LUV-9.30.2013-10Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2013
 
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to ________
Commission File No. 1-7259
 
 
Southwest Airlines Co.
(Exact name of registrant as specified in its charter)
TEXAS
74-1563240
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
P.O. Box 36611
 
Dallas, Texas
75235-1611
(Address of principal executive offices)
(Zip Code)
Registrant's telephone number, including area code:  (214) 792-4000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ  No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ
Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes ¨ No þ

Number of shares of Common Stock outstanding as of the close of business on October 28, 2013: 696,720,541



TABLE OF CONTENTS TO FORM 10-Q

PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheet as of September 30, 2013 and December 31, 2012
Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2013 and 2012
Condensed Consolidated Statement of Cash Flows for the three and nine months ended September 30, 2013 and 2012
Notes to Condensed Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
SIGNATURES
EXHIBIT INDEX




2


SOUTHWEST AIRLINES CO.
FORM 10-Q
PART I – FINANCIAL INFORMATION

Item 1. Financial Statements
Southwest Airlines Co.
Condensed Consolidated Balance Sheet
(in millions)
(unaudited)
 
September 30, 2013
 
December 31, 2012
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,333

 
$
1,113

Short-term investments
1,995

 
1,857

Accounts and other receivables
463

 
332

Inventories of parts and supplies, at cost
521

 
469

Deferred income taxes
233

 
246

Prepaid expenses and other current assets
228

 
210

Total current assets
4,773

 
4,227

 
 
 
 
Property and equipment, at cost:
 

 
 

Flight equipment
16,785

 
16,367

Ground property and equipment
2,963

 
2,714

Deposits on flight equipment purchase contracts
690

 
416

 
20,438

 
19,497

Less allowance for depreciation and amortization
7,235

 
6,731

 
13,203

 
12,766

Goodwill
970

 
970

Other assets
418

 
633

 
$
19,364

 
$
18,596

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
1,134

 
$
1,107

Accrued liabilities
1,172

 
1,102

Air traffic liability
2,981

 
2,170

Current maturities of long-term debt
259

 
271

Total current liabilities
5,546

 
4,650

 
 
 
 
Long-term debt less current maturities
2,616

 
2,883

Deferred income taxes
2,937

 
2,884

Deferred gains from sale and leaseback of aircraft
54

 
63

Other noncurrent liabilities
1,198

 
1,124

Stockholders' equity:
 

 
 

Common stock
808

 
808

Capital in excess of par value
1,205

 
1,210

Retained earnings
6,246

 
5,768

Accumulated other comprehensive loss
(114
)
 
(119
)
Treasury stock, at cost
(1,132
)
 
(675
)
Total stockholders' equity
7,013

 
6,992

 
$
19,364

 
$
18,596


See accompanying notes.

3


Southwest Airlines Co.
Condensed Consolidated Statement of Comprehensive Income
(in millions, except per share amounts)
(unaudited)

 
Three months ended September 30,
 
Nine months ended September 30,
 
2013
 
2012
 
2013
 
2012
OPERATING REVENUES:
 
 
 
 
 
 
 
Passenger
$
4,306

 
$
4,057

 
$
12,524

 
$
12,154

Freight
41

 
39

 
123

 
118

Other
198

 
213

 
624

 
643

Total operating revenues
4,545

 
4,309

 
13,271

 
12,915

 
 
 
 
 
 
 
 
OPERATING EXPENSES:
 

 
 

 
 

 
 

Salaries, wages, and benefits
1,271

 
1,189

 
3,751

 
3,552

Fuel and oil
1,450

 
1,528

 
4,396

 
4,615

Maintenance materials and repairs
271

 
300

 
842

 
862

Aircraft rentals
92

 
92

 
277

 
270

Landing fees and other rentals
290

 
278

 
848

 
791

Depreciation and amortization
221

 
217

 
643

 
620

Acquisition and integration
28

 
145

 
66

 
168

Other operating expenses
532

 
509

 
1,555

 
1,505

Total operating expenses
4,155

 
4,258

 
12,378

 
12,383

 
 
 
 
 
 
 
 
