10-Q 1 s2q200110qtext.txt FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001 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 (I.R.S. 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 [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Number of shares of Common Stock outstanding as of the close of business on July 27, 2001: 763,401,828 SOUTHWEST AIRLINES CO. FORM 10-Q Part I - FINANCIAL INFORMATION Item 1. Financial Statements Southwest Airlines Co. Condensed Consolidated Balance Sheets (in thousands) (unaudited) June 30, 2001 December 31, 2000 ASSETS Current assets: Cash and cash equivalents $968,347 $522,995 Accounts and other receivables 153,511 138,070 Inventories of parts and supplies, at cost 79,570 80,564 Deferred income taxes 28,191 28,005 Fuel hedge contracts 59,512 22,515 Prepaid expenses and other current assets 40,236 39,387 Total current assets 1,329,367 831,536 Property and equipment: Flight equipment 7,241,839 6,831,913 Ground property and equipment 856,627 800,718 Deposits on flight equipment purchase contracts 325,204 335,164 8,423,670 7,967,795 Less allowance for depreciation 2,318,958 2,148,070 6,104,712 5,819,725 Other assets 34,579 18,311 $7,468,658 $6,669,572 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $336,029 $312,716 Accrued liabilities 632,479 499,874 Air traffic liability 510,103 377,061 Income taxes payable 40,203 - Current maturities of long-term debt 110,501 108,752 Total current liabilities 1,629,315 1,298,403 Long-term debt less current maturities 752,602 760,992 Deferred income taxes 971,452 852,865 Deferred gains from sale and leaseback of aircraft 199,933 207,522 Other deferred liabilities 93,802 98,470 Stockholders' equity: Common stock 762,829 507,897 Capital in excess of par value 5,996 103,780 Retained earnings 3,020,813 2,902,007 Accumulated other comprehensive income 31,916 - Treasury stock, at cost - (62,364) Total stockholders' equity 3,821,554 3,451,320 $7,468,658 $6,669,572 See accompanying notes. Southwest Airlines Co. Condensed Consolidated Statements of Income (in thousands, except per share amounts) (unaudited) Three months ended June 30, Six months ended June 30, 2001 2000 2001 2000 OPERATING REVENUES: Passenger $1,505,329 $1,415,958 $2,886,605 $2,615,843 Freight 24,869 27,968 50,650 55,034 Other 23,587 16,749 45,147 32,445 Total operating revenues 1,553,785 1,460,675 2,982,402 2,703,322 OPERATING EXPENSES: Salaries, wages, and benefits 473,042 422,247 920,473 803,736 Fuel and oil 208,029 197,608 417,613 394,679 Maintenance materials and repairs 102,910 90,311 201,434 183,876 Agency commissions 30,084 41,310 60,578 78,526 Aircraft rentals 47,879 49,023 95,924 98,370 Landing fees and other rentals 77,156 64,982 147,174 130,001 Depreciation 78,213 68,523 155,905 135,221 Other operating expenses 245,610 212,113 482,282 408,947 Total operating expenses 1,262,923 1,146,117 2,481,383 2,233,356 OPERATING INCOME 290,862 314,558 501,019 469,966 OTHER EXPENSES (INCOME): Interest expense 16,460 17,442 33,471 34,665 Capitalized interest (5,640) (6,905) (11,839) (13,906) Interest income (10,236) (10,511) (19,118) (17,160) Other (gains) losses, net 2,827 3,667 14,552 (471) Total other expenses (income) 3,411 3,693 17,066 3,128 INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 287,451 310,865 483,953 466,838 PROVISION FOR INCOME TAXES 111,818 120,243 187,275 180,573 NET INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 175,633 190,622 296,678 286,265 CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE (Net of Income Taxes of $14.0 million) - - - (22,131) NET INCOME $175,633 $190,622 $296,678 $264,134 NET INCOME PER SHARE, BASIC BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE $ .23 $ .26 $ .39 $ .38 CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE - - - (.03) NET INCOME PER SHARE, BASIC $ .23 $ .26 $ .39 $ .35 NET INCOME PER SHARE, DILUTED BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE $ .22 $ .24 $ .37 $ .36 CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE - - - (.03) NET INCOME PER SHARE, DILUTED $ .22 $ .24 $ .37 $ .33 WEIGHTED AVERAGE SHARES OUTSTANDING: Basic 762,139 745,943 761,188 745,839 Diluted 806,524 793,069 807,140 791,301 See accompanying notes. Southwest Airlines Co. Condensed Consolidated Statements of Cash Flows (in thousands) (unaudited) Six months ended June 30, 2001 2000 NET CASH PROVIDED BY OPERATING ACTIVITIES $904,820 $811,538 INVESTING ACTIVITIES: Net purchases of property and equipment (460,761) (496,020) FINANCING ACTIVITIES: Payments of long-term debt and capital lease obligations (6,834) (7,790) Payments of cash dividends (10,002) (8,247) Proceeds from Employee stock plans 18,129 25,947 Repurchases of common stock - (107,597) NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 1,293 (97,687) NET INCREASE IN CASH AND CASH EQUIVALENTS 445,352 217,831 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 522,995 418,819 CASH AND CASH EQUIVALENTS AT END OF PERIOD $968,347 $636,650 CASH PAYMENTS FOR: Interest, net of amount capitalized $22,530 $16,362 Income taxes $10,601 $21,328 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. (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 condensed consolidated financial statements for the interim periods ended June 30, 2001 and 2000 include all adjustments (which include only normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. The Condensed Consolidated Balance Sheet as of December 31, 2000 has been derived from the Company's audited financial statements as of that date but does not include all of the information and footnotes required by Generally Accepted Accounting Principles for complete financial statements. Operating results for the three and six months ended June 30, 2001 are not necessarily indicative of the results that may be expected for the year ended December 31, 2001. 