SOUTHWEST Airlines (LUV) Financial Report, December 2011

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SOUTHWEST AIRLINES FINANCIAL REPORT

Ticker : LUV Recommendation: BUY

Price: $8.47 (Dec. 5th 2011)

Highlights

Business mix & market position: Southwest is one of the largest American airlines

in terms of domestic passengers carried, with operating revenue amounting to

$12 billion in 2010. The company revenue breakdown in 2010 is the following:

Passenger (95% of revenue), freight (1%) and others (4%).

Strong effect of the Global Financial Crisis: Southwest Airlines profitability has

been seriously affected by the Crisis – its net income went down from $645

million by the end of 2007 to $99 Millions in 2009 (-84.6%). Nevertheless this

figure is definitely a good result since other major US based Airlines companies

experienced huge losses (Delta Airlines: $-1.2 billion in 2009; American Airlines -

$1.5 billion).

Post-GFC relief: Southwest Airlines recovered quite well from the crisis, with an

overwhelming increase of the net income from $99 million in 2009 to $459 in

2010 (+363%) thanks to a 16% growth of the operating revenues to $12,104

million. This is a good performance considering that the WTI crude oil barrel price

passed the $100 mark in March 2010.

Consistent profitability & lower volatility than competitors: In 2010, Southwest

remained profitable for the 38th consecutive year which is a major achievement in

a fairly cyclical Airline industry. This is mainly due to the fact that Southwest

Airlines is less volatile than the majority of its competition: its volatility (based on

3 month historical values fluctuations) is 20% lower than domestic peers.

Good medium-term prospects: Analysts forecast both a growth of the revenue

and the net profit margin, which result in an increase of the net profit to $844

millions in 2013 (the figure is made up of 12 estimations). Nevertheless, those

expectations are still very dependent on the very volatile fluctuations of oil prices

that represent a third of the Southwest operating expenses.

Earnings/Share June Dec. Year P/E ratio

2008A $0.44 $-0.09 $0.20 X35.84

2009A $0.12 $0.15 $0.19 x85.76

2010A $0.15 $0.18 $0.62 x21.14

2011E $0.21 $0.40 X20.53

Industry:

Airline Industry

Travel services

December 6th, 2011

Jean Lemercier

Cécilia Cosnard

des Closets

Charline Poher

Derek Fleck

Violaine Lièvre

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Investment Summary

Main risk factors in the Airline industry

High volatility of oil prices: fluctuations are very hard to forecast and their increases deeply

affect the company’s profitability. Fuel represents an average of 35% of the Airline industry

operating expenses, and this percentage is likely to increase in the next few years.

o This aspect has been even more important lately due to the instability in oil

exporting countries in the Middle East (Libya, Egypt…) pushing the prices of crude-oil

up.

Economic slowdown in developed countries and especially in the United States sparked off a

decrease in purchasing power; the demand in the Airline industry is hence weaker.

Regulations of Greenhouse gases emissions could increase costs. For instance, the European

Parliament is planning to add aviation to the European emissions trading scheme, airlines

companies could therefore be taxed according to their gases emissions. It is a risk for the

Airline industry that further regulations take place in the future.

Market Profile (Data as of November, 12th 2011)

Market Capitalization $6.391 Billion

Ownership 83% by Institutions

Beta (1year) 1.23

52 week High/Low $13.75/$7.35

Daily Average Volume (3 months average) 2,394,896

Return on Equity (2010) 7.84%

Return on Assets (2010) 3.09%

Debt to equity ratio 54,19%

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Airlines companies face the risk of liability in the event of an aircraft accident or a terrorist

accident such as the World Trade center attacks. These kinds of incidents could involve costs

related to the repair of the aircraft, damages and brand image damages.

Southwest Key strategic factors:

Fuel hedging – Southwest is using a sound strategy using fuel hedge contracts to reduce its

exposure to fluctuations in oil prices. By doing so, the company is able to fix the price of its

fuel and oil expenses for the year, and is not impacted if oil prices rise during the year. This is

positive for investors as it reduces the overall volatility of the company results. However, the

company loses money when oil prices declines.

Low cost model – Southwest top management cuts costs by flying only one aircraft model

(Boeing 737), running a streamlined point to point network (domestically) rather than a hub

and spoke diagram (average aircraft trip length is 653 miles with an average duration of an

hour and 55 minutes) and minimizing the time their planes spend languishing in airports.

Strategic Acquisitions – Southwest has completed mainly four acquisitions since its creation,

in order to increase revenue. Furthermore, the company has been able to enable cost

synergies, expand its operations by gaining airport landing slots and aircraft.

Corporate culture & Brand Identity: The Company is extremely devoted to its unique

corporate culture: to make employees, customers feel like they are more than just a business

– they are part of a family. In order to do so, the company undertook diverse actions:

Southwest extensively invested in its customer service to reduce delays and cancellations, it

raised its employee’s wages and provided them with customized training in order to be

promoted, and developed a unique range of commercials based on humor. Consequently,

the company has always obtained the lowest complaints ratio per passengers among all

major U.S. carriers since 1987.

Main Challenges:

Maintain the quality of its services in recession times: The company is facing a very

challenging business environment, which is why its overall profitability is slumping. The

company’s customer policy has always stated it will provide the best experience possible, for

instance not to charge hidden fees for extra bags, fees to take pets onboard, etc. It will get

even more difficult for the company to stick to its policy in recession times, with labor union

claiming wage increases – jet fuel prices decreasing the profitability and other challenges.

Find new ways to differentiate its offer: The airline’s competitive landscape has changed

since the company’s inception: there are more merging companies and that can

consequently focus on low-fare offers, targeting the same market segment than Southwest.

