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 September 30, 2011
 
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 19, 2011: 778,522,395

 

 

TABLE OF CONTENTS TO FORM 10-Q


Part I- FINANCIAL INFORMATION
Item 1. Financial Statements
  Condensed Consolidated Balance Sheet as of September 30, 2011 and December 31, 2010
  Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2011 and 2010
  Condensed Consolidated Statement of Cash Flows for the three and nine months ended September 30, 2011 and 2010
  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. (Removed and Reserved)
Item 5. Other Information
Item 6. Exhibits
SIGNATURES
EXHIBIT INDEX

 

 
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,
   
December 31,
 
 
 
2011
   
2010
 
ASSETS
 
 
   
 
 
Current assets:
 
 
   
 
 
Cash and cash equivalents
  $ 1,016     $ 1,261  
Short-term investments
    2,640       2,277  
Accounts and other receivables
    369       195  
Inventories of parts and supplies, at cost
    459       243  
Deferred income taxes
    -       214  
Prepaid expenses and other current assets
    110       89  
Total current assets
    4,594       4,279  
 
               
Property and equipment, at cost:
               
Flight equipment
    15,451       13,991  
Ground property and equipment
    2,303       2,122  
Deposits on flight equipment purchase contracts
    229       230  
 
    17,983       16,343  
Less allowance for depreciation and amortization
    6,149       5,765  
 
    11,834       10,578  
Goodwill
    970       -  
Other assets
    487       606  
 
  $ 17,885     $ 15,463  
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Accounts payable
  $ 1,083     $ 739  
Accrued liabilities
    1,193       863  
Air traffic liability
    2,058       1,198  
Current maturities of long-term debt
    986       505  
Total current liabilities
    5,320       3,305  
 
               
Long-term debt less current maturities
    3,220       2,875  
Deferred income taxes
    1,856       2,493  
Deferred gains from sale and leaseback of aircraft
    78       88  
Other non-current liabilities
    926       465  
Stockholders' equity:
               
Common stock
    808       808  
Capital in excess of par value
    1,222       1,183  
Retained earnings
    5,251       5,399  
Accumulated other comprehensive loss
    (513 )     (262 )
Treasury stock, at cost
    (283 )     (891 )
Total stockholders' equity
    6,485       6,237  
 
  $ 17,885     $ 15,463  
 
               
 
               
See accompanying notes.

 

 




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



 
 
Three months ended
   
Nine months ended
 
 
 
September 30,
   
September 30,
 
 
 
2011
   
2010
   
2011
   
2010
 
OPERATING REVENUES:
 
 
   
 
   
 
   
 
 
Passenger
  $ 4,014     $ 3,032     $ 10,829     $ 8,544  
Freight
    35       31       103       94  
Other
    262       129       618       352  
Total operating revenues
    4,311       3,192       11,550       8,990  
 
                               
OPERATING EXPENSES:
                               
Salaries, wages, and benefits
    1,146       938       3,226       2,748  
Fuel and oil
    1,586       926       4,150       2,681  
Maintenance materials and repairs
    272       196       717       556  
Aircraft rentals
    90       43       214       135  
Landing fees and other rentals
    257       210       705       606  
Depreciation and amortization
    191       161       523       469  
Acquisition and integration
    22       1       97       1  
Other operating expenses
    522       362       1,372       1,022  
Total operating expenses
    4,086       2,837       11,004       8,218  
 
                               
OPERATING INCOME
    225       355       546       772  
 
                               
OTHER EXPENSES (INCOME):
                               
Interest expense
    50       43       143       126  
Capitalized interest
    (3 )     (5 )     (8 )     (15 )
Interest income
    (1 )     (2 )     (8 )     (9 )
Other (gains) losses, net
    405       (13 )     351       138  
Total other expenses (income)
    451       23       478       240  
 
                               
INCOME (LOSS) BEFORE INCOME TAXES
    (226 )     332       68       532  
PROVISION (BENEFIT) FOR INCOME TAXES
    (86 )     127       42       204  
 
                               
NET INCOME (LOSS)
  $ (140 )   $ 205     $ 26     $ 328  
 
                               
 
                               
NET INCOME (LOSS) PER SHARE, BASIC
  $ (0.18 )   $ 0.27     $ 0.03     $ 0.44  
 
                               
NET INCOME (LOSS) PER SHARE, DILUTED
  $ (0.18 )   $ 0.27     $ 0.03     $ 0.44  
 
                               
WEIGHTED AVERAGE SHARES
                               
OUTSTANDING:
                               
Basic
    792       746       773       745  
Diluted
    792       747       774       746  
 
                               
Cash dividends declared per common share
  $ 0.0045     $ 0.0045     $ 0.0135     $ 0.0135  
 
                               
See accompanying notes.
 