OPERATING INCOME
390

 
51

 
893

 
532

 
 
 
 
 
 
 
 
OTHER EXPENSES (INCOME):
 

 
 

 
 

 
 

Interest expense
35

 
35

 
97

 
112

Capitalized interest
(4
)
 
(5
)
 
(17
)
 
(16
)
Interest income
(1
)
 
(2
)
 
(5
)
 
(5
)
Other (gains) losses, net
(59
)
 
(10
)
 
(58
)
 
(119
)
Total other expenses (income)
(29
)
 
18

 
17

 
(28
)
 
 
 
 
 
 
 
 
INCOME BEFORE INCOME TAXES
419

 
33

 
876

 
560

PROVISION FOR INCOME TAXES
160

 
17

 
334

 
217

 
 
 
 
 
 
 
 
NET INCOME
$
259

 
$
16

 
$
542

 
$
343

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, BASIC
$
0.37

 
$
0.02

 
$
0.76

 
$
0.45

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, DILUTED
$
0.37

 
$
0.02

 
$
0.75

 
$
0.45

 
 
 
 
 
 
 
 
COMPREHENSIVE INCOME
$
393

 
$
211

 
$
547

 
$
442

 
 
 
 
 
 
 
 
WEIGHTED AVERAGE SHARES OUTSTANDING
 

 
 

 
 

 
 

Basic
703

 
739

 
714

 
756

Diluted
711

 
740

 
722

 
762

 
 
 
 
 
 
 
 
Cash dividends declared per common share
$
.0400

 
$
.0100

 
$
.0900

 
$
.0245


See accompanying notes.

4


Southwest Airlines Co.
Condensed Consolidated Statement of Cash Flows
(in millions)
(unaudited)
 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
 
 
 
Net income
$
259

 
$
16

 
$
542

 
$
343

Adjustments to reconcile net income to cash provided by (used in) operating activities:
 

 
 

 
 

 
 

Depreciation and amortization
221

 
217

 
643

 
620

Unrealized gains on fuel derivative instruments
(58
)
 
(16
)
 
(24
)
 
(154
)
Deferred income taxes
29

 
82

 
52

 
120

Amortization of deferred gains on sale and leaseback of aircraft
(3
)
 
(3
)
 
(9
)
 
(9
)
Changes in certain assets and liabilities:
 

 
 

 
 

 
 

Accounts and other receivables
73

 
(2
)
 
(74
)
 
(107
)
Other assets
(63
)
 
(74
)
 
(83
)
 
(164
)
Accounts payable and accrued liabilities
(98
)
 
(187
)
 
185

 
114

Air traffic liability
(95
)
 
(5
)
 
811

 
688

Cash collateral paid to derivative counterparties
80

 
252

 
56

 
218

Other, net
83

 
184

 
89

 
164

Net cash provided by operating activities
428

 
464

 
2,188

 
1,833

 
 
 
 
 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 

 
 

 
 

 
 

Payments for purchase of property and equipment, net
(268
)
 
(406
)
 
(995
)
 
(949
)
Purchases of short-term investments
(896
)
 
(663
)
 
(2,520
)
 
(1,918
)
Proceeds from sales of short-term and other investments
805

 
798

 
2,385

 
2,223

Other, net
—

 
(6
)
 
—

 
—

Net cash used in investing activities
(359
)
 
(277
)
 
(1,130
)
 
(644
)
 
 
 
 
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 

 
 

 
 

 
 

Proceeds from Employee stock plans
12

 
5

 
31

 
22

Payments of long-term debt and capital lease obligations
(51
)
 
(48
)
 
(267
)
 
(517
)
Payments of cash dividends
(28
)
 
(7
)
 
(71
)
 
(22
)
Repurchase of common stock
(150
)
 
(50
)
 
(501
)
 
(325
)
Other, net
(8
)
 
(2
)
 
(30
)
 
(8
)
Net cash used in financing activities
(225
)
 
(102
)
 
(838
)
 
(850
)
 
 
 
 
 
 
 
 
NET CHANGE IN CASH AND CASH EQUIVALENTS
(156
)
 
85

 
220

 
339

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
1,489

 
1,083

 
1,113

 
829

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
1,333

 
$
1,168

 
$
1,333

 
$
1,168

 
 
 
 
 
 
 
 
CASH PAYMENTS FOR:
 
 
 
 
 
 
 
Interest, net of amount capitalized
$
39

 
$
39

 
$
106

 
$
119

Income taxes
$
124

 
$
2

 
$
147

 
$
97


See accompanying notes.