The Southwest low cost competitive advantage used to exploit is now questionable. It seems

as though the company will have to broaden its competitive scope in order to gain market

share.

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Thoroughly integrate the company it took over – AirTran Airways: Southwest acquired

AirTran Airways on May 2, 2011 for a total transaction cost of $3.2 billion. The company will

have to make choices – it is now able to operate internationally (destinations including

Mexico, the Caribbean, and Atlanta whether this fits the company's global strategy or not will

have to be discussed. In addition, the company will have to successfully integrate AirTran’s

workforce into its operations.

Business description

Established in 1967 in Dallas, Texas by Herb Kelleher, Southwest Airlines is the most successful low-

cost US airline. The company’s strategy of selling low-cost flights combined with high quality service,

customer approach (no assigned seats, no additional fees and flights are always on time), high labor

costs and flying “point-to-point” routes to low-cost airports made the company profitable every year

since its founding, with a $459 Million net income in 2010. Southwest Airlines currently share 2% of

the world air value share, employs more than 35,000 employees and flies with 548 Boeing 737

aircrafts, with a an average of 3,400 daily departures.

Southwest’s Business strategies

Company Ethics

“The mission of Southwest Airlines is dedication to the highest quality of Customer Service delivered

with a sense of warmth, friendliness, individual pride and company spirit” is Southwest’s mission

statement. Gary Kelly, CEO and chairman of the company since 1986, makes sure that the company

conveys an image of a caring and welcoming airline: in fact, Southwest stock are traded on the New

York Stock Exchange (NYSE) under the ticker “LUV”, in reference to their headquarters based on 2702

Love Field Drive in Texas. LUV has since been a shortened motto for the company, indicating their

love for customers, love for their employees, and love for the company.

Southwest’s initial business strategy was to serve low-cost airports in a few cities in the USA (and in

the USA only), targeting the average traveler with a low traveling-budget: it all started between

Dallas, Houston and San Antonio in Texas. As the business grew, their strategy remained the same:

Southwest kept attracting people with its famous no baggage-fee, timely departures, low-fare tickets

and friendly service to name but a few. Today Southwest also targets Business travelers and serves

72 cities in 37 states.

Although the airline’s strategy is to serve its customers with the lowest prices available, Southwest is

known for its high labor-costs: employees earn a relatively high salary in exchange of devoting

themselves to offering the best service and being hard-workers and treating people in an egalitarian

way (some of the many required skills and qualities needed to be a Southwest employee). Fuel cost is

the most important expense and hence the biggest issue in keeping the prices low due to the

versatility of the raw material. However, in order to level these uncontrollable events, the company

makes money where it could lose some and makes considerable efforts in adapting its ways to keep

prices low: in fact, Southwest does not distribute any meals (only snacks), they don’t assign seats,

don’t charge for any ticket change; this is seen through its constant positive financial structure (see

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balance sheet and income statement). The airline also started using electric ground power and

installed blended winglets in order to reduce draft and increase fuel efficiency.

Southwest offers three services: air services, car rentals and hotel reservations. Air services are the

biggest activity for the airline, generating 95% revenue for the company. However, Southwest works

with partners such as Marriott, Best Western and Choice hotels as well as Budget, Avis and Hertz car

rental companies to allow customers to build the best travel experience and ease their way through

their journey, always offering the best deals at the lowest prices. These partnerships generate 5%

revenue.

Through Internet

Southwest has a strong internet presence: one can only purchase tickets through the company’s

internet website (Southwest does not work as a charter company: absolutely no tour operator can

sell Southwest tickets). This decision reflects their strategy to keep the prices at their lowest (no

distribution costs), enhancing buying convenience and drawing customers into the “Southwest Way

of living”. The website also detects and saves passengers’ preferences according to their latest

travels and reservations in order to make it easier for them to book flights, cars and hotels in the

future, as well as learning about new needs and wants. Southwest’s home page allowed the

company to generate 84% of total revenue as of December 2010: the best way for the airline to

communicate promotions and carry out their marketing campaign. In March

2011, southwest.com was the largest airline site in terms of unique visitors.

The airline not only shares information about the company and its culture and financial data, it also

aims to build a relationship with its customers through blogs and social media. Indeed, Southwest

created a blog entitled “Nuts about Southwest” (www.blogsouthwest.com), posting articles of daily

events from employees, videos, pictures and such. Customers and fans can also participate to the

elaboration of the blog, give feedback and share articles. Southwest has more than 1,730 million

followers on Facebook, and more than 1,195 million followers on Twitter: the company always

makes sure to update the latest information and answer requests and possible disappointments.

Customer Care

What makes Southwest Airlines so different from other airline companies is that the company is

customer focused and devoted. Southwest always ensures to provide the best customer service to its

passengers, from departing airport to arriving airport. A way of rewarding customers and gaining

brand loyalty Southwest decided to implement is the “Rapid Rewards Frequent Flyer” program,

which gives points to passengers every time they purchase a ticket on the home page. Customers can

then collect points and eventually book a flight thanks to the earned points (the more paid for the

ticket, the greater the reward).

Southwest ensures passengers a comfortable flight thanks to spacious seating, leather chairs, WiFi,

snacks and a friendly and funny crew. The aim is to give customers the best flight experience and

increase loyalty. Passengers all benefit from the same services: the egalitarian and democratic aspect

of customer care only encourages them to come again. Southwest earned many awards and was

ranked “#1 friendliest airline” in 2006 by Times.com and “#1 most Reliable Airline for dependability”

from the Forbes magazine in 2008.

