Edgar Filing: SOUTHWEST AIRLINES CO

LUV-3.31.2013-10Q

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 March 31, 2013



	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 April 30, 2013: 722,296,988

TABLE OF CONTENTS TO FORM 10-Q



PART I - FINANCIAL INFORMATION
	Item 1. Financial Statements
		Condensed Consolidated Balance Sheet as of March 31, 2013 and December 31, 2012
		Condensed Consolidated Statement of Comprehensive Income for the three months ended March 31, 2013 and 2012
		Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2013 and 2012
		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

SOUTHWEST AIRLINES CO.

FORM 10-Q

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Southwest Airlines Co.

Condensed Consolidated Balance Sheet

(in millions)

(unaudited)



	March 31, 2013			December 31, 2012
ASSETS
Current assets:
Cash and cash equivalents	$	1,338		$	1,113
Short-term investments	1,797			1,857
Accounts and other receivables	429			332
Inventories of parts and supplies, at cost	480			469
Deferred income taxes	255			246
Prepaid expenses and other current assets	215			210
Total current assets	4,514			4,227

Property and equipment, at cost:
Flight equipment	16,643			16,367
Ground property and equipment	2,754			2,714
Deposits on flight equipment purchase contracts	594			416
	19,991			19,497
Less allowance for depreciation and amortization	6,861			6,731
	13,130			12,766
Goodwill	970			970
Other assets	583			633
	$	19,197		$	18,596

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,250		$	1,107
Accrued liabilities	1,004			1,102
Air traffic liability	2,877			2,170
Current maturities of long-term debt	280			271
Total current liabilities	5,411			4,650

Long-term debt less current maturities	2,708			2,883
Deferred income taxes	2,904			2,884
Deferred gains from sale and leaseback of aircraft	60			63
Other noncurrent liabilities	1,153			1,124
Stockholders' equity:
Common stock	808			808
Capital in excess of par value	1,214			1,210
Retained earnings	5,818			5,768
Accumulated other comprehensive loss	(111		)	(119		)
Treasury stock, at cost	(768		)	(675		)
Total stockholders' equity	6,961			6,992
	$	19,197		$	18,596

See accompanying notes.

Southwest Airlines Co.

Condensed Consolidated Statement of Comprehensive Income

(in millions, except per share amounts)

(unaudited)



	Three months ended March 31,
	2013			2012
OPERATING REVENUES:
Passenger	$	3,838		$	3,751
Freight	39			37
Other	207			203
Total operating revenues	4,084			3,991

OPERATING EXPENSES:
Salaries, wages, and benefits	1,183			1,141
Fuel and oil	1,457			1,510
Maintenance materials and repairs	291			272
Aircraft rentals	93			88
Landing fees and other rentals	266			254
Depreciation and amortization	210			201
Acquisition and integration	13			13
Other operating expenses	501			490
Total operating expenses	4,014			3,969

OPERATING INCOME	70			22

OTHER EXPENSES (INCOME):
Interest expense	29			40
Capitalized interest	(5		)	(5		)
Interest income	(2		)	(2		)
Other gains, net	(46		)	(170		)
Total other income	(24		)	(137		)

INCOME BEFORE INCOME TAXES	94			159
PROVISION FOR INCOME TAXES	35			61

NET INCOME	$	59		$	98

NET INCOME PER SHARE, BASIC	$	0.08		$	0.13

NET INCOME PER SHARE, DILUTED	$	0.08		$	0.13

COMPREHENSIVE INCOME	$	67		$	265

WEIGHTED AVERAGE SHARES OUTSTANDING
Basic	725			771
Diluted	727			772

Cash dividends declared per common share	$	.0100		$	.0045

See accompanying notes.

Southwest Airlines Co.

Condensed Consolidated Statement of Cash Flows

(in millions)

(unaudited)



	Three months ended March 31,
	2013			2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	59		$	98
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Depreciation and amortization	210			201
Unrealized gain on fuel derivative instruments	(21		)	(201		)
Deferred income taxes	2			14
Amortization of deferred gains on sale and leaseback of aircraft	(3		)	(3		)
Changes in certain assets and liabilities:
Accounts and other receivables	(97		)	(68		)
Other assets	(25		)	(51		)
Accounts payable and accrued liabilities	120			225
Air traffic liability	707			720
Cash collateral received from derivative counterparties	28			147
Other, net	3			143
Net cash provided by operating activities	983			1,225

CASH FLOWS FROM INVESTING ACTIVITIES:
Payments for purchase of property and equipment, net	(534		)	(127		)
Purchases of short-term investments	(725		)	(621		)
Proceeds from sales of short-term investments	787			736
Net cash used in investing activities	(472		)	(12		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from Employee stock plans	6			5
Payments of long-term debt and capital lease obligations	(164		)	(431		)
Payments of cash dividends	(15		)	(7		)
Repurchase of common stock	(100		)	(50		)
Other, net	(13		)	(1		)
Net cash used in financing activities	(286		)	(484		)

NET CHANGE IN CASH AND CASH EQUIVALENTS	225			729

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD	1,113			829

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	1,338		$	1,558

CASH PAYMENTS FOR:
Interest, net of amount capitalized	$	41		$	47
Income taxes	$	2		$	1

See accompanying notes.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. BASIS OF PRESENTATION

The accompanying unaudited Condensed Consolidated Financial Statements of Southwest Airlines Co. and its subsidiaries (the “Company”) 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 March 31, 2013 and 2012 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 months ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ended December 31, 2013. 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, 2012.

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 months ended March 31, 2012, the Company has reclassified $7 million 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.

In July 2012, the Company announced that AirTran's Boeing 717-200 aircraft will be transitioned out of the Company’s fleet over a three-year period beginning in August 2013. See Note 8 for further information.