5


Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)

1.    BASIS OF PRESENTATION

The accompanying unaudited Condensed Consolidated Financial Statements of Southwest Airlines Co. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles ("GAAP") in the United States for complete financial statements. The unaudited Condensed Consolidated Financial Statements for the interim periods ended September 30, 2013 and 2012 include all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. This includes all normal and recurring adjustments and elimination of significant intercompany transactions. Financial results for the Company and airlines in general can be seasonal in nature. In many years, the Company's revenues, as well as its operating income and net income, have been better in its second and third fiscal quarters than in its first and fourth fiscal quarters. Air travel is also significantly impacted by general economic conditions, the amount of disposable income available to consumers, unemployment levels, and corporate travel budgets. These and other factors, such as the price of jet fuel in some periods, the nature of the Company's fuel hedging program, the periodic volatility of commodities used by the Company for hedging jet fuel, and the requirements related to hedge accounting, have created, and may continue to create, significant volatility in the Company's financial results. See Note 5 for further information on fuel and the Company's hedging program. Operating results for the three and nine months ended September 30, 2013, are not necessarily indicative of the results that may be expected for the year ended December 31, 2013. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in the Southwest Airlines Co. Annual Report on Form 10-K for the year ended December 31, 2012.

Certain prior period amounts have been reclassified to conform to the current presentation. In the unaudited Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2012, the Company has reclassified $11 million and $27 million, respectively, from Other revenues to Passenger revenues associated with its sale of frequent flyer benefits from its co-branded Chase® Visa credit card.

2.    AIRTRAN ACQUISITION AND RELATED MATTERS
 
AirTran Holdings, Inc.
On May 2, 2011 (the “acquisition date”), the Company acquired all of the outstanding equity of AirTran Holdings, Inc. (“AirTran Holdings”), the former parent company of AirTran Airways, Inc. (“AirTran Airways”), in exchange for Southwest Airlines Co. common stock and cash.  Throughout this Form 10-Q, the Company makes reference to AirTran, which is meant to be inclusive of the following: (i) for periods prior to the acquisition date, AirTran Holdings and its subsidiaries, including, among others, AirTran Airways; and (ii) for periods on and after the acquisition date, AirTran Holdings, LLC, the successor to AirTran Holdings, and its subsidiaries, including among others, AirTran Airways.  

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

Expenses related to the AirTran acquisition and integration
The Company has incurred and expects to continue to incur substantial Acquisition and integration expenses in connection with the AirTran acquisition, including the necessary costs associated with integrating the operations of the two companies. While the Company has assumed that a certain level of expenses will be incurred, there are many factors that could affect the total amount or the timing of these expenses, and many of the expenses that will be incurred are, by their nature, difficult to estimate. These expenses could, particularly in the near term, exceed the financial benefits that the Company expects to achieve from the AirTran acquisition and could continue to result in the Company taking significant charges against earnings during the integration process. The Company incurred acquisition and integration-related costs for the three and nine months ended September 30, 2013, of $28 million and $66 million, respectively, primarily consisting of costs associated with a lease contract termination, Employee training, technology

6
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


integration projects, and facility integration expenses. The Company incurred acquisition and integration-related costs for the three and nine months ended September 30, 2012, of $145 million and $168 million, respectively, primarily consisting of costs associated with the lease and sublease of AirTran's Boeing 717-200 fleet, consulting, flight crew training, and seniority integration. In the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income, these costs are classified as Acquisition and integration expenses.  