 

 

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



 
 
Three months ended
   
Nine months ended
 
 
 
September 30,
   
September 30,
 
 
 
2011
   
2010
   
2011
   
2010
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
   
 
   
 
   
 
 
Net income (loss)
  $ (140 )   $ 205     $ 26     $ 328  
Adjustments to reconcile net income (loss) to
                               
cash provided by (used in) operating activities:
                               
Depreciation and amortization
    191       161       523       469  
Unrealized (gain) loss on fuel derivative instruments
    393       (17 )     274       171  
Deferred income taxes
    (90 )     20       33       96  
Amortization of deferred gains on sale and
                               
leaseback of aircraft
    (3 )     (3 )     (10 )     (10 )
Changes in certain assets and liabilities (excluding the effects of acquired business):
                               
Accounts and other receivables
    11       42       (96 )     (66 )
Other current assets
    (42 )     7       (180 )     (6 )
Accounts payable and accrued liabilities
    (39 )     (5 )     266       189  
Air traffic liability
    (92 )     (63 )     485       379  
Cash collateral received from (provided to)
                               
derivative counterparties
    (409 )     15       (429 )     150  
Other, net
    2       23       93       (408 )
Net cash provided by (used in) operating activities
    (218 )     385       985       1,292  
 
                               
CASH FLOWS FROM INVESTING ACTIVITIES:
                               
Payment to acquire AirTran, net of AirTran cash on hand
    -       -       (35 )     -  
Payments for purchase of property and equipment, net
    (276 )     (100 )     (548 )     (398 )
Purchases of short-term investments
    (1,525 )     (1,151 )     (4,788 )     (4,331 )
Proceeds from sales of short-term investments
    1,664       939       4,414       3,484  
Net cash used in investing activities
    (137 )     (312 )     (957 )     (1,245 )
 
                               
CASH FLOWS FROM FINANCING ACTIVITIES:
                               
Proceeds from Employee stock plans
    4       10       35       45  
Proceeds from termination of interest rate
                               
derivative instrument
    -       -       76       -  
Payments of long-term debt and capital lease obligations
    (48 )     (39 )     (110 )     (123 )
Payments of convertible debt
    -       -       (81 )     -  
Payment of credit line borrowing
    -       -       -       (44 )
Payments of cash dividends
    (3 )     (3 )     (14 )     (13 )
Repurchase of common stock
    (175 )     -       (175 )     -  
Other, net
    (2 )     1       (4 )     5  
Net cash used in financing activities
    (224 )     (31 )     (273 )     (130 )
 
                               
NET CHANGE IN CASH AND CASH EQUIVALENTS
    (579 )     42       (245 )     (83 )
 
                               
CASH AND CASH EQUIVALENTS AT
                               
BEGINNING OF PERIOD
    1,595       989       1,261       1,114  
 
                               
CASH AND CASH EQUIVALENTS
                               
AT END OF PERIOD
  $ 1,016     $ 1,031     $ 1,016     $ 1,031  

CASH PAYMENTS FOR:
 
 
   
 
   
 
   
 
 
Interest, net of amount capitalized
  $ 48     $ 33     $ 130     $ 101  
Income taxes
  $ -     $ 105     $ 5     $ 144  
 
                               
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS:
 
Fair value of equity consideration given to acquire AirTran
  $ -     $ -     $ 523     $ -  
Fair value of common stock issued for conversion of debt
  $ -     $ -     $ 78     $ -  
 
                               
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. and its subsidiaries (the “Company” or “Southwest”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  The unaudited Condensed Consolidated Financial Statements for the interim periods ended September 30, 2011 and 2010 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, 2011 are not necessarily indicative of the results that may be expected for the year ended December 31, 2011.  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, 2010.

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. (“Southwest Airlines”) 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 (B717) and Boeing 737-700 aircraft (B737), throughout the United States and to select international locations. Approximately half of AirTran Airways’ flights originate or terminate at its largest hub in Atlanta, Georgia. AirTran Airways also serves a number of markets with non-stop service from smaller hubs in Baltimore, Maryland; Milwaukee, Wisconsin; and Orlando, Florida. The Company believes the acquisition of AirTran positions it to respond better to the economic and competitive challenges of the industry because, among other reasons: (i) it allows the Company to offer more low-fare destinations by extending its network and diversifying into new markets, including significant opportunities to and from Atlanta, the busiest airport in the United States and the largest domestic market the Company previously did not serve, (ii) it expands the Company’s presence in slot-controlled markets  (New York LaGuardia/Ronald Reagan Washington National Airport), and (iii) it provides access to near-international leisure markets in the Caribbean and Mexico.
 
 
 
6

 
 
The accompanying unaudited Condensed Consolidated Financial Statements include the results of operations and cash flows for AirTran from May 2, 2011 through September 30, 2011. AirTran will not be considered a separate segment for financial reporting purposes. In addition, as a result of the manner in which the acquisition and related transactions were structured, AirTran’s public debt is now a direct obligation of Southwest Airlines, which eliminates the subsequent need for reporting of stand-alone AirTran financial results.  For the three and nine months ended September 30, 2011, total operating revenues of $758 million and $1.3 billion and net income of $3 million and net loss of $24 million, respectively, are attributable to AirTran and are included in the Company’s unaudited Condensed Consolidated Statement of Operations.
 
Equity transaction
Each share of AirTran Holdings common stock was exchanged for $3.75 in cash and 0.321 shares of Southwest Airlines common stock. The common stock consideration was based on the average of the Southwest Airlines closing common stock price for the 20 trading days ending April 27, 2011, which was $11.90. The transaction valued AirTran Holdings common stock at approximately $7.57 per share, or $1.0 billion in the aggregate. Stockholders of AirTran Holdings, including those holding restricted stock awards, received approximately 44 million shares of Southwest Airlines common stock, which represented approximately 5.6 percent of the Southwest Airlines common shares outstanding. Additionally, holders of AirTran Holdings equity received cash of $518 million, including $7 million in cash for the fair value of AirTran stock options and performance share units. Including AirTran debt outstanding at the acquisition date (including convertible notes outstanding at the acquisition date) and capitalized aircraft operating leases, the total transaction value was approximately $3.2 billion. Subsequent to the acquisition date, a portion of the convertible notes previously held by AirTran note holders were either converted or called by the Company for an aggregate of approximately seven million shares of Southwest Airlines common stock and $81 million in cash. The equity transaction did not contain any contingent consideration arrangements.

