MANAGEMENT'S DISCUSSION AND ANALYSIS
Published on February 27, 1995
Exhibit 99.3
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
INDUSTRY CONDITIONS
The 1990s have been devastating financially for the passenger domestic airline
industry, with Southwest as the sole exception among larger carriers. Since
1990, the industry has been shrinking and we have been expanding. We are now
carrying more than twice the number of passengers annually than in 1990, an
annualized growth rate of 21 percent. In 1993, with the advent of Continental
Lite and plans laid for the United Shuttle, the competitive trend away from
Southwest began to reverse. In 1994, in the face of our own aggressive
expansion, we experienced a massive increase of new competitive service from
United, Continental, Reno, and TWA. We also were negatively impacted by the
industry's use of persistent fare sales during the fourth quarter, which
occurred at a time when we were aggressively converting Morris Air Corporation
(Morris) to Southwest's operations and were experiencing operating difficulties
of our own in reservations and revenue management. The result was a 47 percent
decline in earnings in fourth quarter 1994 as compared to fourth quarter 1993.
Many of the operational issues that surfaced during fourth quarter 1994 have
been, or will soon be, addressed, most notably reservations capacity. However,
some of their effects will carry over into the first two quarters of 1995, and,
further, we cannot predict the actions of our competitors.
In response to these increasing competitive pressures, we implemented several
measures. However, we face significantly more competition than we did a year
ago, which may also continue to adversely affect comparisons to 1994 quarterly
performances, particularly in first half 1995.
As compared to year ago levels, load factors and passenger revenue yields are
currently down. (The consolidated load factor for January 1995 was 57.8
percent, compared with 63.1 percent for the same month of a year ago.) Our
expectation is that this trend will continue at least during first half 1995.
As expected, the integration of Morris into Southwest during 1994, which
included 21 aircraft and seven new cities, resulted in our immediate
competitive presence in the northwestern region of the U.S. and Salt Lake City.
However, these new markets, which are in the development stage and, therefore,
understandably low-yielding, will need to improve for overall yields to compare
favorably to year ago levels. While there is no way to predict precisely how
fast these markets will develop, we are encouraged by the pace thus far. We
have also been encouraged with Customer acceptance of recent price increases,
which may improve yield comparisons.
From an operating cost perspective, we have been pleased with recent favorable
trends versus year ago levels, including fuel prices. Our goal is to continue
this trend in 1995, despite our basic lack of control over fuel prices.
Significant cost reduction opportunities lie in distribution costs. Ticketless
travel, the new SABRE Basic Booking Request, our enhanced Ticket By Mail
product, and expanded reservations operations should all combine to help reduce
distribution costs. During 1995, we currently plan to add twenty-seven 737-300
aircraft to our fleet and one new city, Omaha, Nebraska, to our route system,
which will allow us to focus on strengthening our existing route system.
RESULTS OF OPERATIONS
1994 COMPARED WITH 1993 The Company's consolidated net income for 1994 was
$179.3 million ($1.22 per share), as compared to the corresponding 1993 amount
(before the cumulative effect of accounting changes) of $154.3 million ($1.05
per share), an increase of 16.2 percent. The increase in earnings was primarily
attributable to an increase in operating income of 8.5 percent and a decrease
in other expenses (nonoperating) of 46.9 percent.
Operating Revenues Consolidated operating revenues increased by 12.9 percent in
1994 to $2,591.9 million, compared to $2,296.7 million for 1993. This increase
in 1994 operating revenues was derived from a 12.7 percent increase in
passenger revenues. Revenue passenger miles (RPMs) increased 14.8 percent in
1994, compared to a 16.8 percent increase in available seat miles (ASMs),
resulting in a decrease in load factor from 68.4 percent in 1993 to 67.3
percent in 1994. The 1994 ASM growth resulted from the addition of 21 aircraft
during 1994.
Freight revenues in 1994 were $54.4 million, compared to $42.9 million in 1993.
The 26.9 percent increase in freight revenues exceeded the 16.8 percent
increase in ASMs for the same period primarily due to increased air freight
volumes and United States mail services.
Operating Expenses Consolidated operating expenses for 1994 were $2,275.2
million, compared to $2,004.7 million in 1993, an increase of 13.5 percent,
compared to the 16.8 percent increase in ASMs. On a per-ASM basis, operating
expenses (excluding 1993 merger expenses) decreased 2.3 percent in 1994. The
primary factors contributing to this decrease were an 8.8 percent decrease in
average jet fuel cost per gallon and lower agency commission costs, offset by
increased aircraft rentals.