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Results from the strategy

Southwest’s strategy paid-off in the short and long term, as these following facts and events show

bellow.

Southwest acquired AirTran Holdings Inc. in September 2010 for $3.2 Billion, allowing the company

to expand its route network throughout the USA (new airports include Atlanta, Logan Airport in

Boston and Ronald Reagan in Washington DC) and introduces international routes towards Mexico

and the Caribbean, thus a new strategy for the airline. This acquisition has many positive aspects:

it will progressively eliminate some of the East Coast competition giving Southwest more

visibility, access to customers and pricing power;

AirTran provides Southwest with expertise on the international environment, 138 new

aircrafts and 37 new cities to serve;

Attract more business travelers thanks to the newly acquired international airports.

Southwest has decided to maintain the “no baggage fee” strategy, as it has been its major

competitive advantage, and AirTran will progressively adopt and adapt to the Southwest Culture

(Southwest plans on painting the aircrafts and train new employees). The acquisition is expected to

generate $400 million net annual sales through the synergies of the two companies by 2013;

however, the total cost of integration in the long-term will cost the company $300 to $500 million.

Together, AirTran and Southwest combine and hope to serve more than 125 million customers and

plan on reaching $13 billion sales.

Shareholders

As of October 2011, the airline issued 747,434,272 outstanding shares, one share valued at $7.94 on

November 30th 2011. Southwest accounts 4 major investors, namely Capital Research Global

Investors (11.5%), Manning and Napier Advisors, Inc. (5.1%), PRIMECAP Management Company

(10.5%) and T. Rowe Price Associates, Inc. (9.1%). Over the past few years, Southwest has been

increasing its stockholder’s equity from 35% in 2008 to 44% in 2010, meaning that the company

continuously attaches great importance to its shareholders.

In conclusion, we can say that Southwest is an outstanding company that passengers and

shareholders trust: Southwest was able to increase sales by 17% from 2009 to 2010 in a time of

economical crisis and low traveling expenses. The company’s strategy combined with its culture and

financial structure makes the airline a successful company listed on the Fortune 500 ranking in 2011.

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Porters Five Forces

The Porter’s five forces model will now be described in order to analyze the profitability of the

industry, hence to estimate the interest for investors to buy company stocks:

First of all, it is essential to clearly identify in which market Southwest is operating. Southwest

Airlines is classified by the “North American Industrial Classification System” as a Scheduled Air

Transportation company.

Threat of New Entrants: (3/5)

The threat of New Entrants is quite low owing to various factors: the centralization of the industry,

high startup costs, post market entry competition and relatively low earnings of companies in the

industry. Most of the new carriers have failed to succeed in the industry historically, and stopped

operations: from 2003 to 2006 companies such as Southeast Airlines, Midway Airlines and Aloha

Airlines have halted operations. However, although strong barriers to entry are present in the airline

industry, some airlines have successfully invested in the airline business. For example, JetBlue, who

began operations in 2000, has become quickly profitable due to a low cost position and high load

factors.

In conclusion, there is a possibility that new competitors could arise in the airline industry, but it is

quite unlikely since becoming viable would take years for a new airline.

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Rivalry among competitors (5/5)

The rivalry among airline companies is overwhelming, mainly due to the fact that the industry is

made of numerous competitors offering almost undifferentiated services. This intense competition,

resulting in a real price war, pushes down the profitability prospects of the industry. As a result,

many airline companies have experienced huge losses and some of them even had to face

bankruptcy (United Airlines, ATA Airlines). Even though some companies tried to differentiate their

service (High quality, more comfortable flights, etc.) most of them failed, because the price

sensitivity of customers is so strong that the price war seems inevitable.

Many of the currently operating airlines will have to trim their margins in order to gain market share

and remain competitive on the market. In conclusion, the rivalry among competitors is so that the

overall profitability of the industry is very low.

Buyer Power (5/5)

As explained earlier, the price sensitivity and low differentiation of airline companies are giving the

buyers tremendous power. Moreover, the relatively high number of airline companies and the low

growth in customers due to bad business environment reinforce the buyer power. In addition,

booking platforms and fare comparators are increasing the amount of pressure on airline tickets

prices, helping increase the buyer power.

In conclusion, the buyer power is high due to significant price sensitivity and low brand loyalty,

leaving little room for Southwest and other airline companies to maneuver.

Supplier Power (4/5)

The airline industry is greatly exposed to supplier power, which we have to breakdown into two

parts: fuel and airplanes. Jet-fuel suppliers are constantly pushing up prices or at least maintaining

them, by cutting off production whenever demand for fuel is decreasing. Besides, even when oil

prices fall, the jet fuel prices do not systematically decrease as well. Jet fuel suppliers’ power is

therefore soaring. On the other hand, current economic conditions have lessened the supplier power

of airframe manufacturers. Airbus and Boeing are highly dependent on airline companies buying

their planes and the recent downturn in sales is increasing this dependency.

In conclusion, if jet fuel and airframe suppliers’ power is quite high, the decrease in airframes sales

and fuel hedging alternatives for airlines are pushing it down.

Threat of Substitutes (1/5)

Substitutes to flights in the US include bus, car and train transportation. Because of an extensive

highway system in the U.S, travelling by car is possible virtually anywhere in the country. However on

long distance trips, people tend to prefer traveling by plane as the time needed is shorter. Trains also

offer long distance trips, and have the advantage of being cheaper than flights. However, the slow

travel rate for trains, the limited number of stations and the relative longer trip duration are the

reason why train transportation only attracts a small percentage of customers in the US.

In conclusion the threat of substitutes is very low and is not likely to increase over the next few years.