Expenses related to the AirTran acquisition

The Company is expected to continue to incur substantial Acquisition and integration 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 acquisition and integration-related costs of $13 million for each of the three month periods ended March 31, 2013 and 2012, primarily consisting of costs

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

associated with consulting, flight crew training, seniority integration, technology, and facility integration. In the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income, these costs are classified as Acquisition and integration expenses.

3. ACCOUNTING CHANGES AND NEW ACCOUNTING PRONOUNCEMENTS

On December 16, 2011, the Financial Accounting Standards Board ("FASB") 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, and the Company adopted this ASU during first quarter 2013. This ASU did not have a material effect on the Company's financial position or results of operations, but did change the Company's disclosure policies for financial derivative instruments. See Note 5.

On February 5, 2013, the FASB ratified ASU No. 2013-02, "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income." The new disclosure requirements mandate that entities report, in one place, information about reclassifications out of Accumulated other comprehensive income (loss) ("AOCI"). The standard requires disclosure of the amount of the reclassification and the effect of the reclassification on the income statement line item. Upon adoption, the reclassification disclosures must be presented, in one place, either parenthetically on the face of the statement where net income is presented or in the notes. This ASU is effective for fiscal years, and interim periods within those years, beginning on or after December 15, 2012, and the Company adopted this ASU during first quarter 2013. This ASU did not have a material effect on the Company's financial position or results of operations, but did change the Company's disclosure policies for amounts reclassified out of AOCI. The Company has elected to disclose the reclassification requirements in Note 6.

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 March 31,
	2013		2012
NUMERATOR:
Net income	$	59	$	98

DENOMINATOR:
Weighted-average shares outstanding, basic	725		771
Dilutive effect of Employee stock options and restricted stock units	2		1
Adjusted weighted-average shares outstanding, diluted	727		772

NET INCOME PER SHARE:
Basic	$	0.08	$	0.13
Diluted	$	0.08	$	0.13

Potentially dilutive amounts excluded from calculations:
Stock options and restricted stock units	17		44
5.25% convertible notes	6		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. Although the Company may periodically enter into jet fuel derivatives for short-term timeframes, because jet fuel is not widely traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel for time horizons longer than approximately 6 to 12 months into the future. 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 or speculative purposes.

The Company has used financial derivative instruments for both short-term and long-term time frames and primarily uses a mixture of purchased call options, collar structures (which include both a purchased call option and a sold put option), call spreads (which include a purchased call option and a sold call option), and fixed price swap agreements in its portfolio.

The Company evaluates its hedge volumes strictly from an “economic” standpoint and thus does not consider whether the hedges have qualified or will qualify for hedge accounting. The Company defines its “economic” hedge as the net volume of fuel derivative contracts held, including the impact of positions that have been offset through sold positions, regardless of whether those contracts qualify for hedge accounting. The level at which the Company is hedged for a particular period is also dependent on current market prices for that period, as well as the types of derivative instruments held and the strike prices of those instruments.

For the three months ended March 31, 2013, the Company had fuel derivative instruments in place for a small portion of its fuel consumption. As of March 31, 2013, the Company had fuel derivative instruments in place to provide coverage for approximately 82 percent of its remaining 2013 estimated fuel consumption. The following table provides information about the Company’s volume of fuel hedging for the years 2013 through 2017 on an “economic” basis considering current market prices:



	Fuel hedged as of
	March 31, 2013	Hedged commodity type as of
Period (by year)	(gallons in millions)(a)	March 31, 2013
Remainder of 2013	1,118	Brent crude oil and Gulf Coast jet fuel
2014	1,444	WTI crude and Brent crude oil
2015	597	WTI crude and Brent crude oil
2016	886	Brent crude oil
2017	619	WTI crude and Brent crude oil

(a) The Company determines gallons hedged based on market prices and forward curves as of March 31, 2013. Due to the types of derivatives utilized by the Company, these volumes may vary significantly as market prices fluctuate.

Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges. Generally, utilizing hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective are recorded in AOCI until the underlying jet fuel is consumed. See Note 6. To the extent that the periodic changes in the fair value of the derivatives are ineffective, the ineffective portion is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income. 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. In a situation where it becomes probable that a fuel 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 2012 or during the three months ended March 31, 2013.

All cash flows associated with purchasing and selling fuel derivatives are classified as Other operating cash flows in the unaudited Condensed Consolidated Statement of Cash Flows. The following table presents the location of all assets and liabilities associated with the Company’s derivative instruments within the unaudited Condensed Consolidated Balance Sheet:



		Asset derivatives				Liability derivatives
	Balance Sheet	Fair value at		Fair value at		Fair value at		Fair value at
(in millions)	location	3/31/2013		12/31/2012		3/31/2013		12/31/2012
Derivatives designated as hedges*
Fuel derivative contracts (gross)	Prepaid expenses and other current assets	$	42	$	—	$	—	$	—
Fuel derivative contracts (gross)	Other assets	292		355		10		16
Interest rate derivative contracts	Other assets	29		31		—		—
Interest rate derivative contracts	Other noncurrent liabilities	—		—		115		126
Total derivatives designated as hedges		$	363	$	386	$	125	$	142
Derivatives not designated as hedges*
Fuel derivative contracts (gross)	Prepaid expenses and other current assets	$	259	$	375	$	261	$	327
Fuel derivative contracts (gross)	Other assets	112		233		222		351
Fuel derivative contracts (gross)	Accrued liabilities	—		10		—		60
Fuel derivative contracts (gross)	Other noncurrent liabilities	—		—		12		—
Total derivatives not designated as hedges		$	371	$	618	$	495	$	738
Total derivatives		$	734	$	1,004	$	620	$	880

