Edgar Filing: SOUTHWEST AIRLINES CO

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, 2011

¨	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 August 3, 2011: 803,997,967

TABLE OF CONTENTS TO FORM 10-Q

Part I- FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheet as of June 30, 2011 and December 31, 2010

Condensed Consolidated Statement of Operations for the three and six months ended June 30, 2011 and 2010

Condensed Consolidated Statement of Cash Flows for the three and six months ended June 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

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,			December 31,
	2011			2010
ASSETS
Current assets:
Cash and cash equivalents	$	1,595			$	1,261
Short-term investments		2,779				2,277
Accounts and other receivables		389				195
Inventories of parts and supplies, at cost		394				243
Deferred income taxes		-				214
Prepaid expenses and other current assets		264				89
Total current assets		5,421				4,279

Property and equipment, at cost:
Flight equipment		15,255				13,991
Ground property and equipment		2,286				2,122
Deposits on flight equipment purchase contracts		226				230
		17,767				16,343
Less allowance for depreciation and amortization		6,046				5,765
		11,721				10,578
Goodwill		971				-
Other assets		832				606
	$	18,945			$	15,463

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,049			$	739
Accrued liabilities		1,130				863
Air traffic liability		2,149				1,198
Current maturities of long-term debt		990				505
Total current liabilities		5,318				3,305

Long-term debt less current maturities		3,242				2,875
Deferred income taxes		2,263				2,493
Deferred gains from sale and leaseback of aircraft		82				88
Other non-current liabilities		838				465
Stockholders' equity:
Common stock		808				808
Capital in excess of par value		1,219				1,183
Retained earnings		5,398				5,399
Accumulated other comprehensive loss		(107	)			(262	)
Treasury stock, at cost		(116	)			(891	)
Total stockholders' equity		7,202				6,237
	$	18,945			$	15,463


See accompanying notes.

Table of Contents

Southwest Airlines Co.

Condensed Consolidated Statement of Operations

(in millions, except per share amounts)

(unaudited)

	Three months ended June 30,						Six months ended June 30,
	2011			2010			2011			2010

OPERATING REVENUES:
Passenger	$	3,876		$	3,016		$	6,814		$	5,511
Freight		36			33			67			63
Other		224			119			357			224
Total operating revenues		4,136			3,168			7,238			5,798

OPERATING EXPENSES:
Salaries, wages, and benefits		1,125			946			2,078			1,810
Fuel and oil		1,527			933			2,565			1,754
Maintenance materials and repairs		246			194			444			360
Aircraft rentals		79			45			125			92
Landing fees and other rentals		247			206			448			396
Depreciation and amortization		176			154			332			308
Acquisition and integration		58			-			75			-
Other operating expenses		471			327			850			661
Total operating expenses		3,929			2,805			6,917			5,381

OPERATING INCOME		207			363			321			417

OTHER EXPENSES (INCOME):
Interest expense		51			42			94			83
Capitalized interest		(2	)		(5	)		(5	)		(10	)
Interest income		(4	)		(4	)		(7	)		(6	)
Other (gains) losses, net		(113	)		146			(54	)		150
Total other expenses (income)		(68	)		179			28			217

INCOME BEFORE INCOME TAXES		275			184			293			200
PROVISION FOR INCOME TAXES		114			72			127			77

NET INCOME	$	161		$	112		$	166		$	123


NET INCOME PER SHARE, BASIC	$	0.21		$	0.15		$	0.22		$	0.17

NET INCOME PER SHARE, DILUTED	$	0.21		$	0.15		$	0.22		$	0.17

WEIGHTED AVERAGE SHARES
OUTSTANDING:
Basic		780			745			764			744
Diluted		787			746			765			745

Cash dividends declared per common share	$	0.0045		$	0.0045		$	0.0090		$	0.0090

See accompanying notes.

Table of Contents

Southwest Airlines Co.

Condensed Consolidated Statement of Cash Flows

(in millions)

(unaudited)

	Three months ended						Six months ended
	June 30,						June 30,
	2011			2010			2011			2010

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	161		$	112		$	166		$	123
Adjustments to reconcile net income to
cash provided by operating activities:
Depreciation and amortization		176			154			332			308
Unrealized (gain) loss on fuel derivative instruments		(129	)		166			(119	)		187
Deferred income taxes		95			63			123			75
Amortization of deferred gains on sale and
leaseback of aircraft		(3	)		(3	)		(7	)		(7	)
Changes in certain assets and liabilities (excluding the effects of acquired business):
Accounts and other receivables		(21	)		(42	)		(107	)		(108	)
Other current assets		(46	)		5			(138	)		(14	)
Accounts payable and accrued liabilities		67			279			305			195
Air traffic liability		64			86			576			442
Cash collateral received from (provided to) fuel
derivative counterparties		(49	)		130			(20	)		135
Other, net		(78	)		(410	)		91			(423	)
Net cash provided by operating activities		237			540			1,202			913

