200       -  
PROVISION FOR INCOME TAXES
    72       16       77       -  
                                 
NET INCOME
  $ 112     $ 91     $ 123     $ -  
                                 
                                 
NET INCOME PER SHARE, BASIC
  $ .15     $ .12     $ .17     $ -  
                                 
NET INCOME PER SHARE, DILUTED
  $ .15     $ .12     $ .17     $ -  
                                 
WEIGHTED AVERAGE SHARES
                               
OUTSTANDING:
                               
Basic
    745       741       744       741  
Diluted
    746       741       745       741  
                                 
See accompanying notes.
                               



 

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

 
   
Three months ended June 30,
   
Six months ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
CASH FLOWS FROM OPERATING ACTIVITIES:
                       
Net income
  $ 112     $ 91     $ 123     $ -  
Adjustments to reconcile net income to
                               
cash provided by operating activities:
                               
Depreciation and amortization
    154       150       308       300  
Unrealized (gain) loss on fuel derivative instruments
    166       (3 )     187       67  
Deferred income taxes
    63       16       75       (5 )
Amortization of deferred gains on sale and
                               
leaseback of aircraft
    (3 )     (4 )     (7 )     (7 )
Changes in certain assets and liabilities:
                               
Accounts and other receivables
    (42 )     (6 )     (108 )     (28 )
Other current assets
    5       (28 )     (14 )     (18 )
Accounts payable and accrued liabilities
    279       104       195       104  
Air traffic liability
    86       (43 )     442       244  
Cash collateral received from (provided to) fuel
                               
    derivative counterparties
    130       (125 )     135       (185 )
Other, net
    (410 )     (17 )     (423 )     (52 )
Net cash provided by operating activities
    540       135       913       420  
                                 
CASH FLOWS FROM INVESTING ACTIVITIES:
                               
Purchases of property and equipment, net
    (159 )     (187 )     (298 )     (272 )
Purchases of short-term investments
    (1,800 )     (1,394 )     (3,180 )     (3,090 )
Proceeds from sales of short-term investments
    1,349       1,203       2,546       2,347  
Other, net
    -       1       -       1  
Net cash used in investing activities
    (610 )     (377 )     (932 )     (1,014 )
                                 
CASH FLOWS FROM FINANCING ACTIVITIES:
                               
Proceeds from sale and leaseback transactions
    -       208       -       381  
Issuance of long-term debt
    -       332       -       332  
Proceeds from Employee stock plans
    23       4       35       8  
Payments of long-term debt and capital lease obligations
    (25 )     (7 )     (85 )     (41 )
Payment of revolving credit facility
    -       (400 )     -       (400 )
Payment of credit line borrowing
    (44 )     (91 )     (44 )     (91 )
Payments of cash dividends
    (3 )     (3 )     (10 )     (10 )
Other, net
    (2 )     -       (2 )     (7 )
Net cash provided by (used in) financing activities
    (51 )     43       (106 )     172  
                                 
NET CHANGE IN CASH AND CASH EQUIVALENTS
    (121 )     (199 )     (125 )     (422 )
CASH AND CASH EQUIVALENTS AT
                               
BEGINNING OF PERIOD
    1,110       1,145       1,114       1,368  
CASH AND CASH EQUIVALENTS
                               
AT END OF PERIOD
  $ 989     $ 946     $ 989     $ 946  
                                 
CASH PAYMENTS FOR:
                               
Interest, net of amount capitalized
  $ 33     $ 42     $ 68     $ 78  
Income taxes
  $ 39     $ 3     $ 39     $ 4  
                                 
See accompanying notes.
                               
 
 
 



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. (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 June 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, but 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 overall financial performance, 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 fiscal periods.  See Note 5 for further information on fuel and the Company’s hedging program. Operating results for the three and six months ended June 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.

Certain prior period amounts have been reclassified to conform to the current presentation.  In the unaudited Condensed Consolidated Balance Sheet as of December 31, 2009, the Company has reclassified $14 million in liabilities from Accounts payable to Accrued liabilities in order to conform to the current presentation. This reclassification had no impact on earnings or cash flows provided by operations.