* 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 had the following amounts associated with fuel derivative instruments and hedging activities in its unaudited Condensed Consolidated Balance Sheet:



	Balance Sheet	March 31,		December 31,
(in millions)	location	2013		2012
Cash collateral deposits provided to counterparties for interest rate contracts - noncurrent	Offset against Other noncurrent liabilities	$	61	$	89
Receivable from third parties for fuel contracts - noncurrent	Other assets	54		54
Prepaid settlements for fuel contracts - current	Prepaid expenses and other current assets	—		15

All of the Company's fuel derivative instruments and interest rate swaps are subject to agreements that follow the netting guidance in the applicable accounting for Derivatives and Hedging. The types of derivative instruments the Company has determined are subject to netting requirements in the accompanying unaudited Condensed Consolidated Balance Sheet are those in which the Company pays or receives cash for transactions with the same counterparty that settle on the same day and in the same currency via one net payment or receipt. For cash collateral held by the Company or provided to counterparties, the Company nets such amounts against the fair value of the Company's derivative portfolio by each counterparty. The Company has elected to utilize netting for both its fuel derivative instruments and interest rate swap agreements and also classifies such amounts as either current or noncurrent, based on the net fair value position with each of the Company's counterparties in the unaudited Condensed Consolidated Balance Sheet.

The Company's application of its netting policy associated with cash collateral 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 outstanding derivative amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of noncurrent outstanding derivative instruments. If the Company's fuel derivative instruments are in a net liability position with the counterparty, cash collateral amounts provided are first netted against noncurrent outstanding 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. At March 31, 2013 and December 31, 2012, no cash collateral deposits, letters of credit, and/or aircraft collateral were provided by or held by the Company associated with its outstanding fuel derivative instruments.

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. The Company has also elected to present its interest rate swap agreement cash collateral utilizing a net presentation. As of March 31, 2013, $56 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, $5 million had been provided to one counterparty at March 31, 2013, as a result of the outstanding net liability derivative position with that counterparty. The outstanding interest rate net derivative positions with all other counterparties at March 31, 2013, were assets to the Company.

The Company has the following recognized financial assets and financial liabilities resulting from those transactions that meet the scope of the disclosure requirements as necessitated by applicable accounting guidance for Balance Sheet Offsetting.



Offsetting of Derivative Assets
(in millions)
		(i)		(ii)			(iii) = (i) + (ii)			(i)		(ii)			(iii) = (i) + (ii)
		March 31, 2013								December 31, 2012
Description	Balance Sheet location	Gross amounts of recognized assets		Gross amounts offset in the Balance Sheet			Net amounts of assets presented in the Balance Sheet			Gross amounts of recognized assets		Gross amounts offset in the Balance Sheet			Net amounts of assets presented in the Balance Sheet
Fuel derivative contracts	Prepaid expenses and other current assets	$	301	$	(261	)	$	40	(a)	$	375	$	(327	)	$	48	(a)
Fuel derivative contracts	Other assets	$	404	$	(232	)	$	172		$	588	$	(367	)	$	221
Fuel derivative contracts	Accrued liabilities	$	—	$	—		$	—		$	10	$	(10	)	$	—
Interest rate derivative contracts	Other assets	$	29	$	—		$	29		$	31	$	—		$	31

(a) Amounts included in Prepaid expenses and other current assets.



Offsetting of Derivative Liabilities
(in millions)
		(i)		(ii)			(iii) = (i) + (ii)		(i)		(ii)			(iii) = (i) + (ii)
		March 31, 2013							December 31, 2012
Description	Balance Sheet location	Gross amounts of recognized liabilities		Gross amounts offset in the Balance Sheet			Net amounts of liabilities presented in the Balance Sheet		Gross amounts of recognized liabilities		Gross amounts offset in the Balance Sheet			Net amounts of liabilities presented in the Balance Sheet
Fuel derivative contracts	Prepaid expenses and other current assets	$	261	$	(261	)	$	—	$	327	$	(327	)	$	—
Fuel derivative contracts	Other assets	$	232	$	(232	)	$	—	$	367	$	(367	)	$	—
Fuel derivative contracts	Accrued liabilities	$	—	$	—		$	—	$	60	$	(10	)	$	50
Fuel derivative contracts	Other noncurrent liabilities	$	12	$	—		$	12	$	—	$	—		$	—
Interest rate derivative contracts	Other noncurrent liabilities	$	115	$	(61	)	$	54	$	126	$	(89	)	$	37

The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the unaudited Condensed Consolidated Balance Sheet in Note 7.

The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Comprehensive Income for the three months ended March 31, 2013 and 2012:



Derivatives in cash flow hedging relationships
	(Gain) loss recognized in AOCI on derivative (effective portion)								(Gain) loss reclassified from AOCI into income (effective portion)(a)						(Gain) loss recognized in income on derivatives (ineffective portion)(b)
	Three months ended								Three months ended						Three months ended
	March 31,								March 31,						March 31,
(in millions)	2013				2012				2013			2012			2013		2012
Fuel derivative contracts	$	29		*	$	(136	)	*	$	26	*	$	23	*	$	10	$	32
Interest rate derivatives	(3		)	*	(2		)	*	5		*	4		*	—		—
Total	$	26			$	(138	)		$	31		$	27		$	10	$	32

*Net of tax

(a) Amounts related to fuel derivative contracts and interest rate derivatives are included in Fuel and oil and Interest expense, respectively.

(b) Amounts are included in Other (gains) losses, net.



