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, 2012
 
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to ________

Commission File No. 1-7259
 

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

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

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

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

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

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

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

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

 
Number of shares of Common Stock outstanding as of the close of business on July 23, 2012:  743,070,523

 
 

 

TABLE OF CONTENTS TO FORM 10-Q

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

 
2
 
 

 

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

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

   
June 30, 2012
   
December 31, 2011
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 1,083     $ 829  
Short-term investments
    2,173       2,315  
Accounts and other receivables
    502       299  
Inventories of parts and supplies, at cost
    446       401  
Deferred income taxes
    284       263  
Prepaid expenses and other current assets
    203       238  
Total current assets
    4,691       4,345  
                 
Property and equipment, at cost:
               
Flight equipment
    15,952       15,542  
Ground property and equipment
    2,570       2,423  
Deposits on flight equipment purchase contracts
    420       456  
      18,942       18,421  
Less allowance for depreciation and amortization
    6,600       6,294  
      12,342       12,127  
Goodwill
    970       970  
Other assets
    513       626  
    $ 18,516     $ 18,068  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Accounts payable
  $ 1,153     $ 1,057  
Accrued liabilities
    1,142       996  
Air traffic liability
    2,528       1,836  
Current maturities of long-term debt
    257       644  
Total current liabilities
    5,080       4,533  
                 
Long-term debt less current maturities
    3,019       3,107  
Deferred income taxes
    2,563       2,566  
Deferred gains from sale and leaseback of aircraft
    69       75  
Other noncurrent liabilities
    945       910  
Stockholders' equity:
               
Common stock
    808       808  
Capital in excess of par value
    1,224       1,222  
Retained earnings
    5,692       5,395  
Accumulated other comprehensive loss
    (320 )     (224 )
Treasury stock, at cost
    (564 )     (324 )
Total stockholders' equity
    6,840       6,877  
    $ 18,516     $ 18,068  
                 
                 
See accompanying notes.
 
 

 
3
 
 

 




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



     
Three months ended June 30,
 
Six months ended June 30,
     
2012 
 
2011 
 
2012 
 
2011 
OPERATING REVENUES:
                     
 
Passenger
$
 4,338 
 
$
 3,892 
 
$
 8,080 
 
$
 6,840 
 
Freight
 
 42 
   
 36 
   
 79 
   
 67 
 
Other
 
 236 
   
 208 
   
 447 
   
 331 
   
Total operating revenues
 
 4,616 
   
 4,136 
   
 8,606 
   
 7,238 
                           
OPERATING EXPENSES:
                     
 
Salaries, wages, and benefits
 
 1,222 
   
 1,125 
   
 2,363 
   
 2,078 
 
Fuel and oil
 
 1,577 
   
 1,527 
   
 3,087 
   
 2,565 
 
Maintenance materials and repairs
 
 291 
   
 246 
   
 562 
   
 444 
 
Aircraft rentals
 
 90 
   
 79 
   
 178 
   
 125 
 
Landing fees and other rentals
 
 260 
   
 247 
   
 513 
   
 448 
 
Depreciation and amortization
 
 202 
   
 176 
   
 403 
   
 332 
 
Acquisition and integration
 
 11 
   
 58 
   
 24 
   
 75 
 
Other operating expenses
 
 503 
   
 471 
   
 995 
   
 850 
   
Total operating expenses
 
 4,156 
   
 3,929 
   
 8,125 
   
 6,917 
                           
OPERATING INCOME
 
 460 
   
 207 
   
 481 
   
 321 
                           
OTHER EXPENSES (INCOME):
                     
 
Interest expense
 
 38 
   
 51 
   
 77 
   
 94 
 
Capitalized interest
 
 (6)
   
 (2)
   
 (11)
   
 (5)
 
Interest income
 
 (2)
   
 (4)
   
 (3)
   
 (7)
 
Other (gains) losses, net
 
 62 
   
 (113)
   
 (109)
   
 (54)
   
Total other expenses (income)
 
 92 
   
 (68)
   
 (46)
   
 28 
                           
INCOME BEFORE INCOME TAXES
 
 368 
   
 275 
   
 527 
   
 293 
PROVISION FOR INCOME TAXES
 
 140 
   
 114 
   
 200 
   
 127 
                           
NET INCOME
$
 228 
 
$
 161 
 
$
 327 
 
$
 166 
                           
NET INCOME PER SHARE, BASIC
$
.30 
 
$
.21 
 
$
.43 
 
$
.22 
                           
NET INCOME PER SHARE, DILUTED
$
.30 
 
$
.21 
 
$
.43 
 
$
.22 
                           
COMPREHENSIVE INCOME (LOSS)
$
 (35)
 
$
 (25)
 
$
 231 
 
$
 321 
                           
WEIGHTED AVERAGE SHARES OUTSTANDING
                     
Basic
 
 757 
   
 780 
   
 764 
   
 764 
Diluted
 
 764 
   
 787 
   
 771 
   
 765 
                           
Cash dividends declared per common share
$
.0100 
 
$
.0045 
 
$
.0145 
 
$
.0090 
                           
See accompanying notes.
           