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, 2000. 2. Dividends - During the three months ended June 30, 2001 and March 31, 2001, dividends of $.0045 per share were declared on the 762.7 million and 760.7 million shares of common stock then outstanding, respectively. During the three months ended June 30, 2000 and March 31, 2000, dividends of $.0037 per share were declared on the 746.5 million and 745.7 million shares of common stock then outstanding, respectively. 3. Common stock - On January 18, 2001, the Company's Board of Directors declared a three-for-two stock split, distributing 253.9 million shares on February 15, 2001. All share and per share data presented in the accompanying unaudited condensed consolidated financial statements and notes thereto have been restated for the stock split. 4. Reclassifications - Certain prior year amounts have been reclassified to conform to the current year presentation. 5. Net income per share - The following table sets forth the computation of basic and diluted net income per share (in thousands except per share amounts)(unaudited): Three months ended June 30, Six months ended June 30, 2001 2000 2001 2000 NUMERATOR: Net income before cumulative effect of change in accounting principle $175,633 $190,622 $296,678 $286,265 Cumulative effect of change in accounting principle - - - (22,131) Net income available to common stockholders $175,633 $190,622 $296,678 $264,134 DENOMINATOR: Weighted-average shares outstanding, basic 762,139 745,943 761,188 745,839 Dilutive effect of Employee stock options 44,385 47,126 45,952 45,462 Adjusted weighted- average shares outstanding, diluted 806,524 793,069 807,140 791,301 NET INCOME PER SHARE: Basic, before cumulative effect of change in accounting principle $.23 $.26 $.39 $.38 Cumulative effect of change in accounting principle - - - (.03) Basic $.23 $.26 $.39 $.35 Diluted, before cumulative effect of change in accounting principle $.22 $.24 $.37 $.36 Cumulative effect of change in accounting principle - - - (.03) Diluted $.22 $.24 $.37 $.33 6. Accounting changes - Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133). SFAS 133 requires the Company to record all financial derivative instruments on its balance sheet at fair value. Derivatives that are not designated as hedges must be adjusted to fair value through income. If the derivative is designated as a hedge, depending on the nature of the hedge, changes in the fair value of derivatives that are considered to be effective, as defined, either offset the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or are recorded in accumulated other comprehensive income until the hedged item is recorded in earnings. Any portion of a change in a derivative's fair value that is considered to be ineffective, as defined, is recorded immediately in Other (gains)/losses in the Condensed Consolidated Statement of Income. Any portion of a change in a derivative's fair value that the Company elects to exclude from its measurement of effectiveness is required to be recorded immediately in earnings. Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices. The Company endeavors to acquire jet fuel at the lowest prevailing prices possible. Because jet fuel is not traded on an organized futures exchange, liquidity for hedging is limited. However, the Company has found that crude oil contracts and heating oil contracts are effective commodities for hedging jet fuel. The Company has financial derivative instruments in the form of the types of hedges it utilizes to decrease its exposure to jet fuel price increases. The Company does not purchase or hold any derivative financial instruments for trading purposes. The Company utilizes financial derivative instruments for both short-term and long-term time frames when it appears the Company can take advantage of market conditions. At June 30, 2001, the Company had a mixture of purchased call options, collar structures, and fixed price swap agreements in place to hedge approximately 80 percent of its remaining 2001 total anticipated jet fuel requirements, approximately 47 percent of its 2002 total anticipated jet fuel requirements, and small portions of its 2003- 2005 total anticipated jet fuel requirements. As of June 30, 2001, nearly all of the Company's remaining 2001 hedges, and the majority of its 2002 hedges, are effectively heating oil-based positions. All other remaining hedge positions are crude oil-based positions. The Company accounts for its fuel hedge derivative instruments as cash flow hedges, as defined. Upon adoption of