Derivatives not in cash flow hedging relationships
	(Gain) loss
	recognized in income on
	derivatives
	Three months ended					Location of (gain) loss
	March 31,					recognized in income
(in millions)	2013		2012			on derivatives
Fuel derivative contracts	$	61	$	(208	)	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 March 31, 2013 and 2012 of $5 million and $6 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 March 31, 2013, were approximately $57 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to March 31, 2013. In addition, as of March 31, 2013, the Company had already recognized cumulative net gains due to ineffectiveness and derivatives that did not qualify for hedge accounting treatment totaling $64 million, net of taxes. These net gains were recognized during the three months ended March 31, 2013 and prior periods, and are reflected in Retained earnings as of March 31, 2013, but the underlying derivative instruments will not expire/settle until second quarter 2013 or future periods.

Interest rate swaps

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

In March 2013, the Company prepaid a portion of AirTran's floating-rate aircraft secured term loans. See Note 11. A portion of the floating-rate debt had been effectively converted to a fixed rate via interest rate swap agreements which were to expire between 2016 and 2020. As a result of the prepayment, the Company released the AOCI balance related to the cash flow hedges of approximately $2 million to earnings during first quarter 2013, resulting in an increase in interest expense.

Credit risk and collateral

Credit exposure related to fuel derivative instruments is represented by the fair value of contracts that are an asset to the Company at the reporting date. At such times, these outstanding instruments expose the Company to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company has not experienced any significant credit loss as a result of counterparty nonperformance in the past. To manage credit risk, the Company selects and periodically reviews counterparties based on credit ratings, limits its exposure with respect to each counterparty, and monitors the market position of the fuel hedging program and its relative market position with each counterparty. At March 31, 2013, the Company had agreements with all of its active counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount based on the counterparty credit rating. The Company also had agreements with counterparties in which cash deposits, letters of credit, and/or pledged aircraft are required to be posted whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of March 31, 2013, at which such postings are triggered:

Counterparty (CP)

(in millions)

Other(a)

Total

Fair value of fuel derivatives

200

Cash collateral held (by) CP

—

Aircraft collateral pledged to CP

—

Letters of credit (LC)

—

Option to substitute LC for aircraft

(340) to (740)(d)

>(125)(d)

N/A

Option to substitute LC for cash

N/A

(100) to (150)(e)

N/A

>(50)(e)

N/A

If credit rating is investment

grade, fair value of fuel

derivative level at which:

Cash is provided to CP

(40) to (340) or >(740)

0 to (125) or >(625)

>(50)

>(75)

>(50)

Cash is received from CP

>75

>150

>175(c)

>125(c)

>200

>30

Aircraft or cash can be pledged to

CP as collateral

(340) to (740)(d)

(125) to (625)(d)

N/A

If credit rating is non-investment

grade, fair value of fuel derivative

level at which:

Cash is provided to CP

(40) to (340) or >(740)

0 to (125) or >(625)

(b)

Cash is received from CP

(b)

Aircraft can be pledged to CP as

collateral

(340) to (740)

(125) to (625)

N/A

(a) Individual counterparties with fair value of fuel derivatives <$20 million.

(b) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.

(d) The Company has the option of providing cash, letters of credit, or pledging aircraft as collateral. No cash, letters of credit, or aircraft were pledged as collateral with such counterparties as of March 31, 2013.

(e) The Company has the option of providing cash or letters of credit as collateral. No cash or letters of credit were pledged as collateral with such counterparties as of March 31, 2013.

6. COMPREHENSIVE INCOME

Comprehensive income 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 for the three months ended March 31, 2013 and 2012 were as follows:



	Three months ended March 31,
(in millions)	2013			2012
NET INCOME	$	59		$	98
Unrealized gain (loss) on fuel derivative instruments, net of deferred taxes of ($1) and $99	(3		)	159
Unrealized gain on interest rate derivative instruments, net of deferred taxes of $5 and $4	8			6
Other, net of deferred taxes of $2 and $2	3			2
Total other comprehensive income	$	8		$	167
COMPREHENSIVE INCOME	$	67		$	265

A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three months ended March 31, 2013:

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)



(in millions)	Fuel derivatives			Interest rate derivatives			Defined benefit pension items		Other			Accumulated other comprehensive income (loss)
Balance at December 31, 2012	$	(63	)	$	(67	)	$	16	$	(5	)	$	(119	)
Changes in fair value	(29		)	3			—		3			(23		)
Reclassification to earnings	26			5			—		—			31
Balance at March 31, 2013	$	(66	)	$	(59	)	$	16	$	(2	)	$	(111	)

The following table illustrates the significant amounts reclassified out of each component of AOCI for the three months ended March 31, 2013.



Three months ended March 31, 2013
	Amounts reclassified from AOCI
(in millions)			Affected line item in the unaudited Condensed Consolidated Statement of Comprehensive Income
AOCI components
Unrealized gain on fuel derivative instruments	$	42	Fuel and oil expense
	$	16	Less: Tax Expense
	$	26	Net of tax

Unrealized gain on interest rate derivative instruments	$	8	Interest expense
	$	3	Less: Tax Expense
	$	5	Net of tax

Total reclassifications for the period	$	31	Net of tax

7. SUPPLEMENTAL FINANCIAL INFORMATION



	March 31,		December 31,
(in millions)	2013		2012
Fuel derivative contracts	$	172	$	221
Interest rate derivative contracts	29		31
Receivable from third parties for fuel contracts - noncurrent	54		54
Intangible assets	132		138
Non-current investments	43		41
Other	153		148
Other assets	$	583	$	633

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)



	March 31,		December 31,
(in millions)	2013		2012
Retirement plans	$	144	$	135
Aircraft rentals	109		139
Vacation pay	275		270
Health	62		70
Fuel derivative contracts	—		50
Workers compensation	158		159
Accrued taxes	58		67
Other	198		212
Accrued liabilities	$	1,004	$	1,102



	March 31,		December 31,
(in millions)	2013		2012
Postretirement obligation	$	154	$	148
Non-current lease-related obligations	349		376
Airport construction obligation	359		331
Other deferred compensation	144		141
Fuel derivative contracts	12		—
Interest rate derivative contracts	54		37
Other	81		91
Other non-current liabilities	$	1,153	$	1,124

For further details on fuel derivative and interest rate derivative contracts, see Note 5.