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. For the three and nine month periods ended September 30, 2011, the Company incurred consolidated acquisition-related costs of $22 million and $97 million, respectively, primarily consisting of financial advisory fees and consulting, severance, and technology costs. In the Company’s unaudited Condensed Consolidated Statement of Operations, these costs are classified as Acquisition and integration expenses.

Tax matters
AirTran experienced an “ownership change” as defined in Section 382 of the Internal Revenue Code of 1986, as amended, as a result of the acquisition. Section 382 of the Code imposes an annual limitation on the amount of taxable income generated subsequent to the ownership change that may be offset with Federal net operating loss carryforwards (“NOLs”) of the corporation incurred before the ownership change. Any unused annual limitation may, subject to certain limits, be carried over to later years, and the limitation may, under certain circumstances, be increased by built-in gains or reduced by built-in losses in the assets held by such corporation at the time of the ownership change. The combined company’s use of NOLs arising after the date of an ownership change would not be limited unless the combined company were to experience a subsequent ownership change. As of the acquisition date, AirTran had NOLs of $542 million, which expire between 2017 and 2029, available to offset future taxable income, resulting in a deferred tax asset of $190 million, which represents the expected tax benefit of the NOLs. No valuation allowance was necessary. The Company currently expects that the ownership change resulting from the AirTran acquisition will not significantly limit its ability to use AirTran’s NOL and alternative minimum tax credit carryforwards in the carryforward period.
 
 
 
7

 

Recording of assets acquired and liabilities assumed
The transaction has been accounted for using the acquisition method of accounting (“purchase accounting”), which requires, among other things, that most assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. No material assets or liabilities arose from contingencies recognized at the acquisition date. Certain estimated values are not yet finalized (see below) and are subject to change. Fair value adjustments made during the third quarter of 2011 primarily included a $13 million increase in the value assigned to the deferred tax asset, a $7 million reduction in the value assigned to the customer relationship intangible, and the related impact on goodwill. The Company will finalize the amounts recognized as it obtains the information necessary to complete the analyses. The Company expects to finalize these amounts prior to December 31, 2011. The following table summarizes the assets acquired and liabilities assumed as of the acquisition date at estimated fair value:

(in millions)
 
May 2, 2011
 
Assets
 
 
 
Cash and cash equivalents
  $ 477  
Restricted cash
    6  
Other current assets
    234  
Operating property and equipment
    1,151  
Goodwill
    970  
Other identified intangibles
    125  
Deferred income taxes
    163  
Other noncurrent assets
    45  
Liabilities
       
Long-term debt and capital leases, including current portion
    (1,119 )
Air traffic liability
    (354 )
Other liabilities assumed
    (657 )
Net assets acquired
  $ 1,041  
 
       

 
The fair values of the assets acquired and liabilities assumed were determined using the market, income, and cost approaches. The market approach, which indicates value for a subject asset based on available market pricing for comparable assets, was utilized to estimate the fair value of AirTran’s aircraft and operating leases. The market approach used by the Company included prices and other relevant information generated by market transactions involving comparable assets, as well as industry pricing guides and other sources. The Company considered the current market for the aircraft, the maintenance condition of the aircraft and the expected proceeds from the sale of the assets, among other factors. The fair value of AirTran’s frequent flyer program liability was estimated based on the weighted average equivalent ticket value of outstanding frequent flyer credits that were expected to be redeemed as of May 2, 2011. The income approach was primarily used to value intangible assets, including customer relationships and marketing agreements, noncompete agreements with certain AirTran executives, the AirTran trademark and trade name, and certain domestic airport take-off and landing slots. The income approach indicates value for a subject asset based on the present value of cash flows projected to be generated by the asset. Projected cash flows are discounted at a required market rate of return that reflects the relative risk of achieving the cash flows and the time value of money. The cost approach, which estimates value by determining the current cost of replacing an asset with another of equivalent economic utility, was used, as appropriate, for certain assets for which the market and income approaches could not be applied due to the nature of the asset. The cost to replace a given asset reflects the estimated reproduction or replacement cost for the asset, less an allowance for loss in value due to depreciation.
 
 
 
8

 
 
Intangible assets
Identifiable intangibles were created as a result of the acquisition of AirTran, which will be amortized as follows:
 
 
·  
Customer Relationships: Amortized based on an accelerated amortization schedule to reflect the  estimated free cash flows the customer relationships are expected to provide.
 
·  
Trademarks/Trade names: Amortized based on an accelerated amortization schedule to reflect the estimated free cash flows the assets are expected to provide.
 
·  
Domestic Slots: Straight-line amortization for owned slots based on the applicable estimated useful life.  Straight-line amortization for leased slots over the applicable lease term.
 
·  
Internally developed software: Straight-line amortization over the expected useful life of the software.
 
·  
Non-compete agreements: Straight-line amortization over the expected useful life of the applicable contract.
 