SFAS 133, the Company recorded the fair value of its fuel derivative instruments in the Condensed Consolidated Balance Sheet and a deferred gain of $46.1 million, net of tax, in accumulated other comprehensive income. The portion of the transition adjustment in "Accumulated other comprehensive income" that was recognized in earnings during second quarter 2001 was a gain of $10.0 million, net of tax. During second quarter 2001, the Company recognized approximately $1.8 million as a net reduction of Other losses, related to the ineffectiveness of its hedges, in the Condensed Consolidated Statement of Income. During second quarter 2001, the Company recognized approximately $4.7 million of net expense, related to amounts excluded from the Company's measurements of hedge effectiveness, in Other (gains)/losses in the Condensed Consolidated Statement of Income. The Company believes the adoption of SFAS 133 will result in more volatility in its financial statements than in the past. Effective January 1, 2000, the Company adopted Staff Accounting Bulletin 101 (SAB 101) issued by the Securities and Exchange Commission in December 1999. As a result of adopting SAB 101, the Company changed the way it recognizes revenue from the sale of flight segment credits to companies participating in its Rapid Rewards frequent flyer program. Prior to the issuance of SAB 101, the Company recorded revenue to "Other revenue" when flight segment credits were sold, consistent with most other major airlines. Beginning January 1, 2000, the Company recognizes "Passenger revenue" when free travel awards resulting from the flight segment credits sold are earned and flown or credits expire unused. Due to this change, the Company recorded a cumulative adjustment in first quarter 2000 of $22.1 million (net of income taxes of $14.0 million) or $.03 per share, basic and diluted. 7. Comprehensive income - Comprehensive income includes changes in the fair value of certain financial derivative instruments, which qualify for hedge accounting, and unrealized gains and losses on certain investments. For the three and six months ended June 30, 2001, comprehensive income totaled $171.8 million and $328.6 million, respectively. The difference between net income and comprehensive income for the three and six months ended June 30, 2001 is as follows (in thousands): Three months ended Six months ended June 30, 2001 June 30, 2001 Net income $175,633 $296,678 Unrealized gain (loss) on derivative instruments, net of deferred taxes of ($2,556) and $21,020 (3,956) 32,538 Other, net of deferred taxes of $50 and ($402) 77 (622) Total other comprehensive income (3,879) 31,916 Comprehensive income $171,754 $328,594 As of June 30, 2001, the Company had approximately $32.5 million in unrealized gains, net of tax, in accumulated other comprehensive income related to fuel hedges, of which approximately $30.0 million is expected to be realized in earnings over the next twelve months following June 30, 2001. Upon the adoption of SFAS 133 on January 1, 2001, the Company recorded unrealized fuel hedge gains of $46.1 million, net of tax, of which approximately $45.1 million is expected to be realized in earnings over the twelve months following January 1, 2001. A rollforward of the amounts included in Accumulated other comprehensive income, net of taxes, is shown below (in thousands): Accumulated Fuel other hedge comprehensive derivatives Other income Balance at December 31, 2000 - - - January 1, 2001 transition adjustment $ 46,089 - $ 46,089 First half 2001 changes in value 13,565 ($622) 12,943 Reclassification to earnings (27,116) - (27,116) Balance at June 30, 2001 $ 32,538 ($622) $ 31,916 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition Comparative Consolidated Operating Statistics Relevant operating statistics for the three and six months ended June 30, 2001 and 2000 follow: SOUTHWEST AIRLINES CO. COMPARATIVE CONSOLIDATED OPERATING STATISTICS Three months ended June 30, Six months ended June 30, 2001 2000 Change 2001 2000 Change Revenue passengers carried 17,526,753 16,501,441 6.2% 33,242,773 30,890,717 7.6% Revenue passenger miles (RPMs) (000s) 11,788,386 10,954,767 7.6% 22,450,777 20,407,968 10.0% Available seat miles (ASMs) (000s) 16,443,810 14,744,769 11.5% 32,296,808 28,898,727 11.8% Load factor 71.7% 74.3% (2.6)pts. 69.5% 70.6% (1.1)pts. Average length of passenger haul 673 664 1.4% 675 661 2.1% Trips flown 238,397 223,643 6.6% 470,190 442,258 6.3% Average passenger fare $85.89 $85.81 0.1% $86.83 $84.68 2.5% Passenger revenue yield per RPM (cents) 12.77 12.93 (1.2)% 12.86 12.82 0.3% Operating revenue yield per ASM (cents) 9.45 9.91 (4.6)% 9.23 9.35 (1.3)% Operating expenses per ASM (cents) 7.68 7.77 (1.2)% 7.68 7.73 (0.6)% Operating expenses per ASM, excluding fuel (cents) 6.42 6.43 (0.2)% 6.39 6.36 0.5% Fuel costs per gallon, excluding fuel tax (cents) 74.96 78.02 (3.9)% 76.71 79.95 (4.1)% Number of Employees at period-end 30,369 27,828 9.1% 30,369 27,828 9.1% Size of fleet at period-end 356 324 9.9% 356 324 9.9% Operating expenses per ASM for the three and six months ended June 30, 2001 and 2000 are as follows (in cents except percent change): Three months ended June 30, Six months