Other Operating Expenses

Other operating expenses consist of distribution costs, advertising expenses, personnel expenses, professional fees, and other operating costs, none of which individually exceed 10 percent of Operating expenses.

8. LEASES

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

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

The Company will lease and/or sublease all 88 of the B717s to Delta at agreed-upon lease rates. In addition, the Company will pay the majority of the costs to convert the aircraft to the Delta livery and perform certain maintenance checks prior to the delivery of each aircraft. The agreement to pay these conversion and maintenance costs is a “lease incentive” under applicable accounting guidance. The sublease terms for the 78 B717s currently on operating lease and the two B717s currently classified as capital leases coincide with the Company's remaining lease terms for these aircraft from the original lessor, which range from approximately 6 years to approximately 12 years. The lease terms

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

for the eight B717s that are owned by the Company are for a period of seven years, after which Delta will have the option to purchase the aircraft at the then-prevailing market value. The Company will account for the lease and sublease transactions with Delta as operating leases, except for the two aircraft classified by the Company as capital leases. The subleases of these two aircraft will be accounted for as direct financing leases. There are no contingent payments and no significant residual value conditions associated with the transaction.

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

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. New ticketing and checkin areas opened during fourth quarter 2012, and 11 new gates and new concessions opened on April 16, 2013. Another new gate is scheduled to open in third quarter 2013, and full completion of the project is scheduled for second half of 2014. The project will include the renovation of the Airport airline terminals and complete replacement of gate facilities with a new 20-gate facility, including infrastructure, systems and equipment, aircraft parking apron, fueling system, roadways and terminal curbside, baggage handling systems, passenger loading bridges and support systems, and other supporting infrastructure.

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

In conjunction with the Company's significant presence at Dallas Love Field, its rights to occupy 16 of the available gates upon completion of the facility, and other factors, the Company agreed to manage the majority of the LFMP

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

project. Based on these facts, the Company 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 March 31, 2013, the Company had recorded LFMP construction costs of $359 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, respectively, in its unaudited Condensed Consolidated Balance Sheet. Upon completion of different phases of the LFMP project, the Company has placed the associated assets in service and has begun depreciating the assets over their estimated useful lives. The amount of depreciation recorded during first quarter 2013 associated with the LFMP project was not material. The corresponding LFMP liabilities will be reduced primarily through the Company's airport rental payments to the City of Dallas once the entire project is completed.

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 March 31, 2013, 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, commercial paper, and Eurodollar time deposits 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 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 Department, 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

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

derivatives that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model, on a monthly basis, the Company compares its option valuations to third party valuations. If any significant differences were to be noted, they would be researched in order to determine the reason. However, historically, no significant differences have been noted. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds.

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

All of the Company’s auction rate security instruments, totaling $38 million (net) at March 31, 2013, are classified as available-for-sale securities and are reflected at their estimated fair value in the unaudited Condensed Consolidated Balance Sheet. In prior periods, due to the auction process which took place every 30-35 days for most securities, quoted market prices were readily available, which would have qualified 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 Department determines the estimated fair values of these securities utilizing a discounted cash flow analysis. The Company has performed, and routinely updates, a valuation for each of its auction rate security instruments, considering, among other items, the collateralization underlying the security investments, the expected future cash flows, including the final maturity, associated with the securities, estimates of the next time the security is expected to have a successful auction or return to full par value, forecasted reset rates based on the London Interbank Offered Rate (“LIBOR”) or the issuer’s net loan rate, and a counterparty credit spread. To validate the reasonableness of the Company’s discounted cash flow analyses, the Company compares its valuations to third party valuations on a quarterly basis.

In association with its estimate of fair value related to auction rate security instruments as of March 31, 2013, the Company has previously recorded a temporary unrealized decline in fair value of $12 million, with an offsetting entry to AOCI. The Company continues to believe that this decline in fair value is due entirely to market liquidity issues, because the underlying assets for the majority of these auction rate securities held by the Company are currently rated investment grade by Moody’s, Standard and Poor’s, and Fitch and are almost entirely backed by the U.S. Government. The range of maturities for the Company’s auction rate securities are from 6 years to 35 years. Considering the relative insignificance of these securities in comparison to the Company’s liquid assets and other sources of liquidity, the Company has no current intention of selling these securities nor does it expect to be required to sell these securities before a recovery in their cost basis. At the time of the first failed auctions during first quarter 2008, the Company held a total of $463 million in auction rate securities and, since that time, has been able to sell $413 million of these instruments at par value.

The following tables present the Company’s assets and liabilities that are measured at fair value on a recurring basis at March 31, 2013, and December 31, 2012:

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)



				Fair value measurements at reporting date using:
				Quoted prices in active markets for identical assets			Significant other observable inputs			Significant unobservable inputs
Description	March 31, 2013			(Level 1)			(Level 2)			(Level 3)
Assets	(in millions)
Cash equivalents
Cash equivalents (a)	$	1,085		$	1,085		$	—		$	—
Commercial paper	240			—			240			—
Certificates of deposit	13			—			13			—
Short-term investments:
Treasury bills	1,560			1,560			—			—
Certificates of deposit	237			—			237			—
Noncurrent investments (b)
Auction rate securities	38			—			—			38
Interest rate derivatives (see Note 5)	29			—			29			—
Fuel derivatives:
Swap contracts (c)	94			—			94			—
Option contracts (c)	611			—			—			611
Other available-for-sale securities	54			49			—			5
Total assets	$	3,961		$	2,694		$	613		$	654
Liabilities
Fuel derivatives:
Swap contracts (c)	$	(93	)	$	—		$	(93	)	$	—
Option contracts (c)	(400		)	—			—			(400		)
Option contracts (d)	(12		)	—			—			(12		)
Interest rate derivatives (see Note 5)	(115		)	—			(115		)	—
Deferred compensation	(140		)	(140		)	—			—
Total liabilities	$	(760	)	$	(140	)	$	(208	)	$	(412	)

(a) Cash equivalents are primarily composed of money market investments.