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Conclusion (18/25)

The industry analysis by Porter’s Five Forces reveals that the airline industry is poorly profitable due

to a remarkable competitive rivalry and the strong supplier power. Nevertheless, the airline market

demand is quite high and if one steps up and beats the competition, profits could be very high.

Therefore investors have to know that investing in an Airline company such as Southwest is quite risky

but potential rewards are significant as well.

Industry overview

Industry Overview and Competitive Positioning:

There are many competing companies in the airline industry. The four best airline companies are Asian ones, and their capitalization ranges between 13 Billion $ and 7 Billion $. However, Southwest is well defending its place by being classified 8th best capitalized company on the NYSE with 6.29 Billion €.

Strengths:

Southwest has invested a lot and capitalized on its competitive strengths: the service is

always on time and the airline is a business-friendly company. There is also a positive

organizational culture which leads to a very high-quality service: some of these factors

include a good crew who cares a lot about their customers, a great teamwork and the overall

efficiency of the airline. These elements convey a good image to the customer and make

them feel confident about the brand.

Strengths

Strong position in the

market

Many acquisitions

High number of passengers

Weaknesses

Only operating on the

domestic market

Dependence on producer

Limited offer

Threats

Fuel-Prices are increasing

Strong competition

More legal restrictions

Terrorism fear

Opportunities

Many market opportunities

Growing market

Advancement of

technology

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Southwest has a strong position as a low-cost carrier in the North American airline market; as

a result, customer loyalty is high and the risk of losing customers is low.

Southwest accounts an average of 3 400 flights a day and is one of the most profitable

companies in the US: the consecutive profitability has always been increasing since 2009; this

allows a good and constant inflow and involves fewer risks for the company.

The company was the first to launch the ticketless travelling and discounts for senior people.

The leadership in this domain reinforces the company’s positive image toward customers.

Moreover, there are no additional fees to shift reservation, which enables customers to feel

more confident about their buying power and will purchase tickets more easily.

Southwest previously acquired many airlines: Muse Air, Morris Air, ATA airlines and the last

one AirTran, increases Southwest’s capital and helps improving its image and visibility

towards customers and shareholders. These acquisitions represent an improved access to

business travelers and international routes. This is another way for Southwest to boost its

market shares.

Southwest is listed 8th best capitalized company on the NYSE (New York Stock Exchange),

with 6.29 Billion €, another proof of its reliability.

Weaknesses:

Until recently, Southwest only relied on its domestic market: apart from recent flying routes

to Mexico and the Caribbean, there are no direct flights away from the USA. Consequently,

the company is missing out on potential customers as it narrows its flights offer, and is

exposed to US market risks, risks that could be outweighed if the company had more

international presence.

The company highly depends on fuel expenses and fluctuations. As the company is

continuously doing its best to offer low-cost fares, it can never predict future oil price raises

and Southwest has to therefore constantly adapt its way to save money on other expenses.

Southwest does not offer many morning flights (before 7 AM) and this can easily discourage

early birds/business passengers from traveling with Southwest. Those elements could lead to

customer’s dissatisfaction and a loss of market share.

Southwest has a single aircraft supplier as it only uses Boeing 737 aircrafts. This can create a

dependence effect towards the supplier, which increases his power, and can possibly

increase prices.

Since Southwest does not sell its tickets on online booking agencies, it reduces its visibility

and purchasing possibilities.

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Southwest features very good strengths which ensures its strong position in the market;

however, Southwest encounters weaknesses which can easily be converted into strengths by

bringing some modifications to its strategy, especially in their offer range.

Opportunities:

Since the company is targeting business travelers more aggressively, this should boost

coming sales and increase inflows as the US total population is composed of a large active

work force.

Many national and international markets and airports are still not tapped, which means that Southwest can possibly expand to them. Southwest is slowly starting to internationalize its flying routes, so this opportunity can be approached in the long term run.

Industrial technologies have developed and improved, representing new opportunities for

the airline industry; Southwest could take advantage of them to solve current problems and

increase their aircraft technology and efficiency.

Traveler traffic should rise from 2011 to 2014; moreover, globalization leads to an increase in

international tourism and in longer flights. These points give the company good sales

perspectives for the coming years.

The US airline industry is competent, technologically superior with financial potency and

access to global market. Southwest can take advantage of it to correct its defects.

American Airlines, the third biggest airline on the US market recently declared that it was

going in bankrupt: a falling competitor is an opportunity for Southwest.

Threats:

The American airline market is an intense competitive market due to the expansion of low

cost carriers, and reorganization of competitors. Despite its strong position in the market,

Southwest has to compete with all the new entrances which could lead to a loss of market

share.

There are more limitations regarding the terms and legal obligations nowadays therefore the

company restricted in what it want to do.

Terrorism impacts customer trust and can reduce considerably the number of travelers

across the world. This element has to be taken into account in case of internationalization.

Many opportunities should make Southwest’s market shares increase easily and some

others can be profitable for the company if it decides to convert its weaknesses. On the

contrary, price of basic expenditures are increasing, consequently making fare-prices for

customers higher. As globalization is significantly gaining power and the company is

classified as a low cost company, these forces should not have a major impact.

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Competition is getting more intense, as a result, Southwest has to improve its offer and

focus on its competitive advantages to remain profitable.

General conclusion

In both conclusions above, we can notice that the positive parts (opportunities and strengths) are

always stronger. Opportunities can be easily profitable for the company and threats can be beaten by

using well-thinking strategies. To conclude, the Southwest SWOT is really positive and forecasts a

good future for the company.