ended June 30, Percent Percent 2001 2000 Change 2001 2000 Change Salaries, wages, and benefits 2.46 2.38 3.4 2.48 2.39 3.8 Employee retirement plans .42 .48 (12.5) .37 .38 (2.6) Fuel and oil 1.27 1.34 (5.2) 1.29 1.37 (5.8) Maintenance materials and repairs .63 .61 3.3 .62 .64 (3.1) Agency commissions .18 .28 (35.7) .19 .27 (29.6) Aircraft rentals .29 .33 (12.1) .30 .34 (11.8) Landing fees and other rentals .47 .44 6.8 .46 .45 2.2 Depreciation .48 .46 4.3 .48 .47 2.1 Other operating expenses 1.48 1.45 2.1 1.49 1.42 4.9 Total 7.68 7.77 (1.2) 7.68 7.73 (.6) Material Changes in Results of Operations Comparison of Three Months Ended June 30, 2001 to Three Months Ended June 30, 2000 Consolidated net income for second quarter 2001 was $175.6 million ($.22 per share, diluted), as compared to second quarter 2000 net income of $190.6 million ($.24 per share, diluted), a decrease of 7.9 percent. The prior year's net income per share amounts have been restated for the 2001 three-for-two stock split (see Note 3 to the unaudited Condensed Consolidated Financial Statements). Operating income for second quarter 2001 was $290.9 million, a decrease of 7.5 percent compared to 2000. Consolidated operating revenues increased 6.4 percent primarily due to a 6.3 percent increase in passenger revenues. The increase in passenger revenues primarily resulted from the Company's increased capacity, as available seat miles (ASMs) increased 11.5 percent. The increase in ASMs resulted primarily from the net addition of 32 aircraft since second quarter 2000, which represents a 9.9 percent increase in the Company's fleet size. The increase in ASMs was partially offset by a decrease in the Company's load factor of 2.6 points to 71.7 percent. The Company experienced a 6.2 percent increase in revenue passengers carried, a 7.6 percent increase in RPMs, and a 1.2 percent decrease in passenger revenue yield per RPM (passenger yield). The decrease in passenger yield is primarily due to a 1.4 percent increase in average length of passenger haul, while the average passenger fare remained basically flat. Based on current traffic, booking, and revenue trends thus far in July, the Company's third quarter 2001 unit revenues are expected to be below those of third quarter 2000. The third quarter 2001 load factor is currently expected to be strong relative to historical levels, but has been stimulated by successful discount and promotional programs. As a result, the Company also expects earnings to be below the third quarter 2000 level. (The immediately preceding sentences are forward-looking statements that involve uncertainties that could result in actual results differing materially from expected results. Some significant factors include, but may not be limited to, competitive pressure such as fare sales and capacity changes by other carriers, general economic conditions, and variations in advance booking trends.) Consolidated freight revenues decreased 11.1 percent primarily due to the current economic and industry environment. There were decreases in both the number of freight shipments and revenue per shipment. Other revenues increased 40.8 percent. Approximately 51.4 percent of the increase in other revenues was from an increase in commissions earned from programs the Company sponsors with certain business partners, such as the Company sponsored First USA Visa card, while 25.4 percent of the increase was due to an increase in charter revenues. Operating expenses per ASM were $.0768, compared to $.0777 for 2000. Excluding fuel expense, operating expenses per ASM decreased .2 percent to $.0642. The Company currently expects that, excluding fuel, operating expenses per ASM in third quarter 2001 will be slightly lower than last year's third quarter performance. (The immediately preceding sentence is a forward-looking statement which involves uncertainties that could result in actual results differing materially from expected results. Some significant factors include, but may not be limited to, wage and productivity pressures from within the Company's work force and general economic conditions). Salaries, wages, and benefits per ASM increased 3.4 percent. The increase was primarily due to an increase in benefits costs, primarily health care and workers' compensation. Employee retirement plans expense per ASM decreased 12.5 percent, primarily due to the decrease in Company earnings available for profitsharing. Fuel and oil expense per ASM decreased 5.2 percent due to a 3.9 percent decrease in the average jet fuel cost per gallon compared to 2000. The average jet fuel cost per gallon in second quarter 2001 was $.7496 compared to $.7802 in second quarter 2000, including the effects of hedging activities. The Company's second quarter 2001 average jet fuel cost is net of approximately $20.4 million in "effective" hedging gains, as defined. See Note 6 to the Condensed Consolidated Financial Statements. The Company's second quarter 2000 average jet fuel cost is net of approximately $3.1 million in gains from hedging activities. As of June 30, 2001, the Company had hedges in place for approximately 80 percent of its anticipated jet fuel requirements for the remainder of 2001 at prices