2.   ACCOUNTING CHANGE

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 six months ended June 30, 2009, were not retrospectively adjusted as the impact 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 six months ended June 30, 2010.
 

 
 
 
 
3.   NEW ACCOUNTING PRONOUNCEMENTS

On September 23, 2009, the Financial Accounting Standards Board (“FASB”) ratified Emerging Issues Task Force (“EITF”) Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables.”  EITF 08-1 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, as currently allowed, but which will be prohibited under EITF 08-1.  EITF 08-1 will be effective for annual reporting periods beginning January 1, 2011.  The Company is currently evaluating the impact of EITF 08-1 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 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 June 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 June 30,
   
Six months ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
NUMERATOR:
                       
Net income
  $ 112     $ 91     $ 123     $ -  
                                 
DENOMINATOR:
                               
Weighted-average shares
                               
outstanding, basic
    745       741       744       741  
Dilutive effect of Employee stock
                               
options
    1       -       1       -  
Adjusted weighted-average shares
                               
outstanding, diluted
    746       741       745       741  
                                 
NET INCOME PER SHARE:
                               
Basic
  $ .15     $ .12     $ .17     $ -  
                                 
Diluted
  $ .15     $ .12     $ .17     $ -  
                                 
Antidilutive stock options
                               
excluded from calculations
    72       79       74       79  
 

 

 

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 second quarter 2010, the Company had fuel derivatives in place related to approximately 44 percent of its fuel consumption.  As of June 30, 2010, the Company had fuel derivative instruments in place to provide coverage on a large portion of its third quarter and fourth quarter 2010 estimated fuel consumption at varying price levels.  The following table provides information about the Company’s volume of fuel hedging for the remainder of 2010, as well as the years 2011 through 2014.  See Management's Discussion and Analysis of Financial Condition and Results of Operations for further information and an update of this data.
 


   
Fuel hedged as
 
   
of June 30, 2010
 
Period
 
(gallons in millions)
 
Second half 2010
    465  
2011
    1,056  
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 derivative 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 income statement.  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 income statement 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 portfolio, 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 underlying derivative instrument settles.  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 half 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 purposes.

 
 

 

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 6/30/10
   
Fair Value at 12/31/09
   
Fair Value at 6/30/10
   
Fair Value at 12/31/09
 
                           
Derivatives designated as hedges
                         
Fuel derivative contracts (gross)*
Other assets
  $ 182     $ -     $ 89     $ -  
Fuel derivative contracts (gross)*
Accrued liabilities
    74       122       43       4  
Fuel derivative contracts (gross)*
Other deferred liabilities
    312       225       123       10  
Interest rate derivative contracts
Other assets
    73       47       -       -  
Interest rate derivative contracts
Other deferred liabilities
    -       -       13       10  
                                   
                                   
Total derivatives designated as hedges
    $ 641     $ 394     $ 268     $ 24  
                                   
Derivatives not designated as hedges
                                 
Fuel derivative contracts (gross)*
Other assets
  $ 48     $ -     $ 42     $ -  
Fuel derivative contracts (gross)*
Accrued liabilities
    164       324       416       566  
Fuel derivative contracts (gross)*
Other deferred liabilities
    203       302       635       870  
                                   
                                   
Total derivatives not designated as hedges
    $ 415     $ 626     $ 1,093     $ 1,436  
                                   
Total derivatives
    $ 1,056     $ 1,020     $ 1,361     $ 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
 
June 30,
   
December 31,
 
(in millions)
Location
 
2010
   
2009
 
Cash collateral deposits provided
Offset against Other
           
to counterparty - noncurrent
deferred liabilities
  $ 100     $ 238  
Cash collateral deposits provided
Offset against Accrued
               
to counterparty - current
liabilities
    95       92  
Due to third parties for settled fuel contracts
Accrued liabilities
    17       15  
Net unrealized losses from fuel
Accumulated other
               
hedges, net of tax
comprehensive loss
    619       580  
 
 
 