Financial Analysis

2007/2008: 11.78% growth revenue (2007/2010): 18.53%

2008/2009: -6.10%

2009/2010: 16.95%

Analysis of income statement’s performance:

Revenues:

2007/2008: The revenues grew by 11.78%, with a contribution of 95.8% from passenger, 1.32% from

freight and 2.88% from other.

0

2000

4000

6000

8000

10000

12000

14000

2007 2008 2009 2010

Revenues

Revenues

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2008/2009: The revenues dropped by -6.10% with a contribution of 95.63% from passenger, 1.23%

from freight, and 3.13% from other.

2009/2010: The revenues grew by 14.49% with a contribution of 95.23% from passenger, 1.07% from

freight and 3.64% from other.

What we can conclude from these numbers:

First, we can say that when the subprime crisis started in 2008, the revenues of the company

immediately decreased. The inflation has obviously had a great impact on the company’s level of

operation. But another important fact to take in consideration is that through these four years, the

contribution to the revenue of other factors is growing progressively, while the contribution of

passengers (the main source of revenues) is declining softly. The conclusion that we can get from this

fact and from the report is that the prices of seats are falling but the number of passengers is still the

same. The company gets its money from other partnerships, such as hotels, car renting, banks…etc. It

emphasizes the change in the company’s strategy. Over the 2007, 2008, 2009, and 2010 fiscal years,

South West’s revenues grew by 18.53%.

Cost of goods sold: (Salaries, wages and benefits, Fuel and oil, Maintenance materials and repairs,

Aircraft rentals, Landing fees & other rentals)

2007 2008 2009 2010

Cost of goods sold $ 7 081,00 $8 590,00 $8 135,00 $9 062,00

2007/2008/2009/2010: 21.86%

Sales were enhanced followed by an increase of costs of goods sold over the four fiscal years (from

2007 to 2010).

EBIT:

2007 2008 2009 2010

EBIT $791,00 $449,00 $262,00 $988,00

Growth EBIT 20%

EBIT (Earnings before Interest and Taxes) is an indicator of the company’s profitability excluding

taxes and interests and shows the cash flow generated by the operating process. EBIT grew by 20%,

roughly in line with revenues (that grew by 18.53%)

As we can notice, in South West’s case the EBIT growth is 20% while the revenue growth represents

18.53%. We can thus say that interests and taxes change the profitability of the company.

Operating margin:

The operating margin stands for the margin that the firm earns after all the operating expenses.

Thanks to the ratios (excel sheet), this margin shrank by 5.49% from 2007 until 2009, but then rose

by 5.63% between 2009 and 2010. Compared to other airlines’ margins, such as United continental

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(for example for 2007/2008: decrease of 19.57%), South West’s one is fairly stable. This fact is a key

point to take into account as a potential investor.

Net profit margin:

This margin is meaningful for investors, since it helps to predict the future earnings per share, hence

the expected return. The Net profit margin had the same tendency than the operating margin; it

decreased moderately over the first three years (from 2007 till 2009) and then amplified in 2010. Yet

again, compared to other companies, the net profit margin fluctuations are quite modest. Therefore

the conclusion remains the same for the operating margin: Southwest is a healthy company for

possible investors.

Thanks to the operating margin and the net profit margin, Southwest managed to catch up its pre-

crisis’s activity level without being as profitable as it used to be.

Conclusion for the income statement: Basically, we learnt from the income statement’s analysis

that, even if the company sometimes generates less cash than other competitors, it is overall more

balanced because the variations of its operating margin and of its revenues are narrower aside to

other airline companies. A stable company is more attractive for prospective investors.

Balance sheet:

Accounts receivable days:

This amount symbolizes the number of days clients have to pay the company back. Southwest had an

average account receivable of 7.17 days over the four past fiscal years.

Compared to other airline companies, Southwest’s average accounts receivable days is low. By

maintaining accounts receivable days, firms are indirectly “allowing” clients to benefit from interest-

free loans. A low ratio implies that the company should re-assess its credit policies in order to ensure

the timely collection of imparted credit - that is not earning interest for the firm. Indeed, a high ratio

implies that a company operates on a cash basis or that its extension of credit and collection of

accounts receivable is very efficient. The higher the ratio, the quicker will a business collect its

receivables and the more cash will the company have on hand. However, an unusual high ratio could

indicate that the company’s credit terms are tighter than its competitors and that it is running the

risk of losing customers.

Accounts payable days:

APD is an accounting entry that corresponds to an entity's obligation to pay off a short-term debt

to its creditors. Just as the Accounts Receivable ratio is used to evaluate a company’s incoming cash

situation, this figure can demonstrate how a business handles its outgoing payments.

Southwest has an average of 24.24 days accounts payable over the four fiscal years. Compared to its

main competitors, this number is low. It usually means that the company is slow in paying its

suppliers. But sometimes, it could be a strategic choice from the company. Indeed high accounts

payable ratio is not always in the best interest of a company. Many companies extend the period of

credit turnover, getting extra liquidity.

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This strategy can be confirmed by examining the quick ratio. Indeed, this ratio indicates whether or

not the company has enough liquidity to cover its short term liabilities. For Southwest, during most

years, this ratio is inferior to 1. (For instance: year 1: quick ratio=0.63) It means that the company

does not have enough cash to pay its short term liabilities. This is why it is adjusting its strategy to get

more liquidity.

Debt-asset ratio:

Indicates what proportion of the company’s assets are being financed through debt. In this case, the

ratio is always kept under 1. This suggests that a majority of its assets are financed by equity rather

than by debt.

Southwest is thus, a very attractive company for potential investors, as it is financing its assets with

equity: the risk is therefore lower for investors. A high debt-to-equity ratio will imply significant

interest payments.