below market prices as of June 30, 2001. Including estimated hedging gains and considering current market prices and the continued effectiveness of the Company's fuel hedges, we are forecasting our third quarter 2001 average fuel price per gallon to be below second quarter 2001's average fuel cost per gallon of $.7496. The Company's fuel hedging strategy could result in the Company not fully benefiting from certain jet fuel price declines. (The immediately preceding two sentences are forward-looking statements, which involve uncertainties that could result in actual results differing materially from expected results. Such uncertainties include, but may not be limited to, the largely unpredictable levels of jet fuel prices and the continued effectiveness of the Company's fuel hedges.) Maintenance materials and repairs per ASM increased 3.3 percent. An increase in airframe inspection and repairs expense per ASM was partially offset by a slight decrease in engine repair expense per ASM. The increase in airframe inspection and repairs was primarily a result of more of these repairs being outsourced than in the prior year due to a larger amount of this type of work than the Company could perform with internal headcount and facilities. The decrease in engine repair expense per ASM was primarily due to the Company's capacity growth exceeding the increase in expense. Virtually all the Company's second quarter capacity growth was accomplished with new aircraft, most of which have not yet begun to incur any meaningful engine repair costs. The Company expects third quarter 2001 maintenance materials and repairs per ASM to approximate third quarter 2000 expense. (The immediately preceding sentence is a forward-looking statement involving uncertainties that could result in actual results differing materially from expected results. Such uncertainties include, but may not be limited to, any unscheduled required aircraft airframe or engine repairs and regulatory requirements.) Agency commissions per ASM decreased 35.7 percent, primarily due to a change in the Company's commission rate policy effective January 1, 2001. The Company reduced the commission rate paid to travel agents from ten percent to eight percent for Ticketless bookings, and from ten percent to five percent for paper ticket bookings. The percentage of commissionable revenues decreased from approximately 28 percent in second quarter 2000 to approximately 26 percent in second quarter 2001. Due to the Company's commission policy change in 2001, we expect agency commissions to continue to show year-over-year decreases throughout 2001 on a per-ASM basis. (The immediately preceding sentence is a forward- looking statement involving uncertainties that could result in actual results differing materially from expected results. Such uncertainties include, but may not be limited to, changes in consumer ticket purchasing habits.) Aircraft rentals per ASM decreased 12.1 percent compared to second quarter 2000 due to a lower percentage of the aircraft fleet being leased. Approximately 26.4 percent of the Company's aircraft fleet was under operating lease at June 30, 2001, compared to 29.3 percent at June 30, 2000. Based on the Company's current new aircraft delivery schedule and scheduled aircraft retirements for 2001, we expect to continue to have year-over-year decreases throughout 2001 for aircraft rentals expense on a per-ASM basis. (The immediately preceding sentence is a forward-looking statement involving uncertainties that could result in actual results differing materially from expected results. Such uncertainties include, but may not be limited to, changes in the Company's current schedule for purchase and/or retirement of aircraft.) Landing fees and other rentals per ASM increased 6.8 percent primarily as a result of an increase in other rentals. This increase is primarily due to the Company's expansion of facilities in several airports. Depreciation expense per ASM increased 4.3 percent primarily due to a higher percentage of owned aircraft. All of the 33 aircraft added to the Company's fleet over the past twelve months have been purchased. This, combined with the retirement of one leased aircraft, has increased the Company's percentage of aircraft owned or on capital lease from 70.7 percent at June 30, 2000 to 73.6 percent at June 30, 2001. Other operating expenses per ASM increased 2.1 percent primarily from small increases in several areas, including system development projects, insurance costs, and employee-related costs such as relocation, travel, and non-essential training that had been previously deferred as part of a prior year cost reduction effort. Other expenses (income) include interest expense, capitalized interest, interest income, and other gains and losses. Interest expense decreased 5.6 percent primarily due to a reduction in interest rates on the Company's floating rate debt. Capitalized interest decreased 18.3 percent primarily due to a reduction in progress payment balances for future aircraft deliveries. Interest income decreased 2.6 percent as higher invested cash balances were more than offset by a decrease in rates earned on investments. Other losses in second quarter 