Operating expenses per ASM for 1994 and 1993 (excluding 1993 merger expenses)
were as follows:
Salaries, wages, and benefits per ASM increased only .5 percent in 1994. This
increase resulted from a 3.0 percent increase in average salary and benefits
cost per Employee, partially offset by slower average headcount growth, which
increased only 13.8 percent in 1994 versus the 1994 capacity (ASM) increase of
16.8 percent. The majority of the increase in average salary and benefits cost
related to increased health benefits and workers' compensation costs. Employee
productivity improved from 2,633 passengers handled per Employee in 1993 to
2,676 in 1994.
Profitsharing and Employee savings plan expenses per ASM increased 4.8 percent
in 1994. The increase is primarily the result of increased matching
contributions to Employee savings plans resulting from increased Employee
participation and higher matching rates in 1994 for flight attendants and
customer service employees under their respective collective bargaining
agreements.
Fuel and oil expenses per ASM decreased 9.9 percent in 1994, primarily due to
an 8.8 percent reduction in the average jet fuel cost per gallon from 1993. Jet
fuel prices remained relatively stable throughout 1994, with quarterly averages
ranging from $0.51 to $0.56 per gallon. Since year-end, fuel prices have
averaged approximately $0.54 per gallon.
In August 1993, the Revenue Reconciliation Act of 1993 was enacted, which,
among other things, included an increase of 4.3 cents per gallon in
transportation fuel tax, which becomes effective September 30, 1995, for jet
fuel used in commercial aviation. This additional fuel tax will increase fuel
expenses approximately $7.5 million in fourth quarter 1995.
Maintenance materials and repairs per ASM was unchanged in 1994 compared to
1993.
Agency commissions per ASM decreased 11.3 percent due to a lower mix of travel
agency sales and lower 1994 passenger revenue per ASM. The lower travel agency
sales mix resulted from 1994 enhancements to Southwest's ticket delivery
systems for direct Customers, as described below.
In response to actions taken by our competitor-owned reservations systems, we
reduced our operating costs and enhanced our ticket delivery systems by
developing our own Southwest Airlines Air Travel ("SWAT") system allowing
high-volume travel agents direct access to reservations; introduced overnight
ticket delivery for travel agents; reduced to three the number of advance days
reservations required for overnight delivery of tickets to consumers (Ticket By
Mail); developed our own Ticketless system, which was rolled out system-wide on
January 31, 1995; and subscribed to a new level of service with SABRE that will
automate the booking process for SABRE travel agencies effective May 1, 1995.
We also continue to actively pursue other cost-effective solutions for
automating non-SABRE travel agency bookings.
Aircraft rentals per ASM increased 7.7 percent in 1994. The increase primarily
resulted from a third quarter 1994 sale/leaseback transaction involving ten new
737-300 aircraft and a lease of three used aircraft under long-term operating
leases. At December 31, 1994, 44.7 percent of the Company's fleet was subject
to operating leases, compared to 43.3 percent at December 31, 1993.
Other operating expenses per ASM decreased 2.2 percent in 1994 compared to
1993. The overall decrease is primarily attributable to operating efficiencies
resulting from the transition of Morris operational functions to Southwest,
primarily contract services which decreased $8.8 million (24.4 percent per
ASM), offset by an increase in advertising costs of $24.1 million (22.9 percent
per ASM) and primarily associated with the start-up of seven new cities and new
competitive pressures in 1994.
Other "Other expenses (income)" included interest expense, interest income, and
nonoperating gains and losses. Interest expense decreased $5.1 million in 1994
due to the March 1, 1993 redemption of $100 million senior unsecured notes due
1996 and the repayment of approximately $54.0 million of Morris long-term debt
during first quarter 1994. Capitalized interest increased $8.6 million in 1994
as a result of higher levels of advance payments on aircraft compared to 1993.
Interest income for 1994 decreased $1.9 million primarily due to lower cash
balances available for short-term investment.
Income Taxes The provision for income taxes decreased in 1994 as a
percentage of income before taxes, including the cumulative effect of accounting
changes, to 40.1 percent from 40.6 percent in 1993. The 1993 rate was higher
due to deferred tax adjustments in 1993 related to the 1993 increase in the
federal corporate income tax rate from 34 percent to 35 percent(see Note 11 to
the Consolidated Financial Statements). This was offset by increased 1994
effective state income tax rates.