 
The identifiable intangibles created as a result of the acquisition have been amortized from the acquisition date. The aggregate amortization expense for the three and nine months ended September 30, 2011, was $9 million and $16 million, respectively. Estimated aggregate amortization expense for the remainder of 2011 and the five succeeding years and thereafter is as follows: 2011 – $9 million, 2012 – $20 million, 2013 – $15 million, 2014 – $11 million, 2015 – $9 million, 2016 – $7 million, 2017 and thereafter - $38 million. The following table is a summary of the acquisition date fair value estimates of the acquired identifiable intangible assets, weighted-average useful lives, and balance of accumulated amortization as of September 30, 2011:
 

 
 
Estimated fair value
   
Weighted-average
   
Accumulated
 
 
 
 of asset/(liability)
   
useful life
   
amortization
 
 
 
(in millions)
   
(in years)
   
(in millions)
 
Customer relationships/marketing agreements
  $ 39       4     $ 8  
Trademarks/trade names
    36       3       5  
Domestic Slots
    43       24       1  
Internally developed software
    2       2       1  
Noncompete agreements
    5       2       1  
Total
  $ 125       10     $ 16  
 
                       
 

 
9

 
Leasehold Interest
Lease fair value adjustments for operating leases were created as a result of the acquisition of AirTran. The fair value adjustments represent the net present value of the differences between contractual lease rates and the estimated fair market lease rates for similar leased assets at the acquisition date. An asset (liability) results when the contractual lease rates are more (less) favorable than market lease terms at the valuation date. As of September 30, 2011, the lease fair value adjustments are classified within Other assets and Other non-current liabilities in the amounts of $2 million and $376 million, respectively. The lease fair value adjustments are amortized on a straight-line basis to aircraft rentals over the individual applicable remaining lease terms. The aggregate amortization income (reduction of expense) for the three and nine months ended September 30, 2011, was $10 million and $16 million, respectively. Estimated aggregate amortization income (reduction of expense) for the remainder of 2011 and the five succeeding years and thereafter is as follows: 2011 - $10 million, 2012 - $39 million, 2013 - $39 million, 2014 - $39 million, 2015 - $39 million, 2016 - $39 million, 2017 and thereafter - $155 million.  The weighted-average useful life for the leasehold interest asset is 9 years and for the leasehold interest liability is 10 years, for a total weighted-average leasehold useful life of 10 years.

Goodwill
Goodwill in the amount of $970 million has been recorded for the acquisition of AirTran. Goodwill is calculated as the excess of the consideration transferred over the net assets recognized and represents the estimated future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. Goodwill will not be amortized, but will be tested for impairment at least annually. None of the goodwill is deductible for tax purposes. Specifically, the goodwill recorded as part of the acquisition of AirTran includes:
·  
The synergies and other benefits that are expected to result from combining the operations of AirTran with the operations of the Company; and
·  
Any intangible assets that do not qualify for separate recognition, such as the AirTran trained and assembled workforce.

The recorded amounts for assets and liabilities are provisional and subject to change. However, the Company does not expect that any future adjustments will be material. The following are the more significant items that are subject to change:
 
·  
The fair value of specific executory contracts, and deferred income taxes and liabilities, pending finalization of valuation efforts; and
·  
The purchase price allocable to goodwill, as a result of changes to the aforementioned items.
 
A single estimate of fair value results from a complex series of judgments about future events and uncertainties and relies heavily on estimates and assumptions. The Company’s judgments used to determine the estimated fair value assigned to each class of assets acquired and liabilities assumed, as well as asset lives, can materially impact its results of operations.

Pro forma impact of the acquisition
The unaudited pro forma results presented below include the effects of the AirTran acquisition as if it had been consummated as of January 1, 2010. The pro forma results include the amortization associated with estimates (certain of which are preliminary) for the acquired intangible assets, fair value adjustments for deferred revenue, favorable/unfavorable leasehold interests, property and equipment, and long-term debt. In addition, the pro forma results do not include any anticipated synergies, or the assumption of hedge accounting for AirTran’s derivative instruments, or other expected benefits of the acquisition. Accordingly, the unaudited pro forma financial information below is not necessarily indicative of either future results of operations or results that might have been achieved had the acquisition been consummated as of January 1, 2010.
 
 
 
10

 
 

 
  
Three months ended
 
 
Nine months ended
September 30,
 
September 30,
(In millions, except per share data)
  
2011
 
2010
 
 
2011
 
2010
Total operating revenues
$
4,312
$
3,860
 
$
12,495
$
10,961
Net income
  
(157)
 
231
 
 
7
 
345
Net income per share, basic
  
(0.20)
 
0.29
 
 
0.01
 
0.44
Net income per share, diluted
  
(0.20)
 
0.29
 
 
0.01
 
0.44

3.   ACCOUNTING CHANGES AND NEW ACCOUNTING PRONOUNCEMENTS

On December 29, 2010, the Financial Accounting Standards Board (“FASB”) ratified Accounting Standards Update (“ASU”) No. 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations.” This ASU specifies that when a business combination occurs, the company must only disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period. This ASU also expands the supplemental pro forma disclosures under Topic 805, “Business Combinations”, formerly Statement of Financial Accounting Standards No. 141(R), to include a description of the nature and amount of material, non-recurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. This ASU is effective prospectively for business combinations in which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Because the Company acquired AirTran on May 2, 2011, the Company implemented this ASU for the interim period ended June 30, 2011. The Company has prepared pro forma disclosures to include the effects of the AirTran acquisition as if it had been consummated as of January 1, 2010. There are no non-recurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. See Note 2.
 