2001 resulted primarily from the reduction in the time value portion of financial derivative instruments, such as premiums paid for option contracts, used in the Company's fuel hedging program. See Note 6 to the Condensed Consolidated Financial Statements. Other losses in second quarter 2000 were primarily due to a write-down associated with a discontinued project. Comparison of Six Months Ended June 30, 2001 to Six Months Ended June 30, 2000 Consolidated net income for the six months ended June 30, 2001 was $296.7 million ($.37 per share, diluted), as compared to 2000 net income, before the cumulative effect of change in accounting principle, of $286.3 million ($.36 per share, diluted), an increase of 3.6 percent. The prior year's net income per share amounts have been restated for the 2001 three- for-two stock split (see Note 3 to the unaudited Condensed Consolidated Financial Statements). The cumulative effect of change in accounting principle for the six months ended June 30, 2000 was $22.1 million, net of taxes of $14.0 million (see Note 6 to the unaudited Condensed Consolidated Financial Statements). Net income and diluted net income per share, after the cumulative change in accounting principle, for the six months ended June 30, 2000 were $264.1 million and $.33, respectively. Operating income for the six months ended June 30, 2001 was $501.0 million, an increase of 6.6 percent compared to 2000. Consolidated operating revenues increased 10.3 percent primarily due to a 10.4 percent increase in passenger revenues. The increase in passenger revenues primarily resulted from the Company's increased capacity. The Company experienced a 7.6 percent increase in revenue passengers carried, a 10.0 percent increase in RPMs, and a .3 percent increase in passenger revenue yield per RPM (passenger yield). The increase in RPMs coupled with an 11.8 percent increase in ASMs resulting in a load factor of 69.5 percent, or 1.1 points below the same prior year period. The increase in ASMs resulted primarily from the net addition of 32 aircraft since second quarter 2000, which represents a 9.9 percent increase in the Company's fleet size. Consolidated freight revenues decreased 8.0 percent primarily due to the current economic and industry environment. There were decreases in both the number of freight shipments and revenue per shipment. Other revenues increased 39.1 percent. Approximately 51.3 percent of the increase in other revenues was from an increase in commissions earned from programs the Company sponsors with certain business partners, such as the Company sponsored First USA Visa card, while 26.4 percent of the increase was due to an increase in charter revenues. Operating expenses per ASM were $.0768, compared to $.0773 for 2000. Excluding fuel expense, operating expenses per ASM increased .5 percent to $.0639. Salaries, wages, and benefits per ASM increased 3.8 percent. Approximately 57 percent of the increase was due to an escalation in health benefits costs, while approximately 43 percent of the increase was in salaries and wages. Employee retirement plans expense per ASM decreased 2.6 percent, primarily due to the increase in ASMs exceeding the increase in Company earnings available for profitsharing. Fuel and oil expense per ASM decreased 5.8 percent due to a 4.1 percent decrease in the average jet fuel cost per gallon compared to 2000. The average jet fuel cost per gallon for the six months ended June 30, 2001 was $.7671 compared to $.7995 in 2000, including the effects of hedging activities. The Company's 2001 average jet fuel cost is net of approximately $44.8 million in "effective" hedging gains, as defined. See Note 6 to the Condensed Consolidated Financial Statements. The Company's 2000 average jet fuel cost is net of approximately $6.3 million in gains from hedging activities. Maintenance materials and repairs per ASM decreased 3.1 percent. A decrease in engine repair expense per ASM was partially offset by an increase in airframe inspection and repairs expense per ASM. The decrease in engine repair expense per ASM was primarily due to the Company's capacity growth exceeding the increase in expense. Virtually all the Company's 2001 capacity growth was accomplished with new aircraft, most of which have not yet begun to incur any meaningful engine repair costs. The increase in airframe inspection and repairs was primarily a result of more of these repairs being outsourced than in the prior year due to a larger amount of this type of work than the Company could perform with internal headcount and facilities. Agency commissions per ASM decreased 29.6 percent, primarily due to a change in the Company's commission rate policy effective January 1, 2001. The Company reduced the commission rate paid to travel agents from ten percent to eight percent for Ticketless bookings, and from ten percent to five percent for paper ticket bookings. The percentage of commissionable revenues decreased from approximately 29 percent in 2000 to approximately 27 percent in 2001. Aircraft rentals per ASM decreased 11.8 percent due to a lower percentage of the aircraft fleet being leased. Landing fees and other rentals per ASM increased 2.2 percent primarily