(b) Noncurrent investments are included in Other assets in the unaudited Condensed Consolidated Balance Sheet.

(d) In the unaudited Condensed Consolidated Balance Sheet amounts are presented as a net liability. See Note 5.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)



				Fair value measurements at reporting date using:
				Quoted prices in active markets for identical assets			Significant other observable inputs			Significant unobservable inputs
Description	December 31, 2012			(Level 1)			(Level 2)			(Level 3)
Assets	(in millions)
Cash equivalents
Cash equivalents (a)	$	829		$	829		$	—		$	—
Commercial paper	170			—			170			—
Certificates of deposit	34			—			34			—
Eurodollar Time Deposits	80			—			80			—
Short-term investments:
Treasury bills	1,624			1,624			—			—
Certificates of deposit	233			—			233			—
Noncurrent investments (b)
Auction rate securities	36			—			—			36
Interest rate derivatives (see Note 5)	31			—			31			—
Fuel derivatives:
Swap contracts (c)	113			—			113			—
Option contracts (c)	850			—			—			850
Option contracts (d)	10			—			—			10
Other available-for-sale securities	49			44			—			5
Total assets	$	4,059		$	2,497		$	661		$	901
Liabilities
Fuel derivatives:
Swap contracts (c)	$	(57	)	$	—		$	(57	)	$	—
Option contracts (c)	(637		)	—			—			(637		)
Swap contracts (d)	(56		)	—			(56		)	—
Option contracts (d)	(4		)	—			—			(4		)
Interest rate derivatives (see Note 5)	(126		)	—			(126		)	—
Deferred Compensation	(137		)	(137		)	—			—
Total liabilities	$	(1,017	)	$	(137	)	$	(239	)	$	(641	)

(a) Cash equivalents are primarily composed of money market investments.

(b) Noncurrent investments are included in Other assets in the unaudited Condensed Consolidated Balance Sheet.

(d) In the unaudited Condensed Consolidated Balance Sheet amounts are presented as a net liability. See Note 5.

The Company had no transfers of assets or liabilities between any of the above levels during the three months ended March 31, 2013, or the year ended December 31, 2012. The following table presents the Company’s activity for items measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2013:

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)



	Fair value measurements using significant unobservable inputs (Level 3)
	Fuel				Auction rate			Other
(in millions)	derivatives				securities			securities		Total
Balance at December 31, 2012	$	219			$	36		$	5	$	260
Total gains or (losses) (realized or unrealized)
Included in earnings	27				—			—		27
Included in other comprehensive income	(46		)		2			—		(44		)
Purchases	189			(a)	—			—		189
Sales	(213		)	(a)	—			—		(213		)
Settlements	23				—			—		23
Balance at March 31, 2013	$	199			$	38	(b)	$	5	$	242
The amount of total losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at March 31, 2013	$	(49	)		$	—		$	—	$	(49	)

(a) The purchase and sale of fuel derivatives are recorded gross based on the structure of the derivative instrument, and

whether a contract with multiple derivatives is purchased as a single instrument or separate instruments.

(b) Included in Other assets in the unaudited Condensed Consolidated Balance Sheet.

The significant unobservable input used in the fair value measurement of the Company’s derivative option contracts is implied volatility. Holding other inputs constant, a significant increase (decrease) in implied volatility would result in a significantly higher (lower) fair value measurement for the Company’s derivative option contracts. The significant unobservable inputs used in the fair value measurement of the Company’s auction rate securities are time to principal recovery, an illiquidity premium, and counterparty credit spread. Holding other inputs constant, a significant increase (decrease) in such unobservable inputs would result in a significantly lower (higher) fair value measurement.

The following table presents a range of the unobservable inputs utilized in the fair value measurements of the Company’s assets and liabilities classified as Level 3 at March 31, 2013:



Quantitative information about Level 3 fair value measurements
	Valuation technique	Unobservable input	Period (by year)	Range
Fuel derivatives	Option model	Implied volatility	Second quarter 2013	10-22%
			Third quarter 2013	15-24%
			Fourth quarter 2013	16-25%
			2014	15-25%
			2015	16-22%
			2016	16-21%
			2017	16-20%
Auction rate securities	Discounted cash flow	Time to principal recovery		6-8 years
		Illiquidity premium		3-4%
		Counterparty credit spread		1-3%

All settlements from fuel derivative contracts that are deemed “effective” are included in Fuel and oil expense in the period the underlying fuel is consumed in operations. Any “ineffectiveness” associated with hedges, including amounts that settled in the current period (realized), and amounts that will settle in future periods (unrealized), is recorded in earnings immediately as a component of Other (gains) losses, net. See Note 5 for further information on hedging. Any gains and losses (realized and unrealized) related to other investments are reported in Other operating expenses and were immaterial for the three months ended March 31, 2013 and 2012.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

The carrying amounts and estimated fair values of the Company’s long-term debt (including current maturities), as well as the applicable fair value hierarchy tier, at March 31, 2013, are presented in the table below. The fair values of the Company’s publicly held long-term debt 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 agreements as Level 2. Seven of the Company’s debt agreements are not publicly held. The Company has determined the estimated fair value of this debt to be Level 3, as certain inputs used to determine the fair value of these agreements are unobservable. The Company utilizes indicative pricing from counterparties and a discounted cash flow method to estimate the fair value of the Level 3 items.