On May 12, 2011, the FASB ratified ASU No. 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” This ASU establishes a global standard for measuring amounts at fair value. 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 fair value. This ASU is effective for reporting periods (including interim periods) beginning after December 15, 2011. For the Company, this ASU will first take effect for the first quarter ending March 31, 2012. Early adoption is not permissible, and this ASU must be applied prospectively.
 
On June 16, 2011, the FASB ratified ASU No. 2011-05, “Presentation of Comprehensive Income.” This ASU eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. Upon adoption, other comprehensive income must be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. 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 other comprehensive income. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. This ASU must be applied retrospectively and early adoption is permitted. The Company will adopt this ASU for the interim period ending March 31, 2012.
 
 
 
11

 

On September 15, 2011, the FASB ratified ASU No. 2011-08, “Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment.” This ASU permits an entity to first assess qualitative factors to determine whether it is more likely than not (a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. After assessing qualitative factors, if an entity determines that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, no further testing is necessary.  If an entity determines that it is more likely than not that the fair value of the reporting unit is less than its carrying value, then the traditional two-step goodwill impairment test must be performed.   As a result of the acquisition of AirTran on May 2, 2011, the Company recognized goodwill. The Company plans to perform its annual impairment test during the fourth quarter ending December 31, 2011. This ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. However, early adoption is permitted. The Company is currently evaluating the impact of ASU No. 2011-08 on its future goodwill impairment tests.

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,
 
 
 
2011
   
2010
   
2011
   
2010
 
NUMERATOR:
 
 
   
 
   
 
   
 
 
Net income (loss)
  $ (140 )   $ 205     $ 26     $ 328  
 
                               
DENOMINATOR:
                               
Weighted average shares
                               
outstanding, basic
  $ 792     $ 746     $ 773    
$
745  
Dilutive effect of Employee stock
                               
awards
    -       1       1       1  
Adjusted weighted-average shares
                               
outstanding, diluted
    792       747       774       746  
 
                               
NET INCOME (LOSS) PER SHARE:
                               
Basic
  $ (0.18 )   $ 0.27     $ 0.03     $ 0.44  
 
                               
Diluted
  $ (0.18 )   $ 0.27     $ 0.03     $ 0.44  
 
                               
Antidilutive stock options
                               
excluded from calculations
    48       64       48       70  
 
                               
 
                               

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 crude oil (“WTI”), Brent crude oil (“Brent”), 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.
 
 
 
12

 

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.  For third quarter 2011, the Company had fuel derivatives in place related to approximately 39 percent of its fuel consumption.  As of September 30, 2011, the Company had fuel derivative instruments in place to provide coverage on a portion of its remaining 2011 estimated fuel consumption at varying WTI price levels.  The following table provides information about the Company’s (inclusive of fuel derivative instruments acquired from Air Tran – See Note 2) volume of fuel hedging for the remainder of 2011, as well as the years 2012 through 2015.

 
 
Fuel hedged as of
 
 
 
September 30, 2011
 
Period (by year)
 
(gallons in millions)
 
Fourth quarter 2011
    177  
2012
    1,341  
2013
    969  
2014
    777  
2015
    357  

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 hedge accounting treatment.  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. The Company’s results are subject to the possibility that periodic changes will not be effective, as defined, or that the derivatives will no longer qualify for hedge accounting.  Ineffectiveness 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 ineffective, the ineffective portion is recorded to Other (gains) losses, net in the statement of operations.  Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last period is recorded to Other (gains) losses, net in the statement of operations in the period of the change; however, any amounts previously recorded to AOCI would remain there until such time as the original forecasted transaction occurs, at which time these amounts would be reclassified to Fuel and oil expense.  When the Company has sold derivative positions in order to effectively “close” or offset a derivative already held as part of its fuel derivative instrument 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 originally forecasted transaction occurs.  In a situation where it becomes probable that a hedged forecasted transaction will not occur, any gains and/or losses that have been recorded to AOCI would be required to be immediately reclassified into earnings.  The Company did not have any such situations occur during 2010 or during the nine months ended September 30, 2011.
 
 
 
13

 

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 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 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 hedging instruments within the unaudited Condensed Consolidated Balance Sheet:

 
14 

 




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
 
9/30/2011
   
12/31/10
   
9/30/2011
   
12/31/10
 
Derivatives designated as hedges*
 
 
 
   
 
   
 
   
 
 
Fuel derivative contracts (gross)
Other current assets
  $ -     $ 151     $ -     $ 16  
Fuel derivative contracts (gross)
Other assets
    -       547       -       88  
Fuel derivative contracts (gross)
Accrued liabilities
    71       122       138       18  
Fuel derivative contracts (gross)
Other noncurrent liabilities
    361       71       157       9  
Interest rate derivative contracts
Other current assets
    1       73       6       -  
Interest rate derivative contracts
Other assets
    63       -       -       -  
Interest rate derivative contracts
Other noncurrent liabilities
    -       -       136       4  
 
 
                               
Total derivatives designated as hedges
 
  $ 496     $ 964     $ 437     $ 135  
 
 
                               