 

 
4
 
 

 





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


       
Three months ended
 
Six months ended
       
June 30,
 
June 30,
   
2012 
 
2011 
 
2012 
 
2011 
CASH FLOWS FROM OPERATING ACTIVITIES:
                       
 
Net income
 
$
 228 
 
$
 161 
 
$
 327 
 
$
 166 
 
Adjustments to reconcile net income to cash provided by operating activities:
                       
 
Depreciation and amortization
   
 202 
   
 176 
   
 403 
   
 332 
 
Unrealized (gain) loss on fuel derivative instruments
   
 63 
   
 (129)
   
 (138)
   
 (119)
 
Deferred income taxes
   
 24 
   
 95 
   
 38 
   
 123 
 
Amortization of deferred gains on sale and leaseback of aircraft
   
 (3)
   
 (3)
   
 (6)
   
 (7)
 
Changes in certain assets and liabilities:
                       
   
Accounts and other receivables
   
 (37)
   
 (21)
   
 (105)
   
 (107)
   
Other current assets
   
 (39)
   
 (46)
   
 (90)
   
 (138)
   
Accounts payable and accrued liabilities
   
 77 
   
 67 
   
 301 
   
 305 
   
Air traffic liability
   
 (28)
   
 64 
   
 693 
   
 576 
   
Cash collateral provided to derivative counterparties
   
 (181)
   
 (49)
   
 (34)
   
 (20)
   
Other, net
   
 (161)
   
 (78)
   
 (19)
   
 91 
 
Net cash provided by operating activities
   
 145 
   
 237 
   
 1,370 
   
 1,202 
                             
CASH FLOWS FROM INVESTING ACTIVITIES:
                       
 
Payment to acquire AirTran, net of AirTran cash on hand
   
 - 
   
 (35)
   
 - 
   
 (35)
 
Payments for purchase of property and equipment, net
   
 (416)
   
 (215)
   
 (543)
   
 (272)
 
Purchases of short-term investments
   
 (633)
   
 (1,779)
   
 (1,255)
   
 (3,263)
 
Proceeds from sales of short-term investments
   
 680 
   
 1,440 
   
 1,416 
   
 2,750 
 
Other, net
   
 14 
   
 - 
   
 14 
   
 - 
 
Net cash used in investing activities
   
 (355)
   
 (589)
   
 (368)
   
 (820)
                             
CASH FLOWS FROM FINANCING ACTIVITIES:
                       
 
Proceeds from Employee stock plans
   
 12 
   
 27 
   
 17 
   
 31 
 
Proceeds from termination of interest rate derivative instrument
   
 - 
   
 - 
   
 - 
   
 76 
 
Payments of long-term debt and capital lease obligations
   
 (38)
   
 (32)
   
 (469)
   
 (62)
 
Payments of convertible debt obligations
   
 - 
   
 (81)
   
 - 
   
 (81)
 
Payments of cash dividends
   
 (8)
   
 (3)
   
 (14)
   
 (10)
 
Repurchase of common stock
   
 (225)
   
 - 
   
 (275)
   
 - 
 
Other, net
   
 (6)
   
 (3)
   
 (7)
   
 (2)
 
Net cash used in financing activities
   
 (265)
   
 (92)
   
 (748)
   
 (48)
                             
NET CHANGE IN CASH AND CASH EQUIVALENTS
   
 (475)
   
 (444)
   
 254 
   
 334 
                             
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
 1,558 
   
 2,039 
   
 829 
   
 1,261 
                             
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
 1,083 
 
$
 1,595 
 
$
 1,083 
 
$
 1,595 
 
CASH PAYMENTS FOR:
                       
 
Interest, net of amount capitalized
 
$
 33 
 
$
 48 
 
$
 80 
 
$
 82 
 
Income taxes
 
$
 94 
 
$
 4 
 
$
 95 
 
$
 5 
                             
See accompanying notes.
                       
 

 
5
 
 

 





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


1. BASIS OF PRESENTATION

The accompanying unaudited Condensed Consolidated Financial Statements of Southwest Airlines Co. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The unaudited Condensed Consolidated Financial Statements for the interim periods ended June 30, 2012 and 2011 include all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. This includes all normal and recurring adjustments and elimination of significant intercompany transactions, but does not include all of the information and footnotes required by generally accepted accounting principles (“GAAP”) for complete financial statements. Financial results for the Company and airlines in general can be seasonal in nature. In many years, the Company's revenues, as well as its operating income and net income, have been better in its second and third fiscal quarters than in its first and fourth fiscal quarters. Air travel is also significantly impacted by general economic conditions, the amount of disposable income available to consumers, unemployment levels, and corporate travel budgets. These and other factors, such as the price of jet fuel in some periods, the nature of the Company's fuel hedging program, the periodic volatility of commodities used by the Company for hedging jet fuel, and the requirements related to hedge accounting, have created, and may continue to create, significant volatility in the Company's financial results. See Note 5 for further information on fuel and the Company's hedging program. Operating results for the three and six months ended June 30, 2012 are not necessarily indicative of the results that may be expected for the year ended December 31, 2012. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in the Southwest Airlines Co. Annual Report on Form 10-K for the year ended December 31, 2011.

Certain prior period amounts have been reclassified to conform to the current presentation.  In the unaudited Condensed Consolidated Statement of Comprehensive Income for the three and six months ended June 30, 2011, the Company has reclassified $16 million and $26 million, respectively, from Other revenues to Passenger revenues associated with its sale of frequent flyer benefits from its co-branded Chase® Visa credit card.