(in millions)	Carrying value	Estimated fair value	Fair value level hierarchy
5.25% Notes due 2014	364	374	Level 2
5.75% Notes due 2016	329	363	Level 2
5.25% Convertible Senior Notes due 2016	116	146	Level 2
5.125% Notes due 2017	328	357	Level 2
Fixed-rate 717 Aircraft Notes payable through 2017 - 10.36%	57	55	Level 2
French Credit Agreements due 2018 - 1.21%	56	56	Level 3
Fixed-rate 737 Aircraft Notes payable through 2018 - 7.02%	34	36	Level 3
Term Loan Agreement due 2019 - 6.315%	233	236	Level 3
Term Loan Agreement due 2019 - 6.84%	90	98	Level 3
Term Loan Agreement due 2020 - 5.223%	442	410	Level 3
Floating-rate 737 Aircraft Notes payable through 2020	388	381	Level 3
Pass Through Certificates due 2022 - 6.24%	385	452	Level 2
7.375% Debentures due 2027	138	154	Level 2

11. LONG-TERM DEBT AND REVOLVING CREDIT FACILITY

AirTran Long-Term Debt

During the first quarter of 2013, the Company prepaid six separate AirTran aircraft secured term loans in the amount of $119 million. The remaining 20 floating-rate 737 aircraft notes payable continue to be financed and mature in years 2016 to 2020. See Note 5 for further information about the impact of the interest rate hedge associated with these transactions.

Unsecured Revolving Credit Facility

On April 2, 2013, the Company entered into a new $1 billion unsecured revolving credit facility expiring in April 2018, and terminated its previous facility, which would have expired in April 2016. Other than an increased borrowing capacity, this new facility is substantially the same as the previous facility. Interest on the facility is based on the Company's credit ratings at the time of borrowing. At the Company's current ratings, the interest cost would be LIBOR plus a spread of 150 basis points. The new facility also contains the same financial covenant as the previous facility, requiring a minimum coverage ratio of adjusted pre-tax income to fixed obligations, as defined. As of March 31, 2013, the Company was in compliance with this covenant in its previous $800 million facility, and there were no amounts outstanding under the revolving credit facility.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Relevant comparative operating statistics for the three months ended March 31, 2013 and 2012 are included below. The Company provides these operating statistics because they are commonly used in the airline industry and, as such, allow readers to compare the Company’s performance against its results for the prior year period, as well as against the performance of the Company’s peers.



	Three months ended March 31,
	2013		2012		Change
Revenue passengers carried	25,203,934		25,560,822		(1.4	)%
Enplaned passengers	30,712,625		31,154,453		(1.4	)%
Revenue passenger miles (RPMs) (000s)⁽¹⁾	23,756,743		23,684,869		0.3	%
Available seat miles (ASMs) (000s)⁽²⁾	30,801,424		30,632,893		0.6	%
Load factor⁽³⁾	77.1	%	77.3	%	(0.2	)%	pts
Average length of passenger haul (miles)	943		927		1.7	%
Average aircraft stage length (miles)	693		685		1.2	%
Trips flown	318,514		333,896		(4.6	)%
Average passenger fare	152.29		146.72		3.8	%
Passenger revenue yield per RPM (cents)⁽⁴⁾	16.16		15.83		2.1	%
Operating revenue per ASM (cents)⁽⁵⁾	13.26		13.03		1.8	%
Passenger revenue per ASM (cents)⁽⁶⁾	12.46		12.24		1.8	%
Operating expenses per ASM (cents)⁽⁷⁾	13.03		12.96		0.5	%
Operating expenses per ASM, excluding fuel (cents)	8.30		8.03		3.4	%
Operating expenses per ASM, excluding fuel and profitsharing (cents)	8.25		8.03		2.7	%
Fuel costs per gallon, including fuel tax	3.36		3.39		(0.9	)%
Fuel costs per gallon, including fuel tax, economic	3.29		3.44		(4.4	)%
Fuel consumed, in gallons (millions)	432		443		(2.5	)%
Active fulltime equivalent Employees	45,791		46,227		(0.9	)%
Aircraft in service at period-end⁽⁸⁾	696		694		0.3	%

(1) A revenue passenger mile is one paying passenger flown one mile. Also referred to as "traffic," which is a measure of demand for a given period.

(2) An available seat mile is one seat (empty or full) flown one mile. Also referred to as "capacity," which is a measure of the space available to carry passengers in a given period.

(3) Revenue passenger miles divided by available seat miles.

(4) Calculated as passenger revenue divided by revenue passenger miles. Also referred to as "yield," this is the average cost paid by a paying passenger to fly one mile, which is a measure of revenue production and fares.

(5) Calculated as operating revenue divided by available seat miles. Also referred to as "operating unit revenues," this is a measure of operating revenue production based on the total available seat miles flown during a particular period.

(6) Calculated as passenger revenue divided by available seat miles. Also referred to as “passenger unit revenues,” this is a measure of passenger revenue production based on the total available seat miles flown during a particular period.

(7) Calculated as operating expenses divided by available seat miles. Also referred to as "unit costs" or "cost per available seat mile," this is the average cost to fly an aircraft seat (empty or full) one mile, which is a measure of cost efficiencies.

(8) Includes leased aircraft and excludes aircraft that are not available for service or are held in storage, for sale, or for return to the lessor.