Derivatives not designated as hedges*
 
                               
Fuel derivative contracts (gross)
Other current assets
  $ -     $ 164     $ -     $ 284  
Fuel derivative contracts (gross)
Other assets
    -       212       -       304  
Fuel derivative contracts (gross)
Accrued liabilities
    257       40       525       222  
Fuel derivative contracts (gross)
Other noncurrent liabilities
    109       33       635       257  
 
 
                               
Total derivatives not designated as hedges
 
  $ 366     $ 449     $ 1,160     $ 1,067  
 
 
                               
Total derivatives
 
  $ 862     $ 1,413     $ 1,597     $ 1,202  
 
 
                               
* 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:

 
15 

 




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




 
Balance Sheet
 
September 30,
   
December 31,
 
(in millions)
location
 
2011
   
2010
 
Cash collateral deposits provided
Offset against Other
 
 
   
 
 
to counterparties - noncurrent
noncurrent liabilities
  $ 246     $ 125  
Cash collateral deposits provided
Offset against Accrued
               
to counterparties - current
liabilities
    212       -  
Cash collateral deposits held from
Offset against Other
               
counterparty - noncurrent
assets
    -       60  
Cash collateral deposits held from
Offset against Other
               
counterparty - current
current assets
    -       -  
Due to third parties for settled fuel contracts
Accrued liabilities
    10       -  
Receivable from third parties for settled
Accounts and other
               
fuel contracts
receivables
    -       1  
Net unrealized (gains) losses from fuel
Accumulated other
               
hedges, net of tax
comprehensive (income) loss
    469       250  

The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2011 and 2010:

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)
2011
 
2010
 
2011
 
2010
 
2011
 
2010
 
Fuel derivative
 
 
   
 
   
 
   
 
   
 
   
 
 
 
contracts
  $ 417 *   $ (122 )*   $ 45 *   $ 77 *   $ 85     $ (24 )
Interest rate
                                               
 
derivatives
    30 *     12 *     -       -       -       -  
 
 
                                               
Total
  $ 447     $ (110 )   $ 45     $ 77     $ 85     $ (24 )
 
 
                                               
*
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
 
 
 
(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)
2011
 
2010
 
2011
 
2010
 
2011
 
2010
 
Fuel derivative
 
 
   
 
   
 
   
 
   
 
   
 
 
 
contracts
  $ 297 *   $ 66 *   $ 78 *   $ 226 *   $ 127     $ 26  
Interest rate
                                               
 
derivatives
    34 *     34 *     -       -       -       -  
 
 
                                               
Total
  $ 331     $ 100     $ 78     $ 226     $ 127     $ 26  
 
 
                                               
*
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.
 

 
16 

 




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




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)
2011
 
2010
on derivatives
Fuel derivative contracts
  $284
 
  $(26)
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)
2011
 
2010
on derivatives
Fuel derivative contracts
  $129
 
  $13
Other (gains) losses, net

The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended September 30, 2011 and 2010 of $36 million and $37 million, respectively, and the nine months ended September 30, 2011 and 2010 of $93 million and $98 million, respectively.  These amounts are excluded from the Company’s measurement of effectiveness for related hedges and are included as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Operations.

The fair values of the derivative instruments, depending on the type of instrument, were 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 cumulative net unrealized losses from fuel hedges as of September 30, 2011, were approximately $228 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2011.  In addition, as of September 30, 2011, the Company had already recognized cumulative net losses due to ineffectiveness and derivatives that do not qualify for hedge accounting treatment totaling $198 million, net of taxes.  These net losses were recognized in third quarter 2011 and prior periods, and are reflected in Retained earnings as of September 30, 2011, but the underlying derivative instruments will not expire/settle until fourth quarter 2011 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.
 
 
 
 
17

 
 
AirTran has also entered into a number of interest rate swap agreements, which convert a portion of AirTran’s floating-rate debt to a fixed-rate basis for the remaining life of the debt, thus reducing the impact of interest rate changes on future interest expense and cash flows. Under these agreements, which expire between 2016 and 2020, the Company pays fixed rates between 4.34 percent and 6.435 percent and receives either three-month or six-month USD London Interbank Offered Rate (LIBOR) on the notional values. The notional amount of outstanding debt related to interest rate swaps as of September 30, 2011, was $451 million. These interest rate swap arrangements were designated as cash flow hedges as of the acquisition date. The ineffectiveness associated with all of the Company’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.  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 to a single counterparty, and monitors the market position of the fuel hedging program and its relative market position with each counterparty.  At September 30, 2011, 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 or credit ratings fall below certain levels.  The Company also had agreements with counterparties in which cash deposits and/or pledged aircraft are required to be posted whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of September 30, 2011, at which such postings are triggered:

 
 
Counterparty (CP)
         
 
 
 
    A       B       C       D       E    
Other(a)
   
Total
 
(in millions)
                                         
 
   
 
 
Fair value of fuel derivatives
  $ (256 )   $ (228 )   $ (95 )   $ (50 )   $ (23 )   $ (5 )   $ (657 )
Cash collateral held from (by) CP
    (205 )     (220 )     (33 )     -       -       -       (458 )
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)
   
>(50)
   
>(75)
   
>(50)
                 
 
 
or >(700)
   
or >(625)
                                         
   Cash is received from CP
 
>40
   
>150
   
>200(c)
   
>125(c)
   
>250
                 
   Aircraft or cash can be pledged to CP
 
(300) to
   
(125) to
      N/A       N/A       N/A                  
 
    (700 )(d)     (625 )(d)                                        
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)
   
(b)
   
(b)
   
(b)
                 
 
 
or >(700)
   
or >(625)
                                         
   Cash is received from CP
 
(b)
   
(b)
   
(b)
   
(b)
   
(b)
                 
   Aircraft can be pledged to CP
 
(300) to
   
(125) to
      N/A       N/A       N/A                  
 
    (700 )     (625 )                                        
 
                                                       
(a) Individual counterparties with fair value of fuel derivatives <$15 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 or pledging aircraft as collateral. No aircraft were pledged as collateral as of September 30, 2011.
 