Enterprise value:

It measures the company’s value and also straightforward market capitalization. In Southwest’s case,

this value is steadily increasing over the four fiscal years, when competitors’ enterprise value is highly

volatile: it is very stable and attractive to investors.

Price-earnings ratio:

This ratio is a key element to investors: it is a valuation of a company’s current share price compared

to its per-share earnings. By relating share prices to actual profits, the P/E ratio highlights the

connection between the price and recent company performance. If prices and profits increase, the

ratio stays the same. The ratio only fluctuates as price and profits become disconnected.

Concerning Southwest, this amount is increasing drastically during the 3 first years and then

decreases during the fourth year: recent profit levels seem to be no longer the main factor in stock

pricing. This might be because change is occurring - investors are expecting a much better or worse

performance the next year - or because impressions are now the dominant factor.

Statement of cash flows:

Total cash flow has increased from $1.10B in 2009 to $1.24B in 2010. This increase displays

Southwest’s ability to be self-sufficient with regards to financing. Furthermore, this increase shows a

healthy similarity to the increase in sales growth around 15-20%. In addition, cash flows from

operating activities have grown steadily from -$1.52B in 2008 to $1.56B in 2010. This can be

explained by the easing of the financial crisis on the airline industry since its severe drop in 2008.

Even when comparing with fiscal year 2009, operating activities have increased by 158% in 2010.

However, cash flows from investing activities have not experienced a similar rebound. While this

number did increase slightly in 2010 to -$1.26B, Southwest’s purchases in this area are continuously

greater than the sales from the proceeds of short-term investments. While investment cash flows

are often negative for companies of this size, it would be important for future investors to keep an

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eye on this information. This rise in investment spending is largely due to some of Southwest’s

recent acquisitions, most notably the purchase of AirTran Airways.

In 2010, cash flows from financing activities were also negative. Decreasing from $1.65B in 2008 to -

$149M in 2010, Southwest can mainly attribute this decrease to a lack of issuance of long-term debt.

Because no further details were given, it is difficult to understand why this occurred.

At the end of fiscal year 2010, Southwest saw a positive net change in cash and cash equivalents for

the first time in three years. When this is paired with an increase and a positive total cash flow, it is

clear that Southwest is doing a sufficient job in financing activities with its own resources.

It is finally important to note the stable increase of the free cash flow margin of Southwest, which

seems to have recovered since the 2008 financial crisis. When compared to other airlines and the

industry median, we see once again that Southwest is outperforming the competition.

South west Performance compared to peers

Introduction

A good way to assess a company’s performance is to compare it to the industry average and its main

competitors. “Taking the pulse” of an investment by doing so helps to pick stock. Regardless of

current news, and announcement that have a great influence on stock prices, the company’s

historical profitability and overall performance related to its industry is a good way to estimate its

future stock price fluctuation (Rise, straight line or fall).

Main Competitors

United Continental Holdings :

This Chicago based company is the result of a 2010 merger combining United Airlines and

Continental Airlines. In 2010, United Continental had revenue of $23.4 billion. The company flies

extensively in the United States and throughout the world as well. When the merger is finally

complete, United will have become the world’s largest airline based on revenue passenger miles.

JetBlue :

Founded in 1999, this airline company appeals to middle and upper class flyers. It has achieved the

highest rankings of any commercial American airline and is the country’s only 4-star airline.

However, JetBlue flies to fewer destinations, both domestically and internationally, in comparison

the other main American competitors.

AMR Corporation :

Originally known simply as American Airlines, AMR has expanded to include TWA Airlines, American

Eagle Airlines and Executive Airlines. A traditional American airline with services focused on the

domestic market, American Airlines has experienced significant financial trouble lately and filed for

bankruptcy in November 2011.

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Profitability

Southwest has been one of the only airlines to maintain profitability over the last four years despite a

challenging business environment (GFC, jet-fuel prices rising). Its four years average profitability

indicators (Operating, net profit and free cash flow margins, in reference to the excel sheet) are all

positives while most of competitor’s 4 years average indicators are negatives (Avg Net profit margin:

-3,4%). In the heart of the crisis, Southwest has definitely outperformed the market – with a net

profit margin of 1,61% (2008) when competitors experienced large losses (12,5% average peer’s net

profit margin). Additionally, its capacity to turn profit into cash is outstandingly greater than its peers

(Southwest’s average FCF: 3,46% - Peers average FCF -1,27%).

Likewise, the company has a better return on investment than its peers (2,2% and -3,09% for its

peers) meaning that Southwest resources are used efficiently. On the other hand, Southwest’s return

on equity has been lower over the last few years than it’s peers’ (5,52% and 7,72% for the peers) due

to a greater market capitalization. Overall, Southwest’s superior profitability makes it more

interesting to invest in than its competitors. The fact that Southwest’s profitability is greater than its

competition is exceptional taking in consideration the fact that it is a bigger company in terms of

market capitalization and operations on the US market.

Financial Liquidity

First of all, it is necessary to understand that airline companies tend to have lower levels of liquidity

than other industries due to the high level of capital needed to enter this market. Thus the peer’s 4

year average current ratio is below 100% (88,70%), meaning that Southwest’s competitors were

technically unable to pay off their short term obligations if they had come due at that point. Quite

surprisingly, Southwest has been able to maintain a good current ratio for the airline industry (4yrs

average : 110) : the company is able to pay off its short term debt by selling off its assets and is

therefore less risky than its peers. In addition, Southwest liquidity has improved, the current ratio

went up from 91,84% in 2007 (competitors avg :83,5%) to 110% (competitors avg 88%). Likewise,

Southwest 4yrs avg quick ratios, cash ratios and operating ratios are all better than its competition

(respectively 88%, 43% and 22% compared to 70%, 30% and 19%). Thus it is apparent that Southwest

is more liquid hence less risky than most of its competitors. Moreover, the competitors have a

negative 4 yrs avg net working capital ($-1134 M) when Southwest’s 4yrs avg net working capital is

positive ($ 272M) – meaning that Southwest has had extra current asset (ex : cash) that have helped

the company’s growth when competitors had to finance the negative net working capital by either

extra debt or equity.