3.    REVOLVING CREDIT FACILITY

On April 2, 2013, the Company entered into a new $1 billion unsecured revolving credit facility expiring in April 2018, and terminated its previous facility, which would have expired in April 2016. Other than a $200 million increase in borrowing capacity, this new facility is substantially the same as the previous facility. Interest on the facility is based on the Company's credit ratings at the time of borrowing. At the Company's current ratings, the interest cost would be LIBOR plus a spread of 150 basis points. The new facility also contains the same financial covenant as the previous facility, requiring a minimum coverage ratio of adjusted pre-tax income to fixed obligations, as defined. As of September 30, 2013, the Company was in compliance with this covenant and there were no amounts outstanding under the revolving credit facility.

4.    NET INCOME PER SHARE

The following table sets forth the computation of basic and diluted net income per share (in millions except per share amounts):

 
Three months ended September 30,
 
Nine months ended September 30,
 
2013
 
2012
 
2013
 
2012
NUMERATOR:
 
 
 
 
 
 
 
Net income
$
259

 
$
16

 
$
542

 
$
343

Incremental income effect of
  interest on 5.25% convertible notes
1

 
—

 
2

 
2

Net income after assumed conversion
$
260

 
$
16

 
$
544

 
$
345

 
 
 
 
 
 
 
 
DENOMINATOR:
 

 
 

 
 

 
 

Weighted-average shares outstanding, basic
703

 
739

 
714

 
756

Dilutive effect of Employee stock options and
  restricted stock units
2

 
1

 
2

 
—

Dilutive effect of 5.25% convertible notes
6

 
—

 
6

 
6

Adjusted weighted-average shares outstanding, diluted
711

 
740

 
722

 
762

 
 
 
 
 
 
 
 
NET INCOME PER SHARE:
 

 
 

 
 

 
 

Basic
$
0.37

 
$
0.02

 
$
0.76

 
$
0.45

Diluted
$
0.37

 
$
0.02

 
$
0.75

 
$
0.45

 
 
 
 
 
 
 
 
Potentially dilutive amounts excluded from calculations:
 

 
 

 
 

 
 

Stock options and restricted stock units
9

 
32

 
10

 
40

5.25% convertible notes
—

 
6

 
—

 
—


5.    FINANCIAL DERIVATIVE INSTRUMENTS

Fuel contracts

7


Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices.  Furthermore, jet fuel and oil typically represent one of the largest operating expenses for airlines. The Company endeavors to acquire jet fuel at the lowest possible cost and to reduce volatility in operating expenses through its fuel hedging program.  Although the Company may periodically enter into jet fuel derivatives for short-term timeframes, because jet fuel is not widely traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel for time horizons longer than approximately 6 to 12 months into the future.  However, the Company has found that financial derivative instruments in other commodities, such as West Texas Intermediate (“WTI”) crude oil, Brent crude oil, and refined products, such as heating oil and unleaded gasoline, can be useful in decreasing its exposure to jet fuel price volatility.  The Company does not purchase or hold any financial derivative instruments for trading or speculative purposes.

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

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

For the three months ended September 30, 2013, the Company had fuel derivative instruments in place for 78 percent of its fuel consumption.  As of September 30, 2013, the Company had fuel derivative instruments in place to provide coverage for up to 48 percent of its remaining 2013 estimated fuel consumption, depending on where market prices settle during the fourth quarter. The following table provides information about the Company’s volume of fuel hedging for the years 2013 through 2017 on an “economic” basis considering current market prices:

 
 
Fuel hedged as of
 
 
 
 
September 30, 2013
 
Derivative underlying commodity type as of
Period (by year)
 
(gallons in millions)(a)
 
September 30, 2013
Remainder of 2013
 
208

 
Brent crude oil and Gulf Coast jet fuel
2014
 
671

 
WTI crude and Brent crude oil
2015
 
790

 
WTI crude and Brent crude oil
2016
 
977

 
Brent crude oil
2017
 
933

 
WTI crude and Brent crude oil

(a) The Company determines gallons hedged based on market prices and forward curves as of September 30, 2013. Due to the types of derivatives utilized by the Company, these volumes may vary significantly as market prices fluctuate.

Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges.  Generally, utilizing hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective are recorded in Accumulated other comprehensive income (loss) ("AOCI") until the underlying jet fuel is consumed.  See Note 6.  To the extent that the periodic changes in the fair value of the derivatives are ineffective, the ineffective portion is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income.  Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income in the period of the change; however, any amounts previously recorded to AOCI would remain there until such time as the original forecasted transaction occurs, at which time these amounts would be reclassified to Fuel and oil expense.

8



In some situations, an entire commodity type used in hedging may cease to qualify for special hedge accounting treatment. As an example, during third quarter 2013, the Company's routine statistical analysis performed to determine which commodities qualify for special hedge accounting treatment on a prospective basis dictated that WTI crude oil based derivatives no longer qualify for hedge accounting. This is primarily due to the fact that the correlation between WTI crude oil prices and jet fuel prices during recent periods has not been as strong as in the past, and therefore the Company can no longer demonstrate that derivatives based on WTI crude oil prices will result in effective hedges on a prospective basis. As such, the change in fair value of all of the Company's derivatives based in WTI have been recorded to Other (gains) losses for third quarter 2013, and all future changes in the fair value of such instruments will continue to be recorded directly to earnings in future periods. The change in fair value of the Company's WTI derivative contracts during third quarter 2013 was an increase of $28 million, which resulted in a gain in the Condensed Consolidated Statement of Comprehensive Income. Any amounts previously recorded to AOCI will remain there until such time as the original forecasted transaction occurs in accordance with hedge accounting requirements. The Company will continue to evaluate whether it can qualify for hedge accounting for WTI derivative contracts in future periods.

In a situation where it becomes probable that a fuel hedged forecasted transaction will not occur, any gains and/or losses that have been recorded to AOCI would be required to be immediately reclassified into earnings.  The Company did not have any such situations occur during 2012 or during the nine months ended September 30, 2013.

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

 
 
 
 
Asset derivatives
 
Liability derivatives
 
 
Balance Sheet
 
Fair value at
 
Fair value at
 
Fair value at
 
Fair value at
(in millions)
 
location
 
9/30/2013
 
12/31/2012
 
9/30/2013
 
12/31/2012
Derivatives designated as hedges*
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
35

 
$
—

 
$
14

 
$
—

Fuel derivative contracts (gross)
 
Other assets
 
114

 
355

 
2

 
16

Fuel derivative contracts (gross)
 
Other noncurrent liabilities
 
15

 
—

 
—

 
—

Interest rate derivative contracts
 
Other assets
 
22

 
31

 
—

 
—

Interest rate derivative contracts
 
Other noncurrent liabilities
 
—

 
—

 
87

 
126

Total derivatives designated as hedges
 
$
186

 
$
386

 
$
103

 
$
142

Derivatives not designated as hedges*
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
268

 
$
375

 
$
239

 
$
327

Fuel derivative contracts (gross)
 
Other assets
 
64

 
233

 
118

 
351

Fuel derivative contracts (gross)
 
Accrued liabilities
 
2

 
10

 
5

 
60

Fuel derivative contracts (gross)
 
Other noncurrent liabilities
 
4

 
—

 
37

 
—

Total derivatives not designated as hedges
 
 
 
$
338

 
$
618

 
$
399

 
$
738

Total derivatives
 
 
 
$
524

 
$
1,004

 
$
502

 
$
880



9


* Represents the position of each trade before consideration of offsetting positions with each counterparty and does not include the impact of cash collateral deposits provided to or received from counterparties.  See discussion of credit risk and collateral following in this Note.