 

 
 
18

 
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, 2011, $64 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, a total of $34 million in collateral had been provided to two counterparties at September 30, 2011, as a result of net liability derivative positions with those counterparties. The outstanding interest rate net derivative positions with all other counterparties at September 30, 2011, were assets to the Company.
 
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. The Company’s application of this policy differs depending on whether its derivative instruments are in a net asset position or a net liability position.  If its fuel derivative instruments are in a net asset position with a counterparty, cash collateral amounts held are first netted against current derivative amounts (those that will settle during the twelve months following the balance sheet date) associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of noncurrent outstanding derivative instruments (those that will settle beyond one year following the balance sheet date).  If the Company’s fuel derivative instruments are in a net liability position with a counterparty, cash collateral amounts provided are first netted against noncurrent derivative amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of current outstanding derivative instruments.

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 (loss) and Comprehensive income (loss) for the three and nine months ended September 30, 2011 and 2010, were as follows:

 
 
Three months ended September 30,
 
(In millions)
 
2011
   
2010
 
Net income (loss)
  $ (140 )   $ 205  
Unrealized gain (loss) on fuel derivative instruments,
               
net of deferred taxes of ($233) and $124
    (372 )     199  
Unrealized gain (loss) on interest rate swaps,
               
net of deferred taxes of ($19) and ($7)
    (30 )     (12 )
Other, net of deferred taxes of ($3) and $1
    (4 )     1  
Total other comprehensive income (loss)
    (406 )     188  
 
               
Comprehensive income (loss)
  $ (546 )   $ 393  
 
               
 

 
 
19

 
 
 
Nine months ended September 30,
 
(In millions)
 
2011
   
2010
 
Net income
  $ 26     $ 328  
Unrealized gain (loss) on fuel derivative instruments,
               
net of deferred taxes of ($137) and $100
    (219 )     160  
Unrealized gain (loss) on interest rate swaps,
               
net of deferred taxes of ($22) and ($21)
    (34 )     (34 )
Other, net of deferred taxes of $1 and $0
    2       (1 )
Total other comprehensive income (loss)
    (251 )     125  
 
               
Comprehensive income (loss)
  $ (225 )   $ 453  

A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three and nine months ended September 30, 2011:

 
Fuel
 
Interest
   
 
 
Accumulated other
 
 
hedge
 
rate
   
 
 
comprehensive
 
(In millions)
derivatives
 
derivatives
 
Other
 
income (loss)
 
Balance at June 30, 2011
  $ (97 )   $ (38 )   $ 28     $ (107 )
Changes in fair value
    (417 )     (30 )     (4 )     (451 )
Reclassification to earnings
    45       -       -       45  
Balance at September 30, 2011
  $ (469 )   $ (68 )   $ 24     $ (513 )

 
Fuel
 
Interest
   
 
 
Accumulated other
 
 
hedge
 
rate
   
 
 
comprehensive
 
(In millions)
derivatives
 
derivatives
 
Other
 
income (loss)
 
Balance at December 31, 2010
  $ (250 )   $ (34 )   $ 22     $ (262 )
Changes in fair value
    (297 )     (34 )     2       (329 )
Reclassification to earnings
    78       -       -       78  
Balance at September 30, 2011
  $ (469 )    $ (68 )    $ 24     $ (513 )
 

 
 
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7.  OTHER ASSETS AND LIABILITIES

 
 
September 30,
   
December 31,
 
(In millions)
 
2011
   
2010
 
Derivative contracts
  $ -     $ 307  
Intangible assets
    168       60  
Non-current investments
    112       97  
Other
    207       142  
Other assets
  $ 487     $ 606  

 
 
September 30,
   
December 31,
 
(In millions)
 
2011
   
2010
 
Retirement plans
  $ 83     $ 171  
Aircraft rentals
    107       27  
Vacation pay
    239       200  
Advances and deposits
    39       33  
Derivative contracts
    116       79  
Workers compensation
    155       142  
Deferred taxes
    159       -  
Other
    295       211  
Accrued liabilities
  $ 1,193     $ 863  

 
 
September 30,
   
December 31,
 
(In millions)
 
2011
   
2010
 
Postretirement obligation
  $ 105     $ 91  
Non-current leasehold interest
    337       -  
Construction obligation
    152       86  
Other
    332       288  
Other non-current liabilities
  $ 926     $ 465  
 
               
 
               
 

 
 
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8.  AIRTRAN LONG-TERM DEBT

As discussed in Note 2, in connection with the acquisition of AirTran, the Company became the holder of $1.1 billion of debt previously issued by AirTran Holdings.  Subsequent to the acquisition date, holders of all of the approximately $70 million (par value) in 5.5% convertible notes due 2015 converted such securities receiving $73 million in cash and 6.2 million shares of Southwest Airlines common stock. All of the approximately $5 million (par value) of 7.0% convertible notes due 2023 were called by Southwest and fully repaid with cash. In addition, the Company terminated AirTran’s $100 million combined revolving credit and letter of credit facility.  As of September 30, 2011, the following debt remained outstanding (in millions):