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

 
6
 






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

 
 
Expenses related to the AirTran acquisition
The Company is expected to continue to incur substantial integration and transition expenses in connection with the AirTran acquisition, including the necessary costs associated with integrating the operations of the two companies. While the Company has assumed that a certain level of expenses will be incurred, there are many factors that could affect the total amount or the timing of these expenses, and many of the expenses that will be incurred are, by their nature, difficult to estimate. These expenses could, particularly in the near term, exceed the financial benefits that the Company expects to achieve from the AirTran acquisition and could continue to result in the Company taking significant charges against earnings during the integration process. The Company incurred consolidated acquisition and integration-related costs for the three months ended June 30, 2012 and 2011 of $11 million and $58 million, respectively, and for the six months ended June 30, 2012 and 2011 of $24 million and $75 million, respectively, primarily consisting of consulting, flight crew training, seniority integration, technology, and facility integration expenses. In the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income, these costs are classified as Acquisition and integration expenses.

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. There were no fair value adjustments during the second quarter of 2012 and the purchase accounting is final. The following table summarizes the assets acquired and liabilities assumed as of the acquisition date at fair value:

(in millions)
 
May 2, 2011
 
Assets
     
Cash and cash equivalents
  $ 477  
Restricted cash
    6  
Other current assets
    234  
Operating property and equipment
    1,154  
Goodwill
    970  
Other identified intangibles
    123  
Deferred income taxes
    162  
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  

3.   ACCOUNTING CHANGES AND NEW ACCOUNTING PRONOUNCEMENTS

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

 
7
 

 





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

 
 
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
   
Six months ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
NUMERATOR:
                       
Net income
  $ 228     $ 161     $ 327     $ 166  
Incremental income effect of
                               
interest on 5.25% convertible notes
    1       1       1       -  
Net income after assumed conversion
  $ 229     $ 162     $ 328     $ 166  
                                 
DENOMINATOR:
                               
Weighted-average shares
                               
outstanding, basic
    757       780       764       764  
Dilutive effect of Employee stock options
                               
and restricted stock units
    1       1       1       1  
Dilutive effect of 5.25% convertible notes
    6       6       6       -  
Adjusted weighted-average shares
                               
outstanding, diluted
    764       787       771       765  
                                 
NET INCOME PER SHARE:
                               
Basic
  $ .30     $ .21     $ .43     $ .22  
                                 
Diluted
  $ .30     $ .21     $ .43     $ .22  
                                 
Potentially dilutive amounts
                               
excluded from calculations:
                               
Stock options and restricted stock units
    42       49       43       48  
5.25% Convertible Notes
    -       -       -       6  

5.      FINANCIAL DERIVATIVE INSTRUMENTS

Fuel contracts
Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices.  Furthermore, jet fuel and oil typically represent one of the largest operating expenses for airlines.  The Company endeavors to acquire jet fuel at the lowest possible cost and to reduce volatility in operating expenses through its fuel hedging program.  Because jet fuel is not widely traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel.  However, the Company has found that financial derivative instruments in other commodities, such as West Texas Intermediate (“WTI”) crude oil, Brent crude oil, and refined products, such as heating oil and unleaded gasoline, can be useful in decreasing its exposure to jet fuel price volatility.  The Company does not purchase or hold any financial derivative instruments for trading purposes.

The Company has used financial derivative instruments for both short-term and long-term time frames, and primarily uses a mixture of purchased call options, collar structures (which include both a purchased call option and a sold put option), call spreads (which include a purchased call option and a sold call option), and fixed price swap agreements in its portfolio. Although the use of collar structures and swap agreements can reduce the overall cost of hedging, these instruments carry more risk than purchased call options in that the Company could end up in a liability position when the collar structure or swap agreement settles.  With the use of purchased call options and call spreads, the Company cannot be in a liability position at settlement, but may be exposed to price changes beyond a certain market price.
 
 
8
 

 





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

 

The Company evaluates its hedge volumes strictly from an “economic” standpoint and thus does not consider whether the hedges have qualified or will qualify for hedge accounting.  The Company defines its “economic” hedge as the net volume of fuel derivative contracts held, including the impact of positions that have been offset through sold positions, regardless of whether those contracts qualify for hedge accounting.  The level at which the Company is hedged for a particular period is also dependent on current market prices for that period as well as the types of derivative instruments held and the strike prices of those instruments.  For example, the Company may enter into “out-of-the-money” option contracts (including catastrophic protection), which may not generate intrinsic gains at settlement if market prices do not rise above the option strike price.  Therefore, even though the Company may have an “economic” hedge in place for a particular period, that hedge may not produce any hedging gains and may even produce hedging losses depending on market prices, the types of instruments held, and the strike prices of those instruments.

For second quarter 2012, the Company had fuel derivatives in place for approximately 11 percent of its fuel consumption.  As of June 30, 2012, the Company had fuel derivative instruments in place to provide coverage on a portion of its remaining 2012 estimated fuel consumption. The following table provides information about the Company’s volume of fuel hedging for the years 2012 through 2016 on an “economic” basis considering current market prices:

   
Fuel hedged as of
   
   
June 30, 2012
 
Hedged commodity type
Period (by year)
 
(gallons in millions)(a)
 
as of June 30, 2012
Remainder of 2012
    427  
WTI crude oil
2013 
    1,119  
WTI crude and Brent crude oil
2014 
    1,171  
WTI crude and Brent crude oil
2015 
    609  
WTI crude and Brent crude oil
2016 
    277  
Brent crude oil
           
(a) The Company determines gallons hedged based on market prices and forward curves as of June 30, 2012. Due to the types of derivatives utilized by the Company, these volumes may vary significantly as market prices fluctuate.

Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges.  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 unaudited Condensed Consolidated Statement of Comprehensive Income.  Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income 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 2011 or during the six months ended June 30, 2012.
 

 
9
 

 





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

 
 
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.  Factors that have and may continue to lead to ineffectiveness and unrealized gains and losses on derivative contracts include: significant fluctuations in energy prices, the number of derivative positions the Company holds, significant weather events affecting refinery capacity and the production of refined products, and the volatility of the different types of products the Company uses in hedging. 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.  The Company also examines the effectiveness of each individual hedge and 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:

10
 
 

 





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
 
06/30/12
   
12/31/11
   
06/30/12
   
12/31/11
 
Derivatives designated as hedges*
                         
Fuel derivative contracts (gross)
Other current assets
  $ 20     $ 17     $ 7     $ -  
Fuel derivative contracts (gross)
Other assets
    47       542       8       107  
Fuel derivative contracts (gross)
Accrued liabilities
    72       97       26       8  
Fuel derivative contracts (gross)
Other noncurrent liabilities
    154       93       49       24  
Interest rate derivative contracts
Other assets
    69       64       -       -  
Interest rate derivative contracts
Accrued liabilities
    -       2       -       -  
Interest rate derivative contracts
Other noncurrent liabilities
    -       -       128       132  
                                   
Total derivatives designated as hedges
  $ 362     $ 815     $ 218     $ 271  
                                   
Derivatives not designated as hedges*
                                 
Fuel derivative contracts (gross)
Other current assets
  $ 53     $ 124     $ 30     $ 58  
Fuel derivative contracts (gross)
Other assets
    93       26       100       272  
Fuel derivative contracts (gross)
Accrued liabilities
    229       326       442       687  
Fuel derivative contracts (gross)
Other noncurrent liabilities
    164       9       310       122  
                                   
Total derivatives not designated as hedges
    $ 539     $ 485     $ 882     $ 1,139  
                                   
Total derivatives
    $ 901     $ 1,300     $ 1,100     $ 1,410  
                                   
* Represents the position of each trade before consideration of offsetting positions with each counterparty and does not include the impact of cash collateral deposits provided to or received from counterparties. See discussion of credit risk and collateral following in this Note.
 

In addition, the Company also had the following amounts associated with fuel derivative instruments and hedging activities in its unaudited Condensed Consolidated Balance Sheet:

 
11
 
 

 





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



   
Balance Sheet
 
June 30,
   
December 31,
(in millions)
 
location
 
2012
   
2011
Cash collateral deposits provided
 
Offset against Other
         
to counterparties - noncurrent
 
noncurrent liabilities
  $ 32     $ 41
Cash collateral deposits provided
 
Offset against Accrued
             
to counterparties - current
 
liabilities
    135       185
Cash collateral deposits provided
 
Accounts and other
             
to counterparties - current
 
receivables
    98       -
Due to third parties for fuel contracts
 
Accrued liabilities
    8       21
Receivable from third parties for
 
Accounts and other
             
fuel contracts - current
 
receivables
    -       3
Receivable from third parties for
                 
fuel contracts - noncurrent
 
Other assets
    54       -

The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Comprehensive Income for the three and six months ended June 30, 2012 and 2011:

Derivatives in cash flow hedging relationships
 
 
(Gain) loss
   
(Gain) loss
 
(Gain) loss
 
 
recognized in AOCI on
   
reclassified from AOCI
 
recognized in income
 
 
derivatives (effective
   
into income (effective
 
on derivatives
 
 
portion)
   
portion)(a)
   
(ineffective portion)(b)
 
 
Three months ended
 
Three months ended
 
Three months ended
 
 
June 30,
 
June 30,
 
June 30,
 
(in millions)
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
                                     
Fuel derivative
                                   
contracts
  $ 279 *   $ 196 *   $ 28 *   $ 18 *   $ 8     $ 8  
Interest rate
                                               
derivatives
    8 *     11 *     -       -       -       -  
                                                 
Total
  $ 287     $ 207     $ 28     $ 18     $ 8     $ 8  
                                                 
*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)
 
 
Six months ended
 
Six months ended
 
Six months ended
 
 
June 30,
 
June 30,
 
June 30,
 
(in millions)
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
                                     
Fuel derivative
                                   
contracts
  $ 143 *   $ (119 )*   $ 51 *   $ 34 *   $ 40     $ 42  
Interest rate
                                               
derivatives
    2 *     4 *     -       -       -       -  
                                                 
Total
  $ 145     $ (115 )   $ 51     $ 34     $ 40     $ 42  
                                                 
*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.
 
 
 
 
12
 

 





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
 
June 30,
recognized in income
(in millions)
2012 
 
2011 
on derivatives
             
Fuel derivative contracts
  $40     $(150)
Other (gains) losses, net
 

 
Derivatives not in cash flow hedging relationships
             
 
(Gain) loss
 
 
recognized in income on
 
 
  derivatives
 
 
Six months ended
Location of (gain) loss
 
June 30,
recognized in income
(in millions)
2012 
 
2011 
on derivatives
             
Fuel derivative contracts
  $(169)     $(155)
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 June 30, 2012 and 2011 of $12 million and $26 million, respectively, and the six months ended June 30, 2012 and 2011 of $18 million and $57 million, respectively.  These amounts are excluded from the Company’s measurement of effectiveness for related hedges and are included as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income.