 
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The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Operations for the three and six months ended June 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 June 30,
   
Three months ended June 30,
   
Three months ended June 30,
 
(in millions)
 
2010
   
2009
   
2010
   
2009
   
2010
   
2009
 
                                     
Fuel derivative contracts
  $ 172 *   $ (7 ) *   $ (74 ) *   $ 96 *   $ 58     $ (25 )
                                                 
Interest rate derivatives
    21 *     (20 ) *     -       -       -       -  
                                                 
Total
  $ 193     $ (27 )   $ (74 )   $ 96     $ 58     $ (25 )
*   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)
 
   
Six months ended June 30,
   
Six months ended June 30,
   
Six months ended June 30,
 
(in millions)
 
2010
   
2009
   
2010
   
2009
   
2010
   
2009
 
                                     
Fuel derivative contracts
  $ 188 *   $ 45 *   $ (149 ) *   $ 206 *   $ 54     $ (9 )
                                                 
Interest rate derivatives
    22 *     (25 )     -       -       -       -  
                                                 
Total
  $ 210     $ 20     $ (149 )   $ 206     $ 54     $ (9 )
*   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.
                                 
 
 
 

 
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Derivatives not in Cash Flow Hedging Relationships
 
 
Amount of (Gain) Loss Recognized in Income on Derivatives
 
 
Three months ended June 30,
Location of (Gain) Loss Recognized in Income
(in millions)
2010
 
2009
on Derivatives
         
Fuel derivative contracts
 $57
 
 $(38)
Other (gains) losses, net

 


Derivatives not in Cash Flow Hedging Relationships
 
 
Amount of (Gain) Loss Recognized in Income on Derivatives
 
 
Six months ended June 30,
Location of (Gain) Loss Recognized in Income
(in millions)
2010
 
2009
on Derivatives
         
Fuel derivative contracts
 $34
 
 $(64)
Other (gains) losses, net

 
The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during second quarter 2010 and 2009, respectively, of $30 million and $37 million, and during the six months ended June 30, 2010 and 2009, respectively, of $61 million and $69 million.  These amounts are excluded from the Company’s measurement of effectiveness for related hedges.

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 June 30, 2010, are approximately $255 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to June 30, 2010.  In addition, as of June 30, 2010, the Company had already recognized cumulative net losses due to ineffectiveness and derivatives that do not qualify for hedge accounting totaling $90 million, net of taxes.  These net losses were recognized in second quarter 2010 and prior periods, and are reflected in “Retained earnings” as of June 30, 2010, but the underlying derivative instruments will not expire/settle until later periods of 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. For the interest rate swap agreements accounted for as fair value hedges, they 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.
 
 
 

 
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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 June 30, 2010, the Company had agreements with all of its counterparties 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 June 30, 2010, at which such postings are triggered:
 

   
Counterparty (CP)
       
      A       B       C       D       E    
Total
 
(in millions)
                                             
Fair value of fuel derivatives
  $ (118 )   $ (310 )   $ (37 )   $ -     $ 100     $ (365 )
Cash collateral held by CP
    70       125       -       -       -       195  
Aircraft collateral pledged to CP
    -       173       -       -       -       173  
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 >(554)
                                 
Cash is received from CP
 
>40
   
>150
    >200 ***     >125 ***     >250 ***          
Aircraft is pledged to CP
 
(300) to (700)
   
(125) to (554)
      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 >(554)
                                 
Cash is received from CP
    *       *       *       *       **          
Aircraft is pledged to CP
 
(300) to (700)
   
(125) to (554)
      N/A       N/A       N/A          
                                                 
* Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.
                 
** If either party is rated below investment grade by two of the three major rating
                 
agencies, a cash collateral agreement would be negotiated with the CP.
                         