(In millions)
 
September 30, 2011
 
B737 Aircraft Purchase Financing Facilities:
 
 
 
    Floating-rate aircraft notes payable through 2020, 1.91 percent
 
 
 
    weighted-average interest rate as of September 30, 2011
  $ 616  
    Fixed-rate aircraft notes payable through 2018, 7.02 percent
       
    weighted-average interest rate as of September 30, 2011
    43  
 
       
Fixed-rate B717 aircraft notes payable through 2017, 10.43 percent
       
weighted-average interest rate as of September 30, 2011
    78  
5.25% convertible senior notes due 2016
    119  
Total long-term debt
    856  
Less current maturities of long-term debt
    (75 )
Long-term debt less current maturities
  $ 781  
 
       

As discussed further in Note 5, a portion of the above floating-rate debt has been effectively converted to a fixed rate via interest rate swap agreements which expire between 2016 and 2020. 

As of September 30, 2011, aggregate principal maturities of AirTran debt and capital leases (not including amounts associated with interest rate swap agreements and interest on capital leases) were $24 million for the remainder of 2011, $66 million in 2012, $77 million in 2013, $76 million in 2014, $90 million in 2015, $193 million in 2016, and $320 million thereafter.

At September 30, 2011, the net book value of the assets pledged as collateral for the AirTran B737 and B717 aircraft notes payable, primarily aircraft and engines, was $922 million.
 
 
 
22

 

B737 Aircraft purchase financing facilities
For purposes of financing the future acquisition of B737 aircraft from Boeing, AirTran has previously entered into aircraft purchase financing facilities.  As of September 30, 2011, a total of 30 aircraft were financed under these debt facilities.

As of September 30, 2011, 27 B737 aircraft were financed under floating-rate facilities.  Each note is secured by a first mortgage on the aircraft to which it relates. The notes bear interest at a floating rate per annum equal to a margin plus the three or six-month LIBOR in effect at the commencement of each semi-annual or three-month period, as applicable. Payments of principal and interest under the notes are payable semi-annually or every three months as applicable. As of September 30, 2011, the remaining debt outstanding may be prepaid without penalty under all aircraft loans provided under such facilities with the exception of two aircraft loans. Under the aircraft loans for such two aircraft, the right to prepay without penalty commences on the second anniversary, March 2012, or third anniversary, January 2013, of the date such loans were made. The notes mature in years 2016 to 2020. 

As of September 30, 2011, three B737 aircraft were financed under a fixed-rate facility. Each note is secured by a first mortgage on the aircraft to which it relates. Payments of principal and interest under the notes are payable semi-annually.  The remaining debt outstanding may be prepaid without penalty. The notes mature in years 2016 to 2018.
 
Fixed-rate B717 aircraft notes payable
As of September 30, 2011, eight B717 aircraft were pledged as collateral for the obligations related to enhanced equipment trust certificates (EETCs). Principal and interest payments on the EETCs are due semi-annually through April 2017.

5.25% Convertible senior notes
In October 2009, AirTran completed a public offering of $115 million of convertible senior notes due in 2016.  The net proceeds from the offering were used for general corporate purposes.  Such notes bear interest at 5.25% payable semi-annually, in arrears, on May 1 and November 1.  As a result of the acquisition, the 5.25% convertible senior notes are convertible into AirTran conversion units of 164.136 per $1,000 in principal amount of such notes. This is equal to shares of Southwest Airlines common stock at a conversion rate of 52.6877 shares and $615.17 in cash per $1,000 in principal amount of such notes. This conversion rate is subject to adjustment under certain circumstances such as: granting of stock and cash dividends, a make-whole fundamental change of ownership provision, the issuance of rights or warrants, and/or a distribution of capital stock. Subsequent to the acquisition, holders of $5 million in principal amount elected to convert their notes. Remaining holders may convert their 5.25% convertible senior notes into shares of common stock at their option at any time. The 5.25% convertible senior notes are not redeemable at the Company’s option prior to maturity. The holders of the 5.25% convertible senior notes may require the Company to repurchase such notes, in whole or in part, for cash upon the occurrence of a fundamental change, as defined in the governing supplemental indenture, at a repurchase price of 100 percent of the principal amount plus any accrued and unpaid interest.

 
 
23

 
 
As a result of triggering the fundamental change of ownership provision in the 5.25% convertible senior notes and as a result of the acquisition, an embedded conversion option is deemed to exist. In accordance with applicable accounting guidance, the embedded conversion option is required to be separated and accounted for as a free-standing derivative. A fair value calculation, utilizing similar market yields and the Southwest Airlines common stock price, was performed for the debt with and without the equity to measure the equity component. The value allocated to the conversion option of $35 million is classified as permanent equity. The estimated premium associated with the notes excluding the equity feature was $10 million, and is being amortized to interest expense over the remaining life of the notes.

The dilutive effect of the shares that would be issued if the convertible notes were converted is included in the Company’s dilutive net income per share calculation, unless such conversion would be considered antidilutive. See Note 4.

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 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.

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.  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.

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, 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 we