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		(215	)		(159	)		(272	)		(298	)
Purchases of short-term investments		(1,779	)		(1,800	)		(3,263	)		(3,180	)
Proceeds from sales of short-term investments		1,440			1,349			2,750			2,546
Net cash used in investing activities		(589	)		(610	)		(820	)		(932	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from Employee stock plans		27			23			31			35
Proceeds from termination of interest rate
derivative instrument		-			-			76			-
Payments of long-term debt and capital lease obligations		(32	)		(25	)		(62	)		(85	)
Payments of convertible debt		(81	)		-			(81	)		-
Payment of credit line borrowing		-			(44	)		-			(44	)
Payments of cash dividends		(3	)		(3	)		(10	)		(10	)
Other, net		(3	)		(2	)		(2	)		(2	)
Net cash used in financing activities		(92	)		(51	)		(48	)		(106	)

NET CHANGE IN CASH AND CASH EQUIVALENTS		(444	)		(121	)		334			(125	)

CASH AND CASH EQUIVALENTS AT
BEGINNING OF PERIOD		2,039			1,110			1,261			1,114

CASH AND CASH EQUIVALENTS
AT END OF PERIOD	$	1,595		$	989		$	1,595		$	989

CASH PAYMENTS FOR:
Interest, net of amount capitalized	$	48	$	33	$	82	$	68
Income taxes	$	4	$	39	$	5	$	39

SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS:
Fair value of equity consideration given to acquire AirTran	$	523	$	-	$	523	$	-
Fair value of common stock issued for conversion of debt	$	78	$	-	$	78	$	-

See accompanying notes.

Table of Contents

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 June 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 six months ended June 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 selected 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.

Table of Contents

The accompanying unaudited Condensed Consolidated Financial Statements include the results of operations and cash flows for AirTran beginning on May 2, 2011, through June 30, 2011. AirTran will be integrated into the Company’s operations and 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. Total operating revenue of $540 million and a Net loss of $27 million are attributable to AirTran and are included in the Company’s unaudited Condensed Consolidated Statement of Operations for both the three and six month periods ended June 30, 2011. These amounts exclude the effects of amortization of intangible assets and liabilities created as a result of the acquisition and certain acquisition-related expenses incurred by the Company. These amounts include $14 million (net of taxes) in certain acquisition-related expenses incurred by AirTran.

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 existing AirTran debt (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 the Company's 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 six month periods ended June 30, 2011, the Company incurred consolidated acquisition-related costs of $58 million and $75 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

Table of Contents

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. The Company currently expects the ownership change resulting from the AirTran acquisition will not significantly limit its ability to use AirTran’s net operating loss and alternative minimum tax credit carryforwards in the carryforward period.

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. The Company’s ability to use the NOLs will also depend on the amount of taxable income generated in future periods.

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. 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		237
Operating property and equipment		1,151
Goodwill		971
Other identified intangibles		132
Deferred income taxes		150
Other noncurrent assets		45
Liabilities
Long-term debt and capital leases, including current portion		(1,121	)
Air traffic liability		(353	)
Other liabilities assumed		(654	)
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

Table of Contents

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.

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 life of the applicable contract.

The identifiable intangibles created as a result of the acquisition have been amortized from the acquisition date. Estimated aggregate amortization expense for the remainder of 2011 and the five succeeding years and thereafter is as follows: 2011 – $26 million, 2012 – $22 million, 2013 – $16 million, 2014 – $12 million, 2015 – $10 million, 2016 – $7 million, 2017 and thereafter - $39 million. The following table is a summary of the fair value estimates of the acquired identifiable intangible assets, weighted-average useful lives, and balance of accumulated amortization as of June 30, 2011:

	Estimated
	fair value of		Weighted-average		Accumulated
	asset/(liability)		useful life		amortization
	(in millions)		(in years)		(in millions)
Customer relationships/marketing agreements	$	46		4	$	3
Trademarks/trade names		36		3		2
Domestic Slots		43		24		-
Internally developed software		2		2		-
Noncompete agreements		5		2		-
Total	$	132		10	$	5

Table of Contents

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 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 June 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 rent expense over the individual applicable remaining lease terms, resulting in recognition of rent as if the Company had entered into the leases at market rates at the acquisition date. Estimated aggregate amortization income (reduction of expense) for the remainder of 2011 and the five succeeding years and thereafter is as follows: 2011 - $26 million, 2012 - $39 million, 2013 - $39 million, 2014 - $39 million, 2015 - $39 million, 2016 - $39 million, 2017 and thereafter - $155 million. Accumulated amortization as of June 30, 2011, was immaterial for the leasehold interest asset and $6 million for the leasehold interest liability. 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 $971 million was 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 expected 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 items are subject to change:

·	Amounts for intangibles, 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 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.