as a result of an increase in other rentals. This increase is primarily due to the Company's expansion of facilities in several airports. Depreciation expense per ASM increased 2.1 percent primarily due to a higher percentage of the aircraft fleet being owned. Other operating expenses per ASM increased 4.9 percent primarily from small increases in several areas that had previously been deferred as part of a prior year cost reduction effort. Other expenses (income) include interest expense, capitalized interest, interest income, and other gains and losses. Interest expense decreased 3.4 percent primarily due to a reduction in interest rates on the Company's floating rate debt. Capitalized interest decreased 14.9 percent primarily due to a reduction in progress payment balances for future aircraft deliveries. Interest income increased 11.4 percent primarily due to an increase in invested cash balances. Other losses in 2001 resulted primarily from the reduction in the time value portion of financial derivative instruments, such as premiums paid for option contracts, used in the Company's fuel hedging program. See Note 6 to the Condensed Consolidated Financial Statements. Liquidity and Capital Resources Net cash provided by operating activities was $904.8 million for the six months ended June 30, 2001 and $1,391.6 million for the 12 months then ended. Cash generated for the 12 months ended June 30, 2001 was primarily used to finance aircraft-related capital expenditures and provide working capital. During the 12 months ended June 30, 2001, net capital expenditures were $1,099.4 million, which primarily related to the purchase of 33 new 737-700 aircraft, and progress payments for future aircraft deliveries. The Company's contractual commitments consist primarily of scheduled aircraft acquisitions. As of June 30, 2001, 13 737-700s are scheduled for delivery in the remainder of 2001, 27 in 2002, 13 in 2003, 29 in 2004, five in 2005, and 47 thereafter. In addition, the Company has options to purchase up to 87 737-700s during 2003-2008 and purchase rights for an additional 217 737-700s during 2007-2012. The Company has the option, which must be exercised two years prior to the contractual delivery date, to substitute 737-600s or 737-800s for the 737-700s scheduled subsequent to 2002. Aggregate funding needed for fixed commitments at June 30, 2001 was approximately $3,675 million due as follows: $348 million in 2001; $766 million in 2002; $472 million in 2003; $641 million in 2004; $379 million in 2005; and $1,069 million thereafter. The Company has various options available to meet its capital and operating commitments, including cash on hand at June 30, 2001 of $968.3 million, internally generated funds, and a revolving credit line with a group of banks of up to $475 million (none of which had been drawn at June 30, 2001). 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 $318.8 million in public debt securities, which it may utilize for aircraft financing during 2001 and 2002. In July 2001, the Company redeemed $100 million of senior unsecured 9.4% Notes originally issued in 1991. The Company recently announced new service to Norfolk International Airport in Norfolk, Virginia. Service will begin on October 7, 2001, with daily nonstop flights from Baltimore/Washington, Jacksonville, Las Vegas, and Orlando, plus direct or connecting service from 32 other cities. Item 3. Quantitative and Qualitative Disclosures About Market Risk See Item 7A. Quantitative and Qualitative Disclosures About Market Risk in the Company's Annual Report on Form 10-K for the year ended December 31, 2000 and Note 6 to the Condensed Consolidated Financial Statements. PART II. OTHER INFORMATION Item 1. Legal Proceedings The Company received a statutory notice of deficiency from the Internal Revenue Service (IRS) in July 1995 in which the IRS proposed to disallow deductions claimed by the Company on its federal income tax returns for the taxable years 1989 through 1991 for the costs of certain aircraft inspection and maintenance procedures. In response to the statutory notice of deficiency, the Company filed a petition in the United States Tax Court on October 30, 1997, seeking a determination that the IRS erred in disallowing the deductions claimed by the Company and there is no deficiency in the Company's tax liability for the taxable years in issue. On December 21, 2000, the national office of the IRS published a revenue ruling in which it concluded that aircraft inspection and maintenance is currently deductible as an ordinary and necessary business expense. In accordance with the revenue ruling, the IRS conceded the proposed adjustments to the deductions claimed by the Company for aircraft inspection and maintenance expense, and on June 1, 2001, a decision was entered by the Tax Court holding that there is no deficiency in income tax for the taxable years 1989 through 1991. The IRS similarly proposed to disallow deductions claimed by the Company on its federal income tax returns for the taxable years 1992 through 1994 for the costs of certain aircraft inspection and maintenance expenses. Although the examination of such returns has not been finally concluded, the