1993 COMPARED WITH 1992 Prior to 1993, Morris operated as a charter carrier. In
1993, Morris began operating as a FAR 121 Certificated Air Carrier, or
scheduled service carrier, consistent with Southwest. For comparability from
1993 to 1992, the statistical and operating data for 1992 are based on
scheduled passenger service only (i.e., Southwest). Accordingly, RPMs and ASMs
for 1992 relate only to scheduled carrier operations.
The Company's consolidated income for the year 1993 was $154.3 million ($1.05
per share), before the cumulative effect of accounting changes, compared to pro
forma consolidated income of $97.4 million ($.68 per share) for 1992, an
increase of 58.4 percent. The increase in earnings was primarily attributable
to an increase in operating income of 50.7 percent and was achieved despite an
increase in the federal income tax rate, which increased the provision for
income taxes $6.5 million, or $.04 per share.
Operating Revenues Consolidated operating revenues increased by 27.4 percent in
1993 to $2,296.7 million. Operating revenue per ASM for scheduled service
carrier operations increased in 1993 to $.0835 from $.0789 in 1992. The
increase in consolidated operating revenues was primarily related to a 36.5
percent increase in passenger revenues, which accounted for 96.5 percent of
total operating revenues in 1993 versus 90.1 percent in 1992.
Consolidated RPMs increased 36.6 percent in 1993, which exceeded the 28.8
percent increase in ASMs, resulting in an increase in the load factor from 64.5
percent to 68.4 percent. The 1993 ASM increase resulted from the conversion of
the Morris system from charter to scheduled service and the addition of 16
aircraft to the
Southwest fleet. The additional 16 Southwest aircraft were primarily used to
expand California, St. Louis, and Chicago markets and to initiate service from
Louisville, Baltimore and San Jose.
Freight revenues increased in 1993 to $42.9 million from $33.1 million in 1992.
The 29.6 percent increase in freight revenues exceeded the 28.8 percent ASM
increase primarily due to further expansion of United States mail services and
increased freight marketing programs.
Charter and other revenues decreased in 1993 from 1992 on a consolidated basis
as Morris converted its operations in 1993 to scheduled service from charter
operations. In 1993, consistent with the beginning of scheduled carrier
service, Morris revenues were primarily derived from scheduled operations and,
accordingly, classified as "passenger" revenues. Morris charter revenues
totaled $117.8 million in 1992.
Operating Expenses Consolidated operating expenses increased 24.6 percent to
$2,004.7 million from $1,609.2 million in 1992. The primary factors
contributing to the increase were the 28.8 percent increase in ASMs; increased
contributions to profit-sharing and Employee savings plans; higher agency
commissions; higher aircraft rentals; and increased maintenance costs.
On a consolidated basis, the Company incurred $10.8 million of one-time merger
expenses in connection with the December 1993 Morris acquisition. These
expenses included $1.9 million of various professional fees; $4.7 million for
disposal of duplicate or incompatible property and equipment; and $4.2 million
for Employee relocation and severance costs related to elimination of duplicate
or incompatible operations. As required for financial reporting purposes, these
expenses have been reported as operating expenses.
Salaries, wages, and benefits per ASM decreased 2.3 percent in 1993. Excluding
the effects of Morris, Southwest's cost per ASM for salaries, wages, and
benefits increased .9 percent from 1992 to 1993. This increase resulted from a
2.2 percent increase in salaries and wages, offset by a 5.0 percent decrease in
health benefit and workers' compensation costs per ASM. Headcount for Southwest
increased 17.0 percent in 1993, slightly more than the 15.9 percent increase in
ASMs. However, Employee productivity improved to 2,633 passengers handled per
Employee in 1993 from 2,597 in 1992.
Morris contracted out all ground handling services, which are included in
"other operating expenses." Consequently, salaries, wages, and benefits on a
per-ASM basis are considerably lower for Morris than for Southwest contributing
to the decrease in consolidated salaries, wages, and benefits per ASM.
Profitsharing and Employee savings plan expenses per ASM increased 16.7 percent
in 1993. The increase was primarily the result of higher earnings in 1993. For
additional information, see Note 10 to the Consolidated Financial Statements.
Fuel and oil expenses per ASM decreased 2.6 percent in 1993 due to a 2.7 percent
reduction in the average cost per gallon of jet fuel from 1992. Jet fuel prices
remained relatively stable throughout 1993, continuing the trend which began in
1992, with quarterly averages ranging from $0.57 to $0.63 per gallon.