The fair values of the derivative instruments, depending on the type of instrument, were determined by the use of present value methods or option value models with assumptions about commodity prices based on those observed in underlying markets or provided by third parties.  Included in the Company’s cumulative net unrealized losses from fuel hedges as of June 30, 2012, were approximately $148 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to June 30, 2012.  In addition, as of June 30, 2012, the Company had already recognized cumulative net gains due to ineffectiveness and derivatives that do not qualify for hedge accounting treatment totaling $19 million, net of taxes.  These net gains were recognized in second quarter 2012 and prior periods, and are reflected in Retained earnings as of June 30, 2012, but the underlying derivative instruments will not expire/settle until third quarter 2012 or future periods.
 

 
13
 

 





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

 
 
Interest rate swaps
The Company is party to certain interest rate swap agreements that are accounted for as either fair value hedges or cash flow hedges, as defined in the applicable accounting guidance for derivative instruments and hedging. The interest rate swap agreements accounted for as fair value hedges qualify for the “shortcut” method of accounting for hedges, which dictates that the hedges are assumed to be perfectly effective, and, thus, there is no ineffectiveness to be recorded in earnings.  For the Company’s interest rate swap agreements accounted for as cash flow hedges, ineffectiveness is required to be measured at each reporting period.  The ineffectiveness associated with all of the Company’s, including AirTran’s, interest rate cash flow hedges for all periods presented was not material.

In June 2012, the Company terminated the floating-to-fixed interest rate swap agreements related to its Floating-rate 737 Aircraft Notes payable 2018 through 2020.  These swaps were previously designated as cash flow hedges and the gains and/or losses that had previously been deferred in AOCI, which were not material, will be released to expense/income in accordance with the original debt payment schedule.  The periodic release of amounts deferred in AOCI related to these interest rate swap agreements is not expected to have a material effect on the Company’s financial position or results of operations. 
 
 
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 June 30, 2012, the Company had agreements with all of its active counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount or credit ratings fall below certain levels.  The Company also had agreements with counterparties in which cash deposits, letters of credit, and/or pledged aircraft are required to be posted whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of June 30, 2012, at which such postings are triggered:

   
Counterparty (CP)
           
   
A
   
B
   
C
   
D
   
E
   
Other(a)
   
Total
(in millions)
                                       
Fair value of fuel derivatives
$
(59)
 
$
(72)
 
$
(65)
 
$
(11)
 
$
64 
 
$
 
$
 (140)
Cash collateral held from (by) CP
 
 (100)
   
 (129)
   
 (36)
   
 - 
   
 - 
   
 - 
   
 (265)
Aircraft collateral pledged to CP
                                       
Letters of credit (LC)
                                       
   Option to substitute LC for aircraft
 
(340) to
   
>(125)(d)
   
N/A
   
N/A
   
N/A
           
   
(740)(d)
                                   
                                         
   Option to substitute LC for cash
 
N/A
   
N/A
   
(100) to
   
N/A
   
>(50)(e)
           
               
(150)(e)
                       
If credit rating is investment
                                       
grade, fair value of fuel
                                       
derivative level at which:
                                       
   Cash is provided to CP
 
(40) to (340)
   
0 to (125)
   
>(50)
   
>(75)
   
>(50)
           
   
or >(740)
   
or >(625)
                             
   Cash is received from CP
 
>75
   
>150
   
>200(c)
   
>125(c)
   
>250
           
   Aircraft or cash can be pledged
                                       
     to CP as collateral
 
(340) to
   
(125) to
   
N/A
   
N/A
   
N/A
           
   
(740)(d)
   
(625)(d)
                             
                                         
 
 
14
 

 





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

 
 
                                         
If credit rating is non-investment
                                       
grade, fair value of fuel derivative
                                       
level at which:
                                       
   Cash is provided to CP
 
(40) to (340)
   
0 to (125)
   
(b)
   
(b)
   
(b)
           
   
or >(740)
   
or >(625)
                             
   Cash is received from CP
 
(b)
   
(b)
   
(b)
   
(b)
   
(b)
           
   Aircraft can be pledged to CP
                                       
     as collateral
 
(340) to
   
(125) to
   
N/A
   
N/A
   
N/A
           
   
(740)
   
(625)
                             
                                         
(a) Individual counterparties with fair value of fuel derivatives <$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, letters of credit, or pledging aircraft as collateral. No letters of credit or aircraft were pledged as collateral with such counterparties as of June 30, 2012.
(e) The Company has the option of providing cash or letters of credit as collateral. No letters of credit were pledged as collateral with such counterparties as of June 30, 2012.

The Company also has agreements with each of its counterparties associated with its outstanding interest rate swap agreements in which cash collateral may be required based on the fair value of outstanding derivative instruments, as well as the Company’s and its counterparty’s credit ratings.  As of June 30, 2012, $68 million had been provided to one counterparty associated with interest rate derivatives based on the Company’s outstanding net liability derivative position with that counterparty.  In addition, in connection with interest rate swaps entered into by AirTran, $24 million had been provided to one counterparty at June 30, 2012, as a result of a net liability derivative position with that counterparty. The outstanding interest rate net derivative positions with all other counterparties at June 30, 2012, were assets to the Company.
 
Applicable accounting provisions require an entity to select a policy for 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. 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.