From the analysis of the leverage ratios, we can say that Southwest has been more liquid, generated

more cash from its operations and held more cash compared to its short term liabilities than its

competitors did over the last 4 years on average. This means that Southwest is less risky, detains

more cash from its operations and is therefore able to invest more without using debt/equity

financing compared to its competitors.

Financial leverage ratios

It is very important to look at financial leverage ratios to understand how companies are financed

(debt/equity) and the relative importance of assets and earning to the company’s leverage. However

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it has been difficult to take conclusion from the analysis of financial leverage ratios for many reasons:

Southwest’s competitors have had very low share prices, making their shareholders equity fall and

artificially increase their financial leverage ratio. Using a same reasoning process, their retained

earnings to total assets over the last 4 years is negative due to negative earnings. However, it is

important to see that Southwest’s financial leverage ratio is quite low (55% over the last 4 years) and

its 4 years retained earnings to total assets (33%) indicate that a third of the company’s growth is

financed by profit, which is a good result. Besides, Southwest 4 yrs avg debt to assets is lower than its

peers (61% compared to 96%) signifying that southwest is less leveraged than its competitors and

again, less risky.

We can surely say after a deep analysis of the financial leverage ratios that Southwest is relatively

safer than its competitors due to lower level of debts to equity and a greater value of its assets

compared to its debt. In other words South west is less leveraged than its competitors so it is safer to

invest in the company.

Efficiency ratios

Efficiency ratios give a grasp of how efficiently a business uses and controls its assets and how well

the company manages its suppliers and customers payments. The most significant findings after a

profound analysis are the following: Southwest got paid two times quicker by its customers than its

competitors over the last four years (days in account receivable: higher level of available cash and

therefore better future prospects. On the other hand, Southwest competitors had lower level of

inventory (Peers 4 yr avg days in inventory: 5 compared to 7,75) revealing a weakness on

Southwest’s inventory management. Efforts will have to be made by Southwest’s management on

this point, but when looking at the global efficiency of the company the outcome is positive

compared to competition.

Southwest is having better operating process than its competition, implying that sales will be turned

into cash more easily through Southwest’s operations than its peers’ operations.

Growth Rates

Growth rates give an indication of the future development of a business. However, comparing

Southwest growth rates to its peers is quite delicate due to the fact that most of them had low

operations level during the GFC (Global Financial Crisis) so they had gigantic growth rates after the

end of the GFC. Yet, it is interesting to see that Southwest net income growth has been 3 times

greater than its peers after the GFC (respectively 360 and 91%). Similarly, Southwest’s free cash flow

growth has been two times higher than its peers over the last 4 years (167% and 90,7%).

Southwest future developments are potentially greater than the majority of its peers (Jet Blue, AMR

and United Continental).

Conclusion

Based on a financial comparison to peers, Southwest is without a doubt a company we advise to

invest in. It has clearly outperformed its main competitors in terms of operating efficiency and

profitability, and at the same time it has been able to keep a low level of risk/leverage. It seems as

though Southwest shows better growth prospects than its competition, and is clearly less risky.

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Investment Risks

Market Risks

Like any airline around the world, Southwest’s economic results are heavily influenced by oil prices.

When prices of jet fuel increase, airlines either take a hit to their profit margin, or are forced to

charge customers extra for the fuel. The aeronautical industry and the raw materials it supplies to

Southwest are also variable, meaning that prices for these necessary parts could change at any time.

Economic Risks:

Within the past five years, the United States has suffered due to the economic crisis. This situation

means that travelers take fewer vacations requiring flights and businesses have cut back on the

number of flights for meetings and conferences. In addition, almost all of Southwest’s operations are

domestic, meaning if the American economy continues to suffer, so will their business.

Business Risks:

Southwest distinguishes itself from competitors by offering cheaper flights and friendly customer

service. If the company is unable to maintain this reputation, customers are likely to quickly look

elsewhere. Because Southwest is not providing a unique service, its economic vitality will depend on

its efforts to continue its successful business plan and culture. Furthermore, with its recent

acquisition of AirTran Airways, Southwest’s future depends on its ability to successfully manage

these new operations, particularly in Mexico and the Caribbean.

International/Translation Risks:

The international risks are limited because of Southwest’s heavy concentration on the American

market. No foreign currencies appear in any of the financial statements. This, in turn, means that

Southwest has not diversified its services in order to protect against negative domestic

circumstances.

General conclusion

Going through this Financial Report, we can say that Southwest is definitely a successful

company proven by the many financial, investment and background. Not only is it listed on

the Fortune 500 ranking in 2011, Southwest is also classified 8th best capitalized company

on the NYSE; two strong reasons for shareholders to trust the airline. During the last few

years, Southwest was able to face all kinds of challenges the economy and market have to

offer: from the crisis to the rising prices in raw materials; in the end, Southwest continuously

succeeded in increasing its sales. Moreover, forecasts show that this tendency will keep on

rising for the next years to come. It is true that investing in an airline company can be risky;

however, Southwest has already demonstrated its value and its strengths by its strong

strategy, culture, financial structure and stability. Finally, it seems as though Southwest

shows better growth prospects than its competition, and is clearly less risky: this is why we

highly recommend shareholders to invest in this company.