*** Thresholds may vary based on changes in credit ratings within investment grade.
                 

 
The Company also has a cash collateral agreement with one of its counterparties associated with its outstanding interest rate swap agreements.  With other counterparties to which the Company has interest rate swap agreements, no cash collateral is required as long as credit ratings remain at investment grade.  With each of these other counterparties, the net fair value of the interest rate swap agreements outstanding at June 30, 2010, was either an asset to the Company or was immaterial.

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.
 
 
 

 
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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 six months ended June 30, 2010 and 2009, were as follows:

   
Three months ended June 30,
 
(In millions)
 
2010
   
2009
 
             
Net income
  $ 112     $ 91  
Unrealized gain/(loss) on fuel derivative instruments,
         
net of deferred taxes of ($61) and $64
    (98 )     103  
Unrealized gain/(loss) on interest rate swaps,
               
net of deferred taxes of ($13) and $12
    (21 )     20  
Other, net of deferred taxes of ($2) and $1
    (4 )     2  
Total other comprehensive income/(loss)
    (123 )     125  
                 
Comprehensive income/(loss)
  $ (11 )   $ 216  


   
Six months ended June 30,
 
(In millions)
 
2010
   
2009
 
             
Net income
  $ 123     $ -  
Unrealized gain/(loss) on derivative instruments,
               
net of deferred taxes of ($24) and $100
    (39 )     161  
Unrealized gain/(loss) on interest rate swaps,
               
net of deferred taxes of ($14) and $15
    (22 )     25  
Other, net of deferred taxes of ($1) and $1
    (2 )     1  
Total other comprehensive income/(loss)
    (63 )     187  
                 
Comprehensive income
  $ 60     $ 187  
 
 
 

 
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A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three and six months ended June 30, 2010 and 2009:


   
Fuel
   
Interest
         
Accumulated other
 
   
hedge
   
rate
         
comprehensive
 
(In millions)
 
derivatives
   
derivatives
   
Other
   
income (loss)
 
Balance at March 31, 2010
  $ (521 )   $ (20 )   $ 23     $ (518 )
Changes in fair value
    (172 )     (21 )     (4 )     (197 )
Reclassification to earnings
    74       -       -       74  
Balance at June 30, 2010
  $ (619 )     (41 )     19     $ (641 )
 

   
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
    (188 )     (22 )     (2 )     (212 )
Reclassification to earnings
    149       -       -       149  
Balance at June 30, 2010
  $ (619 )     (41 )     19     $ (641 )
 

 

 
7.           ACCRUED LIABILITIES

   
June 30,
   
December 31,
 
(In millions)
 
2010
   
2009
 
             
Retirement plans
  $ 106     $ 46  
Aircraft rentals
    79       112  
Vacation pay
    198       190  
Advances and deposits
    26       32  
Fuel derivative contracts
    126       32  
Workers compensation
    135       130  
Other
    272       187  
Accrued liabilities
  $ 942     $ 729  
 
 
 

 
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8.      DIVIDENDS

During the three month periods ended June 30, 2010 and March 31, 2010, dividends of $.0045 per share were declared on the 746 million shares and 744 million shares of Common Stock then outstanding, respectively.  During the three month periods ended June 30, 2009 and March 31, 2009, dividends of $.0045 per share were declared on the 741 million shares and 740 million shares of Common Stock then outstanding, respectively.

9.      COMMITMENTS AND 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 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 is expected to commence during the second half of 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 infrastructure.

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 June 30, 2010, the Company had spent a total of $53 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 the bonds being utilized to finance the majority of the LFMP will be issued during the second half of 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 guaranty 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 June 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.  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 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.
 