6.      COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) includes changes in the fair value of certain financial derivative instruments that qualify for hedge accounting, unrealized gains and losses on certain investments, and actuarial gains/losses arising from the Company’s postretirement benefit obligation.  The differences between Net income and Comprehensive income (loss) for the three and six months ended June 30, 2012 and 2011 were as follows:

   
Three months ended June 30,
 
(in millions)
 
2012
   
2011
 
NET INCOME
  $ 228     $ 161  
                 
Unrealized loss on fuel derivative instruments, net of
               
deferred taxes of ($156) and ($111)
    (251 )     (178 )
Unrealized loss on interest rate derivative instruments, net of
               
net of deferred taxes of ($5) and ($7)
    (8 )     (11 )
Other, net of deferred taxes of ($3) and $2
    (4 )     3  
Total other comprehensive loss
  $ (263 )   $ (186 )
                 
COMPREHENSIVE LOSS
  $ (35 )   $ (25 )
                 
                 
 
 
 
15
 

 





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

 
 
   
Six months ended June 30,
 
(in millions)
 
2012
   
2011
 
NET INCOME
  $ 327     $ 166  
                 
Unrealized gain (loss) on interest rate derivative instruments, net of
               
deferred taxes of ($57) and $96
    (92 )     153  
Unrealized loss on interest rate derivative instruments, net of
               
net of deferred taxes of ($1) and ($3)
    (2 )     (4 )
Other, net of deferred taxes of ($1) and $4
    (2 )     6  
Total other comprehensive income (loss)
  $ (96 )   $ 155  
                 
COMPREHENSIVE INCOME
  $ 231     $ 321  
                 
                 

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

                       
Accumulated other
     
Fuel
 
Interest rate
       
comprehensive
(in millions)
 
derivatives
 
derivatives
 
Other
 
income (loss)
Balance at March 31, 2012
 
$
 (24)
 
$
 (60)
 
$
 27 
 
$
 (57)
 
Changes in fair value
   
 (279)
   
 (8)
   
 (4)
   
 (291)
 
Reclassification to earnings
   
 28 
   
 - 
   
 - 
   
 28 
Balance at June 30, 2012
 
$
 (275)
 
$
 (68)
 
$
 23 
 
$
 (320)
 
 
                       
Accumulated other
     
Fuel
 
Interest rate
       
comprehensive
(in millions)
 
derivatives
 
derivatives
 
Other
 
income (loss)
Balance at December 31, 2011
 
$
 (183)
 
$
 (66)
 
$
 25 
 
$
 (224)
 
Changes in fair value
   
 (143)
   
 (2)
   
 (2)
   
 (147)
 
Reclassification to earnings
   
 51 
   
 - 
   
 - 
   
 51 
Balance at June 30, 2012
 
$
 (275)
 
$
 (68)
 
$
 23 
 
$
 (320)


7.  OTHER ASSETS AND LIABILITIES

   
June 30,
   
December 31,
 
(in millions)
 
2012
   
2011
 
Derivative contracts
  $ 154     $ 253  
Intangible assets
    151       155  
Non-current investments
    59       97  
Other
    149       121  
Other assets
  $ 513     $ 626  
 
 
 
16

 





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

 

 
   
June 30,
   
December 31,
 
(in millions)
 
2012
   
2011
 
Retirement plans
  $ 178     $ 110  
Aircraft rentals
    85       57  
Vacation pay
    258       248  
Health
    60       56  
Derivative contracts
    33       85  
Workers compensation
    163       162  
Accrued Taxes
    138       68  
Other
    227       210  
Accrued liabilities
  $ 1,142     $ 996  
 
 
   
June 30,
   
December 31,
 
(in millions)
 
2012
   
2011
 
Postretirement obligation
  $ 112     $ 107  
Non-current leasehold interest
    292       311  
Airport construction obligation
    268       202  
Other
    273       290  
Other non-current liabilities
  $ 945     $ 910  

8.  SUBSEQUENT EVENTS

On July 9, 2012, the Company announced that it had signed an agreement with Delta Air Lines, Inc. (“Delta”) and Boeing Capital Corp. to lease or sublease all 88 of AirTran’s Boeing 717-200 aircraft (“B717s”) to Delta, with the first delivery expected to occur in August 2013, at a rate of approximately three B717s per month.  A total of 78 of the B717s are on operating lease, eight are owned, and two are currently classified as capital leases.  Since the eight owned B717s and two of the B717s on operating lease are pledged as collateral for the obligations related to enhanced equipment trust certificates (EETCs) held by the Company, the leases and subleases related to these aircraft are subject to noteholder approval.  The Company has reported that the B717s add complexity to the Company’s operations, as Southwest Airlines has historically operated an all-Boeing 737 fleet.  From a fleet management perspective, the transition of the B717s to Delta at the rate of approximately three B717s per month beginning in August 2013 allows the Company to minimize the impact of this transaction on operations.  This is because the B717 capacity lost will be replaced through the capacity gained as a result of the Company’s modification of the retirement dates for a portion of its 737-300 and 737-500 aircraft, and its receipt of new 737 deliveries from Boeing, or other used 737s that could be acquired.

The Company will lease and/or sublease all 88 of the B717s to Delta at agreed-upon lease rates.  In addition, the Company will pay the majority of the costs to convert the aircraft to the Delta livery and to perform certain maintenance checks prior to the delivery of each aircraft.  The agreement to pay these conversion and maintenance costs is a “lease incentive” under applicable accounting guidance.  The sublease terms for the 78 B717s currently on operating lease and the two B717s currently classified as capital leases coincide exactly with the Company’s remaining lease terms for these aircraft from the original lessor, which range from approximately six years to approximately twelve years.  The lease terms for the eight B717s that are owned by the Company are for a period of seven years, after which Delta will have an option to purchase the aircraft at the then-prevailing market value.  The Company will account for each of the lease and sublease transactions with Delta as operating leases, except for the two aircraft classified by the Company as capital leases.  The sublease of these aircraft will be accounted for as direct financing leases.  There are no contingent payments and no significant residual value conditions associated with the transaction.
 