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APPENDICIS

Southwest Stock Price

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In million $

Year ended 31/12/2010

Revenues:

Passenger $ 11 489,00

Freight $ 125,00

Other $ 490,00

Total Operating revenue $12 104,00

Cost and expenses:

Salaries , wages and benefits $3 704,00

Fuel and oil $3 620,00

Maintenance materials and repairs $751,00

Aircraft rentals $180,00

Landing fees & other rentals $807,00

Depreciation & Amortization $628,00

Other operating expenses $1 426,00

Total operating expenses $11 116,00

Operating income $988,00

Other expenses (Income)

Interest expense $167,00

Capitalized interest ($18,00)

Interest income ($12,00)

Other (gains) losses,net $106,00

Total other expenses $243,00

Income from continuing operation before income taxes $745,00

Provision for income taxes $286,00

Net income $459,00

Basic net income per common share $0,62

Diluted net income per common share: $0,61

Southwest Income Statement 2010

Impact of Fuel Cost on Southwest Airlines Co Operations

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Cash flows from operating activities 2010

Net Income $459

Adjustements to reconcile net income to cash provided by operating activities :

Depreciation and amortization 628

Unrealized loss on fuel derivative instruments 139

Share based compensation expense

Excess tax benefits from share based compensation arrangements

Deferred income taxes 133

Amortization of deferred gains on sale and leaseback of aircraft -14

Changes in certain assets and liabilities :

Accounts and other receivables -26

Other current assets -8

Accounts payable and accrued liabilities 193

Air traffic liability 153

Cash collateral received from (provided to) fuel derivative counterparties 265

Other, net -361

Net cash provided (used) by operating activities $1 561

Cash flows from investing activities

Purchases of property and equipment,net ($493)

Purchases of short-term investments -5 624

Proceeds from sales of short-term investments 4 852

Other, net

Net cash provided (used) by investing activities ($1 265)

Cash flows from financing activities

Issuance of long-term debt

Proceeds from (payments of) Revolving credit facility

Excess tax benefits from share based compensation arrangements

Proceeds from sale and leaseback transactions

Proceeds from Employee stock plans 55

Payments of long-term debt and capital lease obligations -155

Proceeds from (payment of) credit line borrowing -44

Payment of cash dividends ($13)

Repurchase of common stock

Other, net 8

Net cash provided by (used in) financing activities ($149)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS $116

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1 096

CASH AND CASH EQUIVALENTS AT END OF PERIOD $1 212

Southwest Cashflow Statement

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Southwest Stock price variation (in %) and (W&T Offshore.inc – an oil price indicator, in %)

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W&T Offshore.inc stock price (Indicator of oil prices)

Data from INFINANCIALS

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Profitability 2007 2008 2009 2010 Operating margin - Operating Income/Revenue 8,02% 4,07% 2,53% 8,16%

Net Profit Margin - Net profit/Revenue 6,54% 1,61% 0,96% 3,79%

Free Cash Flow margin : FCF/Revenue 15,35% -22,34% 3,86% 16,97%

Return on Assets - Net profit/Total Assets 3,85% 1,27% 0,69% 2,97%

Return on Equity - Net profit/Shareholder's Equity 9,29% 3,59% 1,82% 7,36%

Liquidity Ratios

Current ratio - Current Assets/Current liabilities 91,84% 94,55% 124,60% 129,47%

Net Working capital - Current Assets - Current liabilities (millions) -395 -153 663 974

Quick ratio - (Cash + ST investments + AR)/CL 63,21% 71,70% 102,49% 112,95%

Cash ratio - (Cash + Cash equivalents)/ CL 45,74% 48,75% 41,34% 38,15%

Operating CF ratio - (Cash Flow from operations)/ Current

Liabilities 58,81% -54,85% 36,55% 47,23%

Financial leverage Ratios

Financial leverage ratios - Total financial debt/Equity 30,13% 73,91% 64,45% 54,19%

Retained Earnings to Total Assets - Earning/total assets 28,55% 34,97% 34,84% 34,92%

Debt to Assets ratio - (Total liabilities/Total Assets) 58,62% 64,79% 61,78% 59,67%

Efficiency Ratios

Sales to total Assets - Sales/Total Assets 0,59 0,78 0,73 0,78

Days in Account payable - (360*AP)/Sales 27,71 24,62 31,58 37,24

Days in Account receivable - (360*AR)/Sales 10,19 6,83 5,88 5,80

Days in Inventory- (Inventory*360)/Sales 9,46 6,63 7,69 7,23

Growth Rates

Growth of Sales- (2010 Sales - 2009)/2009 8,53% 11,78% -6,11% 16,95%

Growth of Net income (2010 Net Income - 2009)/2009 29,26% -72,40% -44,38% 363,64%

Growth of Free Cash Flow (2010 FCF - 2009)/2009 Non meaningful Non meaningful Non meaningful 167,00%

Valuation Ratios

Market Capitalization (12 months avrg,infinancials) - in Million 8965 6379 8490 9702

Enterprise value (MC + Net debt) 8277 8237 9412 9544

Price to earnings ratio Market capitalization/net income 13,89922481 35,83707865 85,75757576 21,1372549

Enterprise value to Sales- EV/Sales 0,83531082 0,747255738 0,909371981 0,78849967

Price/Book Ratio Market capitalization/Shareholder Equity 1,291600634 1,287906319 1,556655666 1,555555556

Southwest Ratios

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0% 5%

10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95%

100%

2007 2008 2009 2010

Others

Freight

Passenger