Table of Contents

		Three months			Six months
		ended June 30,			ended June 30,
(In millions, except per share data)		2011	2010		2011	2010
Total operating revenues	$	4,402	3,868	$	8,171	7,105
Net income		160	109		163	109
Net income per share, basic		0.20	0.14		0.21	0.14
Net income per share, diluted		0.20	0.14		0.21	0.14

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.

Table of Contents

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,
	2011		2010		2011		2010

NUMERATOR:
Net income	$	161	$	112	$	166	$	123
Incremental income effect of
interest on 5.25% convertible notes		1		-		-		-
Net income after assumed conversion	$	162	$	112	$	166	$	123

DENOMINATOR:
Weighted average shares
outstanding, basic		780		745		764		744
Dilutive effect of Employee stock
awards		1		-		1		-
Dilutive effect of 5.25% convertible notes		6		1		-		1
Adjusted weighted-average shares
outstanding, diluted		787		746		765		745

NET INCOME PER SHARE:
Basic	$	0.21	$	0.15	$	0.22	$	0.17

Diluted	$	0.21	$	0.15	$	0.22	$	0.17

Antidilutive stock options
excluded from calculations		49		72		48		74

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.

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.

Table of Contents

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 second quarter 2011, the Company had fuel derivatives in place related to approximately 36 percent of its fuel consumption. As of June 30, 2011, the Company had fuel derivative instruments in place to provide coverage on a large 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 June 30, 2011
Period (by year)	(gallons in millions)
Second half 2011		629
2012		1,297
2013		919
2014		622
2015		239

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 six months ended June 30, 2011.

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

Table of Contents

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:

Table of Contents

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	06/30/11		12/31/10		06/30/11		12/31/10

Derivatives designated as hedges
Fuel derivative contracts (gross)*	Other current assets	$	226	$	151	$	19	$	16
Fuel derivative contracts (gross)*	Other assets		794		547		102		88
Fuel derivative contracts (gross)*	Accrued liabilities		56		122		1		18
Fuel derivative contracts (gross)*	Other noncurrent liabilities		20		71		2		9
Interest rate derivative contracts	Other current assets		2		73		-		-
Interest rate derivative contracts	Other assets		32		-		-		-
Interest rate derivative contracts	Accrued liabilities		-		-		5		-
Interest rate derivative contracts	Other noncurrent liabilities		-		-		75		4

Total derivatives designated as hedges		$	1,130	$	964	$	204	$	135

Derivatives not designated as hedges
Fuel derivative contracts (gross)*	Other current assets	$	317	$	164	$	359	$	284
Fuel derivative contracts (gross)*	Other assets		279		212		583		304
Fuel derivative contracts (gross)*	Accrued liabilities		1		40		165		222
Fuel derivative contracts (gross)*	Other noncurrent liabilities		9		33		104		257

Total derivatives not designated as hedges		$	606	$	449	$	1,211	$	1,067

Total derivatives		$	1,736	$	1,413	$	1,415	$	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:

Table of Contents

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

	Balance Sheet	June 30,		December 31,
(in millions)	location	2011		2010
Cash collateral deposits provided	Offset against Other
to counterparty - noncurrent	noncurrent liabilities	$	86	$	125
Cash collateral deposits provided	Offset against Accrued
to counterparty - current	liabilities		109		-
Cash collateral deposits held from	Offset against Other
counterparty - noncurrent	assets		75		60
Cash collateral deposits held from	Offset against Other
counterparty - current	current assets		35		-
Receivable from third parties for settled	Accounts and other
fuel contracts	receivables		5		1
Net unrealized (gains) losses from fuel	Accumulated other
hedges, net of tax	comprehensive (gain) loss		97		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 six months ended June 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
		June 30,								June 30,								June 30,
(in millions)		2011				2010				2011				2010				2011			2010

Fuel derivative
contracts			$	196	*		$	172	*		$	18	*		$	74	*		$	8		$	58
Interest rate
derivatives				11	*			21	*			-				-				-			-

Total			$	207			$	193			$	18			$	74			$	8		$	58

*	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)		2011				2010				2011				2010				2011			2010

Fuel derivative
contracts			$	(119	)*		$	188	*		$	34	*		$	149	*		$	42		$	54
Interest rate
derivatives				4	*			22	*			-				-				-			-

Total			$	(115	)		$	210			$	34			$	149			$	42		$	54

*	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.