 
17
 

 





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

 
 
This transaction will be accounted for based on the guidance provided for lease transactions.  As such, once all components to this transaction are finalized and the lease inception has occurred, which the Company currently anticipates will be during third quarter 2012, the Company expects to record a charge of approximately $140 million, which represents the remaining estimated cost of the lease of the 78 B717s that are currently accounted for as operating leases, and including the conversion, maintenance, and other contractual costs to be incurred, net of the future sublease income associated with these aircraft.  The majority of the charges recorded by the Company for this transaction are expected to be included as a component of Acquisition and integration costs in the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income, and the corresponding liability for this transaction will be included as a component of Other noncurrent liabilities in the Company’s unaudited Condensed Consolidated Balance Sheet.  See Note 2 for further information on the Company’s Acquisition and integration costs.  The Company may also incur other costs associated with this transaction, such as contract termination costs with certain aircraft maintenance vendors.  Any such charges would be recorded at the time of contract termination.


9. COMMITMENTS AND CONTINGENCIES

Commitments
During 2008, the City of Dallas approved the Love Field Modernization Program (“LFMP”), a project to reconstruct Dallas Love Field (“Airport”) with modern, convenient air travel facilities.  Pursuant to a Program Development Agreement (“PDA”) with the City of Dallas, and the Love Field Airport Modernization Corporation (or “LFAMC,” a Texas non-profit “local government corporation” established by the City to act on the City’s behalf to facilitate the development of the LFMP), the Company is managing this project.  Major construction commenced during 2010, with completion of the project scheduled for the second half of 2014.  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 were issued by the LFAMC, and the Company has guaranteed principal and interest payments on the bonds.  An additional tranche of such bonds totaling $146 million was issued during second quarter 2012, and the Company has guaranteed the principal and interest payments on these bonds as well. The Company currently expects that as a result of the funding commitments from the above mentioned sources and the bonds that have been issued thus far, no further bond issuances will be required to complete the LFMP project.
 
 
18
 

 





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

 
 
The Company has agreed to manage the majority of the LFMP project and, as a result, has evaluated its ongoing accounting requirements in consideration of accounting guidance provided for lessees involved in asset construction.  The Company has recorded and will continue to record an asset and corresponding obligation for the cost of the LFMP project as the construction of the facility occurs.  As of June 30, 2012, the Company had incurred construction costs of $268 million, classified as both an asset as a component of Ground property and equipment and a corresponding liability as a component of Other non-current liabilities in its unaudited Condensed Consolidated Balance Sheet.  Upon completion of the LFMP project, the Company expects to begin depreciating the assets over their estimated useful lives, and reduce the corresponding liabilities primarily through the Company’s airport rental payments to the City of Dallas.

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

Contingencies
The Company is from time to time subject to various legal proceedings and claims arising in the ordinary course of business, including, but not limited to, examinations by the IRS.  The Company's management does not expect that the outcome in any of its currently ongoing legal proceedings or the outcome of any adjustments presented by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow.

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, 2012, the Company held certain items that are required to be measured at fair value on a recurring basis.  These included cash equivalents, short-term investments (primarily treasury bills, commercial paper, and certificates of deposit), certain noncurrent investments, interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities.  The majority of the Company’s short-term investments consist of instruments classified as Level 1.  However, the Company has certificates of deposit and commercial paper that are classified as Level 2, due to the fact that the fair value for these instruments is determined utilizing observable inputs in non-active markets.  Noncurrent investments consist of certain auction rate securities, primarily those collateralized by student loan portfolios, which are guaranteed by the U.S. Government. Other available-for-sale securities primarily consist of investments associated with the Company’s excess benefit plan.

The Company’s fuel and interest rate derivative instruments consist of over-the-counter (OTC) contracts, which are not traded on a public exchange.  Fuel derivative instruments include swaps, as well as different types of option contracts, whereas interest rate derivatives consist solely of swap agreements.  See Note 5 for further information on the Company’s derivative instruments and hedging activities.  The fair values of swap contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets.  Therefore, the Company has categorized these swap contracts as Level 2.  The Company’s Treasury Group, which reports to the Chief Financial Officer, determines the value of option contracts utilizing an option pricing model based on inputs that are either readily available in public markets, can be derived from information available in publicly quoted markets, or are provided by financial institutions that trade these contracts. The option pricing model used by the Company is an industry standard model for valuing options and is the same model used by the broker/dealer community (i.e., the Company’s counterparties). The inputs to this option pricing model are the option strike price, underlying price, risk free rate of interest, time to expiration, and volatility. Because certain inputs used to determine the fair value of option contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as Level 3. Volatility information is obtained from external sources, but is analyzed by the Company for reasonableness and compared to similar information received from other external sources. The fair value of option contracts considers both the intrinsic value and any remaining time value associated with those derivatives that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model, on a monthly basis, the Company compares its option valuations to third party valuations. If any significant differences were to be noted, they would be researched in order to determine the reason. However, historically, no significant differences have been noted. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds.
 