 

 
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All of the Company’s auction rate security instruments are reflected at estimated fair value in the unaudited Condensed Consolidated Balance Sheet.  At June 30, 2010, approximately $93 million of these instruments are classified as available for sale securities and $12 million are classified as trading securities. The $12 million classified as trading securities are subject to an agreement with the counterparty, as discussed below, and are included in “Short-term investments” 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 June 30, 2010, the Company has recorded a temporary unrealized decline in fair value of $17 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, for the $93 million in instruments classified as available for sale, these auction rate securities represented an immaterial portion of the Company’s total cash, cash equivalent, and investment balance at June 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 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. For the $12 million in instruments classified as trading securities, the Company is party to an agreement with the counterparty in which the Company put the instruments back to the counterparty at full par value on June 30, 2010.  However, the cash settlement for these instruments was not finalized until July 1, 2010.  Both the put option and the auction rate instruments were marked to market through earnings each period; however, these adjustments offset and had minimal impact on net earnings for all periods presented.  At the time of the first failed auctions during first quarter 2008, the Company held a total of $463 million in securities.  Since that time, the Company has been able to sell $341 million of these instruments at par value in addition to the $12 million subject to the agreement that settled July 1, 2010.

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 June 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
 
June 30, 2010
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets
 
(in millions)
 
Cash equivalents
  $ 989     $ 989     $ -     $ -  
Short-term investments:
                               
   Treasury bills
    1,838       1,838       -       -  
   Certificates of deposit
    286       286       -       -  
   Auction rate securities
    12       -       -       12  
Noncurrent investments (a)
    93       -       -       93  
Interest rate derivatives (see Note 5)
    73       -       73       -  
Fuel derivatives:
                               
   Swap contracts (b)
    212       -       212       -  
   Option contracts (b)
    541       -       -       541  
   Swap contracts (c)
    1       -       1       -  
   Option contracts (c)
    230       -       -       230  
Other available-for-sale securities
    36       28       -       8  
Total assets
  $ 4,311     $ 3,141     $ 286     $ 884  
                                 
Liabilities
                               
Fuel derivatives:
                               
   Swap contracts (b)
  $ (624 )           $ (624 )   $ -  
   Option contracts (b)
    (593 )             -       (593 )
   Swap contracts (c)
    -               -       -  
   Option contracts (c)
    (132 )             -       (132 )
Interest rate derivatives (see Note 5)
    (13 )             (13 )     -  
Total liabilities
  $ (1,362 )           $ (637 )   $ (725 )
(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 $195 million in cash collateral provided to counterparties. See Note 5.
         
(c) In the unaudited Condensed Consolidated Balance Sheet, amounts are included in "Other assets."
         

 

 
 
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Fair Value Measurements at Reporting Date Using
 
         
Quoted Prices in Active Markets for Identical Assets
         
Significant Unobservable Inputs
 
         
Significant Other
 
         
Observable 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) 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.
                 
 

 
The Company had no transfers of assets or liabilities between any of the above levels during the six months ended June 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 six months ended June 30, 2010:



   
Fair Value Measurements Using Significant
 
   
Unobservable Inputs (Level 3)
 
   
Fuel
   
Auction Rate
     
Other
       
(in millions)
 
Derivatives
   
Securities (a)
     
Securities
   
Total
 
Balance at March 31, 2010
  $ 178     $ 159  
 (b)
  $ 8     $ 345  
Total gains or (losses) (realized or unrealized)
                                 
  Included in earnings
    (270 )     (2 )       -       (272 )
  Included in other comprehensive income
    (256 )     1         -       (255 )
  Purchases
    445       -         -       445  
  Sales
    (57 )     (53 )       -       (110 )
  Settlements
    6       -         -       6  
Balance at June 30, 2010
  $ 46     $ 105  
 (b)
  $ 8     $ 159  
                                   
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 June 30, 2010
  $ (219 )   $ -       $ -     $ (219 )
                                   
(a) Includes those classified as short-term investments and noncurrent investments.
                   
(b) Includes $12 million classified as trading securities.
                           





   
Fair Value Measurements Using Significant
 
   
Unobservable Inputs (Level 3)
 
   
Fuel
   
Auction Rate
     
Other
       
(in millions)
 
Derivatives
   
Securities (a)
     
Securities
   
Total
 
Balance at December 31, 2009
  $ 140     $ 174  
 (b)
  $ 8     $ 322  
Total gains or (losses) (realized or unrealized)
                                 
  Included in earnings
    (248 )     -