Table of Contents

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)	2011		2010		on derivatives

Fuel derivative contracts		$(150)		$57	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)	2011		2010		on derivatives

Fuel derivative contracts		$(155)		$34	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, 2011 and 2010 of $26 million and $30 million, respectively, and the six months ended June 30, 2011 and 2010 of $57 million and $61 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 total net unrealized losses from fuel hedges as of June 30, 2011, were approximately $87 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to June 30, 2011. In addition, as of June 30, 2011, the Company had already recognized cumulative net gains due to ineffectiveness and derivatives that do not qualify for hedge accounting treatment totaling $26 million, net of taxes. These net gains were recognized in second quarter 2011 and prior periods, and are reflected in Retained earnings as of June 30, 2011, but the underlying derivative instruments will not expire/settle until third 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.

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

Table of Contents

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 June 30, 2011 was $462 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 June 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 June 30, 2011, at which such postings are triggered:

Counterparty (CP)

Other(a)

Total

(in millions)

Fair value of fuel derivatives

213

(186

)

102

204

367

Cash collateral held from (by) CP

110

(195

)

(85

)

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 can be pledged to CP

(300) to

(125) to

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)

or >(700)

or >(625)

Cash is received from CP

(b)

Aircraft can be pledged to CP

(300) to

(125) to

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.

(d) The Company has the option of providing cash or pledging aircraft as collateral. No aircraft were pledged as collateral as of June 30, 2011.

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

Table of Contents

derivative instruments, as well as the Company’s and its counterparty’s credit ratings. As of June 30, 2011, $31 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, based on interest rate swaps entered into by AirTran, $21 million in collateral had been set aside as restricted cash and $6 million had been provided to a counterparty at June 30, 2011, as a result of net liability derivative positions with those counterparties. See Note 7. The outstanding interest rate net derivative positions with all other counterparties at June 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 and Comprehensive income (loss) for the three and six months ended June 30, 2011 and 2010, were as follows:

	Three months ended June 30,
(In millions)	2011			2010


Net income	$	161		$	112
Unrealized (loss) on fuel derivative instruments,
net of deferred taxes of ($111) and ($61)		(178	)		(98	)
Unrealized (loss) on interest rate swaps,
net of deferred taxes of ($7) and ($13)		(11	)		(21	)
Other, net of deferred taxes of $2 and ($2)		3			(4	)
Total other comprehensive loss		(186	)		(123	)

Comprehensive loss	$	(25	)	$	(11	)

	Six months ended June 30,
(In millions)	2011			2010


Net income	$	166		$	123
Unrealized gain/(loss) on fuel derivative instruments,
net of deferred taxes of $96 and ($24)		153			(39	)
Unrealized (loss) on interest rate swaps,
net of deferred taxes of ($3) and ($14)		(4	)		(22	)
Other, net of deferred taxes of $4 and ($1)		6			(2	)
Total other comprehensive income (loss)		155			(63	)

Comprehensive income	$	321		$	60

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

Table of Contents

	Fuel				Interest							Accumulated other
	hedge				rate							comprehensive
(In millions)	derivatives				derivatives				Other			income (loss)
Balance at March 31, 2011		$	81			$	(27	)		$	25		$	79
Changes in fair value			(196	)			(11	)			3			(204	)
Reclassification to earnings			18				-				-			18
Balance at June 30, 2011		$	(97	)		$	(38	)		$	28		$	(107	)

	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			119				(4	)			6			121
Reclassification to earnings			34				-				-			34
Balance at June 30, 2011		$	(97	)			(38	)			28		$	(107	)

7. OTHER ASSETS AND LIABILITIES

	June 30,				December 31,
(In millions)	2011				2010

Fuel derivatives contracts		$	312	$	307
Intangible assets			184		60
Non-current investments			89		97
Restricted cash			67		-
Maintenance deposits			60		-
Other			120		142
Other assets		$	832	$	606

	June 30,				December 31,
(In millions)			2011		2010

Retirement plans		$	203	$	171
Aircraft rentals			100		27
Vacation pay			235		200
Advances and deposits			32		33
Fuel derivative contracts			5		79
Workers compensation			151		142
Deferred taxes			102		-
Other			302		211
Accrued liabilities		$	1,130	$	863

	June 30,				December 31,
(In millions)			2011		2010

Postretirement obligation		$	98	$	91
Non-current leasehold interest			337		-
Construction obligation			130		86
Other			273		288
Other non-current liabilities		$	838	$	465

Table of Contents

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 Southwest Airlines common shares. 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 June 30, 2011, the following debt remained outstanding (in millions):

(In millions)