Maintenance materials and repairs per ASM increased 5.4 percent in 1993. This
increase was primarily the result of higher airframe component repairs and
higher amortization of capitalized scheduled airframe overhauls.
Agency commissions per ASM increased 6.0 percent in 1993 primarily due to
increased passenger revenues per ASM.
Aircraft rentals per ASM increased 30.0 percent in 1993. The increase was
primarily attributable to the expansion of Morris scheduled operations, which
leased 18 of its 21 aircraft, 11 of which were leased in 1993. Additionally,
the increase partially resulted from the sale/leaseback financing by Southwest,
since late 1992, of seven 737-300 aircraft with long-term operating leases.
Also in 1993, Southwest leased one used 737-300 aircraft under a long-term
operating lease and one used 737-200 aircraft under a short-term operating
lease.
Depreciation expense per ASM decreased 8.5 percent in 1993 due to the expansion
of Morris, which, as stated above, consisted primarily of a leased aircraft
fleet.
Other operating expenses per ASM increased 13.8 percent from 1992 to 1993. This
increase is primarily the result of higher usage of contract services at
Morris. As previously discussed, Morris contracted for all ground handling
service, along with various other services that are handled internally at
Southwest.
Other "Other expenses(income)" included interest expense, interest
income, and nonoperating gains and losses. Interest expense, net of capitalized
interest, decreased 7.0 percent in 1993 due to the March 1, 1993 early
redemption of $100 million in senior unsecured 9% Notes due 1996. See Note 6 to
the Consolidated Financial Statements for further information. Net nonoperating
losses in 1993 resulted from the write-down of certain internal system
development costs and the settlement of certain employment-related litigation
for $1.7 million.
Income Taxes The provision for income taxes increased in 1993, as a percentage
of income before income taxes and cumulative effect of accounting changes, to
40.6 percent from pro forma 38.1 percent in 1992. The increase was primarily
the result of the increase in the federal income tax rate. See Note 11 to the
Consolidated Financial Statements for further information.
LIQUIDITY AND CAPITAL RESOURCES
Cash provided from operations was $412.7 million in 1994, compared to $392.7
million in 1993. During 1994, additional funds of $315.0 million were generated
from the sale and leaseback of ten new 737-300 aircraft subject to long-term
operating leases (increasing total commitments for operating leases by $619.0
million).
During 1994, capital expenditures of $788.6 million were primarily for the
purchase of 18 new 737-300 aircraft, one used 737-300 aircraft previously
leased by Morris, and progress payments for future aircraft deliveries. At
December 31, 1994, capital commitments of the Company consisted primarily of
scheduled aircraft acquisitions.
As of January 1995, Southwest had one-hundred-sixteen 737s on firm order,
including twenty-five to be delivered in 1995, with options to purchase another
seventy-four. Aggregate funding required for firm commitments approximated
$3,042.7 million through the year 2001 of which $602.6 million related to 1995.
See Note 4 to the Consolidated Financial Statements for further information.
The Company recently completed the construction of a $10.0 million reservation
center in Little Rock, Arkansas, which began accepting calls on January 24,
1995, and announced that it will build an additional reservation center in
Oklahoma City scheduled to open in second quarter 1995. Total estimated cost of
the new Oklahoma City reservation center is approximately $10.0 million.
As of December 31, 1994 and since 1990, the Company had authority from its
Board of Directors to purchase 3,750,000 shares of its common stock from
time-to-time on the open market. No shares have been purchased since 1990.
The Company has various options available to meet its capital and operating
commitments, including cash on hand at December 31, 1994 of $174.5 million,
internally generated funds, and a revolving credit line with a group of banks
of up to $300 million (none of which had been drawn at December 31, 1994). In
addition, the Company will also consider various borrowing or leasing options
to maximize earnings and supplement cash requirements.
The Company currently has outstanding shelf registrations for the issuance of
$100 million senior unsecured notes and $98 million pass-through certificates
relating to sale/leaseback transactions. The Company presently intends to
utilize these sources of financing during 1995.
Cash provided from operations was $392.7 million in 1993 as compared to $282.1
million in 1992. During 1993, additional funds of $90.0 million were generated
from the sale and leaseback of three new 737-300 aircraft subject to long-term
operating leases (increasing total commitments for operating leases by $145.0
million). Morris also generated $17.8 million from certain bank borrowings.
These proceeds were primarily used to finance aircraft-related capital
expenditures and to provide working capital.