 
19
 

 





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

 
 
The Company’s investments associated with its excess benefit plan consist of mutual funds that are publicly traded and for which market prices are readily available.  This plan is a non-qualified deferred compensation plan designed to hold Employee contributions in excess of limits established by Section 415 of the Internal Revenue Code of 1986, as amended.  Payments under this plan are made based on the participant’s distribution election and plan balance. Assets related to the funded portion of the deferred compensation plan are held in a rabbi trust and the Company remains liable to these participants for the unfunded portion of the plan. The Company records changes in the fair value of the liability and the asset in the Company’s earnings.

All of the Company’s auction rate security instruments, totaling $54 million at June 30, 2012, are classified as available-for-sale securities and are reflected at estimated fair value in the unaudited Condensed Consolidated Balance Sheet.  In periods when an auction process successfully took place every 30-35 days, quoted market prices would be readily available, which would qualify the securities as Level 1. However, due to events in credit markets beginning during first quarter 2008, the auction events for these remaining instruments failed, and have continued to fail through the current period.  Therefore, the Company’s Treasury Group determines the estimated fair values of these securities utilizing a discounted cash flow analysis.  The Company has performed, and routinely updates, a valuation for each of its auction rate security instruments, considering, among other items, the collateralization underlying the security investments, the expected future cash flows, including the final maturity, associated with the securities, estimates of the next time the security is expected to have a successful auction or return to full par value, forecasted reset rates based on the London Interbank Offered Rate (“LIBOR”) or the issuer’s net loan rate, and a counterparty credit spread.  To validate the reasonableness of the Company’s discounted cash flow analyses, the Company compares its valuations to third party valuations on a quarterly basis.
 
 
 
 
 
 
20
 

 





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

 
 
In association with its estimate of fair value related to auction rate security instruments as of June 30, 2012, the Company has recorded a temporary unrealized decline in fair value of $19 million, with an offsetting entry to AOCI.  The Company continues to believe that this decline in fair value is due entirely to market liquidity issues, because the underlying assets for the majority of these auction rate securities held by the Company are currently rated investment grade by Moody’s, Standard and Poor’s, and Fitch and are almost entirely backed by the U.S. Government. The range of maturities for the Company’s auction rate securities are from 6 years to 35 years. Considering the relative insignificance of these securities in comparison to the Company’s liquid assets and other sources of liquidity, the Company has no current intention of selling these securities nor does it expect to be required to sell these securities before a recovery in their cost basis.  At the time of the first failed auctions during first quarter 2008, the Company held a total of $463 million in auction rate securities and, since that time, has been able to sell $390 million of these instruments at par value.

The Company remains in discussions with its remaining counterparties to determine whether mutually agreeable decisions can be reached regarding the effective repurchase of its remaining auction rate securities.  The Company continues to earn interest on 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 is other than temporary, it will record a charge to earnings as appropriate.
 
 
 
 

 
21
 
 

 





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



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

         
Fair value measurements at reporting date using:
 
         
Quoted prices in
   
Significant
   
Significant
 
         
active markets
   
other observable
   
unobservable
 
         
for identical assets
   
inputs
   
inputs
 
Description
 
June 30, 2012
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets
 
(in millions)
 
Cash equivalents
                       
Cash equivalents (a)
  $ 909     $ 909     $ -     $ -  
Commercial paper
    150       -       150       -  
Certificates of deposit
    24       -       24       -  
Short-term investments:
                               
Treasury bills
    1,954       1,954       -       -  
Certificates of deposit
    219       -       219       -  
Noncurrent investments (b)
                               
Auction rate securities
    54       -       -       54  
Interest rate derivatives (see Note 5)
    69       -       69       -  
Fuel derivatives:
                               
Swap contracts (c)
    13       -       13       -  
Option contracts (c)
    199       -       -       199  
Swap contracts (d)
    173       -       173       -  
Option contracts (d)
    447       -       -       447  
Other available-for-sale securities
    47       42       -       5  
Total assets
  $ 4,258     $ 2,905     $ 648     $ 705  
                                 
Liabilities
                               
Fuel derivatives:
                               
Swap contracts (c)
  $ (16 )   $ -     $ (16 )   $ -  
Option contracts (c)
    (128 )     -       -       (128 )
Swap contracts (d)
    (374 )     -       (374 )     -  
Option contracts (d)
    (454 )     -       -       (454 )
Interest rate derivatives (see Note 5)
    (128 )     -       (128 )     -  
Deferred compensation
    (126 )     (126 )     -       -  
Total liabilities
  $ (1,226 )   $ (126 )   $ (518 )   $ (582 )
                                 
                                 
(a) Cash equivalents is primarily composed of money market investments.
 
(b) Noncurrent investments are included in Other assets in the unaudited Condensed Consolidated Balance Sheet.
 
(c) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net asset, and are also net of cash collateral received from counterparties. See Note 5.
 
(d) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net liability, and are also net of cash collateral provided to counterparties. See Note 5.
 
   
 
 
22
 
 

 





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



         
Fair value measurements at reporting date using:
 
         
Quoted prices in
   
Significant
   
Significant
 
         
active markets
   
other observable
   
unobservable
 
         
for identical assets
   
inputs
   
inputs
 
Description
 
December 31, 2011
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets
 
(in millions)
 
Cash equivalents
                       
Cash equivalents (a)
  $ 774     $ 774     $ -     $ -  
Commercial paper
    48       -       48       -  
Certificates of deposit