IRS has advised the Company that it will concede the proposed adjustments to the deductions claimed for these aircraft inspection and maintenance expenses. Management believes the final resolution of this controversy will not have a material adverse effect upon the financial position or results of operations of the Company. Item 2. Changes in Securities and Use of Proceeds Recent Sales of Unregistered Securities None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders The Company's Annual Meeting of Shareholders was held in Dallas, Texas on Wednesday, May 16, 2001. The following matters were voted on at the meeting: (i) The following nominees were elected to the Company's Board of Directors to hold office for a term expiring in 2004: C. Webb Crockett: 612,072,046 shares voted for and 49,410,553 shares withheld; William P. Hobby: 612,356,815 shares voted for and 49,125,784 shares withheld; Travis C. Johnson: 614,151,994 shares voted for and 47,330,605 shares withheld. There were no broker non-votes on this matter. (ii) A Company proposal to amend the Company's Articles of Incorporation to increase the number of authorized shares was considered. A total of 610,752,557 shares were voted for the proposal, 48,303,507 shares were voted against the proposal and 2,426,535 shares abstained from voting. There were no broker non-votes on this matter. (iii) A Company proposal to approve an officer's stock option agreements was considered. A total of 534,355,956 shares were voted for the proposal, 122,778,161 shares were voted against the proposal and 4,348,482 shares abstained from voting. There were no broker non-votes on this matter. (iv) A Company proposal to amend the Company's Employee Stock Purchase Plan was considered. A total of 647,745,993 shares were voted for the proposal, 10,949,100 shares were voted against the proposal and 2,787,506 shares abstained from voting. There were no broker non-votes on this matter. (v) A shareholder proposal related to shareholder right to vote on the Company's shareholder rights plan was considered. A total of 371,239,730 shares were voted for the proposal, 205,702,143 shares were voted against the proposal and 7,026,161 shares abstained from voting. There were 77,514,565 broker non-votes on this matter. (vi) A shareholder proposal related to annual election of directors was considered. A total of 332,806,499 shares were voted for the proposal, 245,084,706 shares were voted against the proposal and 6,076,829 shares abstained from voting. There were 77,514,565 broker non-votes on this matter. Item 5. Other Information Effective June 19, 2001, Herbert D. Kelleher relinquished his duties as President and Chief Executive Officer. In addition, Mr. Kelleher, 70, signed a new three-year employment contract to remain as Chairman of the Board. Mr. Kelleher will continue his responsibilities for the consideration and effectuation of board policies; longer range strategic planning; Governmental Affairs; and from a marketing standpoint, Schedule Planning. Jim Parker, formerly Vice President-General Counsel, moved into Mr. Kelleher's position as Chief Executive Officer with the additional title of Vice Chairman. The President and Chief Operating Officer, the Vice President-Revenue Management, and the Executive Vice President-Chief Financial Officer (as to Finance and Fuel) will report to Mr. Parker, 54, in his new duties. Colleen Barrett, formerly Executive Vice President-Customers and Corporate Secretary, moved into Mr. Kelleher's position as President with the additional title of Chief Operating Officer and maintaining her title as Corporate Secretary. The Executive Vice President- Customers, Executive Vice President-Operations, and Executive Vice President-Chief Financial Officer (as to Systems, Purchasing, and Technical Services) will report to Ms. Barrett, 56, in her new duties. Gary Kelly, formerly Vice President-Finance and Chief Financial Officer became Executive Vice President-Chief Financial Officer, replacing John Denison, who previously announced his retirement. Mr. Kelly, 46, has primary responsibilities for Finance, Fuel, Systems, Purchasing, and Technical Services Departments. Donna Conover, formerly Vice President-Inflight and Provisioning, became Executive Vice President-Customers. Ms. Conover, 48, has primary responsibilities for the People, Customer Relations and Rapid Rewards, Reservations, and Inflight and Provisioning Departments. Jim Wimberly, Executive Vice President-Chief of Operations, 48, has added supervisory responsibility for the Properties and Facilities Department, in addition to his previous responsibilities for the Maintenance, Ground Operations, Flight Operations, and Schedule Planning (as to operational aspects) Departments. Item 6. Exhibits and Reports on Form 8-K a) Exhibits (3.1) Articles of Amendment to the Articles of Incorporation of Southwest dated as of May 21, 2001 (3.2) Bylaws of Southwest, as amended through May 2001 b) Reports on Form 8-K None SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SOUTHWEST AIRLINES CO. August 1, 2001 By /s/ Gary C. Kelly Gary C. Kelly Executive Vice President - Chief Financial Officer (Principal Financial and Accounting Officer)