Reconciliation of Reported Amounts to non-GAAP Financial Measures (unaudited) (in millions, except per share and per ASM amounts)



	Three months ended March 31,						Percent
	2013			2012			Change
Fuel and oil expense, unhedged	$	1,405		$	1,479
Add: Fuel hedge losses included in Fuel and oil expense	52			31
Fuel and oil expense, as reported	$	1,457		$	1,510
Add (Deduct): Net impact from fuel contracts	(29		)	25
Fuel and oil expense, non-GAAP	$	1,428		$	1,535		(7.0	)%

Total operating expenses, as reported	$	4,014		$	3,969
Deduct: Reclassification between Fuel and oil and Other (gains), net, associated with current period settled contracts	—			(2		)
Add (Deduct): Contracts settling in the current period, but for which gains and/or (losses) have been recognized in a prior period*	(29		)	27
Deduct: Acquisition and integration costs	(13		)	(13		)
Total operating expenses, non-GAAP	$	3,972		$	3,981		(0.2	)%

Operating income, as reported	$	70		$	22
Add: Reclassification between Fuel and oil and Other losses, net, associated with current period settled contracts	—			2
Add (Deduct): Contracts settling in the current period, but for which gains and/or (losses) have been recognized in a prior period*	29			(27		)
Add: Acquisition and integration costs	13			13
Operating income, non-GAAP	$	112		$	10		n/a

Net income, as reported	$	59		$	98
Deduct: Mark-to-market impact from fuel contracts settling in future periods	(61		)	(205		)
Add: Ineffectiveness from fuel hedges settling in future periods	10			31
Add (Deduct): Other net impact of fuel contracts settling in the current or a prior period (excluding reclassifications)	29			(27		)
Add: Income tax impact of fuel contracts	8			77
Add: Acquisition and integration costs, net (a)	8			8
Net income (loss), non-GAAP	$	53		$	(18	)	n/a

Net income per share, diluted, as reported	$	0.08		$	0.13
Deduct: Net impact to net income above from fuel contracts divided by dilutive shares	(0.02		)	(0.16		)
Add: Impact of special items, net (a)	0.01			0.01
Net income (loss) per share, diluted, non-GAAP	$	0.07		$	(0.02	)	n/a

Operating expenses per ASM (cents)	13.03			12.96
Deduct: Fuel expense divided by ASMs	(4.73		)	(4.93		)
Deduct: Impact of special items	(0.04		)	(0.04		)
Operating expenses per ASM, non-GAAP, excluding fuel and special items (cents)	8.26			7.99			3.4	%

* As a result of prior hedge ineffectiveness and/or contracts marked to market through earnings.

(a) Amounts net of tax.

Note Regarding Use of Non-GAAP Financial Measures

The Company's unaudited Condensed Consolidated Financial Statements are prepared in accordance with GAAP. These GAAP financial statements include (i) unrealized non-cash adjustments and reclassifications, which can be significant, as a result of accounting requirements and elections made under accounting pronouncements relating to derivative instruments and hedging and (ii) other charges the Company believes are not indicative of its ongoing operational performance.

As a result, the Company also provides financial information in this filing that was not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. The Company provides supplemental non-GAAP financial information, including results that it refers to as "economic," which the Company's management utilizes to evaluate its ongoing financial performance and which the Company believes provides greater transparency to investors as supplemental information to its GAAP results. The Company's economic financial results differ from GAAP results in that they only include the actual cash settlements from fuel hedge contracts - all reflected within Fuel and oil expense in the period of settlement. Thus, Fuel and oil expense on an economic basis reflects the Company’s actual net cash outlays for fuel during the applicable period, inclusive of settled fuel derivative contracts. Any net premium costs paid related to option contracts are reflected as a component of Other (gains) losses, net, for both GAAP and non-GAAP (including economic) purposes in the period of contract settlement. These economic results provide a better measure of the impact of the Company's fuel hedges on its operating performance and liquidity since they exclude the unrealized, non-cash adjustments and reclassifications that are recorded in GAAP results in accordance with accounting guidance relating to derivative instruments, and they reflect all cash settlements related to fuel derivative contracts within Fuel and oil expense. This enables the Company's management, as well as investors, to consistently assess the Company's operating performance on a year-over-year or quarter-over-quarter basis after considering all efforts in place to manage fuel expense. However, because these measures are not determined in accordance with GAAP, the measures are susceptible to varying calculations, and not all companies calculate the measures in the same manner. As a result, the aforementioned measures, as presented, may not be directly comparable to similarly titled measures presented by other companies.

For further information on (i) the Company's fuel hedging program, (ii) the requirements of accounting for derivative instruments, and (iii) the causes of hedge ineffectiveness and/or mark-to-market gains or losses from derivative instruments, please refer to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012, and Note 5 to the unaudited Condensed Consolidated Financial Statements.

In addition to its “economic” financial measures, as defined above, the Company has also provided other non-GAAP financial measures as a result of items that the Company believes are not indicative of its ongoing operations. These include charges (before the impact of profitsharing and/or taxes) related to expenses associated with the Company’s acquisition and integration of AirTran. The Company believes that evaluation of its financial performance compared to prior and future periods can be enhanced by a presentation of results that exclude the impact of these items. As a result of the Company’s acquisition of AirTran, which closed on May 2, 2011, the Company has incurred and expects to continue to incur substantial charges associated with integration of the two companies. While the Company cannot predict the exact timing or amounts of such charges, it does expect to treat these charges as special items in its future presentation of non-GAAP results. See Note 2 and Note 8 to the unaudited Condensed Consolidated Financial Statements for further information on the AirTran acquisition.

Material Changes in Results of Operations

Overview

The Company recorded first quarter GAAP and non-GAAP results for 2013 and 2012 as follows:



	Three months ended
(in millions, except per share amounts)	March 31,
GAAP	2013	2012	Percent Change
Operating income	70