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

 
 
Balance Sheet
 
September 30,
 
December 31,
(in millions)
 
location
 
2013
 
2012
Cash collateral deposits provided to counterparties for interest
  rate contracts - noncurrent
 
Offset against Other noncurrent liabilities
 
33

 
89

Receivable from third parties for fuel contracts - current
 
Accounts and other receivables
 
43

 
—

Receivable from third parties for fuel contracts - noncurrent
 
Other assets
 
14

 
54

Prepaid settlements for fuel contracts - current
 
Prepaid expenses and other current assets
 
—

 
15

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

The Company's application of its netting policy associated with cash collateral differs depending on whether its derivative instruments are in a net asset position or a net liability position. If its fuel derivative instruments are in a net asset position with a counterparty, cash collateral amounts held are first netted against current outstanding derivative amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of noncurrent outstanding derivative instruments. If the Company's fuel derivative instruments are in a net liability position with the counterparty, cash collateral amounts provided are first netted against noncurrent outstanding derivative amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of current outstanding derivative instruments. At September 30, 2013, and December 31, 2012, no cash collateral deposits, letters of credit, and/or aircraft collateral were provided by or held by the Company associated with its outstanding fuel derivative instruments.

The Company also has agreements with each of its counterparties associated with its outstanding interest rate swap agreements in which cash collateral may be required based on the fair value of outstanding derivative instruments, as well as the Company's and its counterparty's credit ratings. The Company has also elected to present its interest rate swap agreement cash collateral utilizing a net presentation. As of September 30, 2013, $32 million had been provided to one counterparty associated with interest rate derivatives based on the Company's outstanding net liability derivative position with that counterparty. In addition, in connection with interest rate swaps entered into by AirTran, $1 million had been provided to one counterparty at September 30, 2013, as a result of the outstanding net liability derivative position with that counterparty. The outstanding interest rate net derivative positions with all other counterparties at September 30, 2013, were assets to the Company.

The Company has the following recognized financial assets and financial liabilities resulting from those transactions that meet the scope of the disclosure requirements as necessitated by applicable accounting guidance for balance sheet offsetting:

10


Offsetting of derivative assets
 
(in millions)
 
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
 
September 30, 2013
 
December 31, 2012
 
Description
 
Balance Sheet location
 
Gross amounts of recognized assets
 
Gross amounts offset in the Balance Sheet
 
Net amounts of assets presented in the Balance Sheet
 
Gross amounts of recognized assets
 
Gross amounts offset in the Balance Sheet
 
Net amounts of assets presented in the Balance Sheet
 
Fuel derivative contracts
 
Prepaid expenses and other current assets
 
$
303

 
$
(253
)
 
$
50

(a)
$
375

 
$
(327
)
 
$
48

(a)
Fuel derivative contracts
 
Other assets
 
$
178

 
$
(120
)
 
$
58

 
$
588

 
$
(367
)
 
$
221

 
Fuel derivative contracts
 
Accrued liabilities
 
$
2

 
$
(2
)
 
$
—

 
$
10

 
$
(10
)
 
$
—

 
Fuel derivative contracts
 
Other noncurrent liabilities
 
$
19

 
$
(19
)
 
$
—

 
$
—

 
$
—

 
$
—

 
Interest rate derivative contracts
 
Other assets
 
$
22

 
$
—

 
$
22

 
$
31

 
$
—

 
$
31

 
(a) Amounts included in Prepaid expenses and other current assets.
Offsetting of derivative liabilities
(in millions)
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
September 30, 2013
 
December 31, 2012
Description
 
Balance Sheet location
 
Gross amounts of recognized liabilities
 
Gross amounts offset in the Balance Sheet
 
Net amounts of liabilities presented in the Balance Sheet
 
Gross amounts of recognized liabilities
 
Gross amounts offset in the Balance Sheet
 
Net amounts of liabilities presented in the Balance Sheet
Fuel derivative contracts
 
Prepaid expenses and other current assets
 
$
253

 
$
(253
)
 
$
—

 
$
327

 
$
(327
)
 
$
—

Fuel derivative contracts
 
Other assets
 
$
120

 
$
(120
)
 
$
—

 
$
367

 
$
(367
)
 
$
—

Fuel derivative contracts
 
Accrued liabilities
 
$
5

 
$
(2
)
 
$
3

 
$
60

 
$
(10
)
 
$
50

Fuel derivative contracts
 
Other noncurrent liabilities
 
$
37

 
$
(19
)
 
$
18

 
$
—

 
$
—

 
$
—

Interest rate derivative contracts
 
Other noncurrent liabilities
 
$
87

 
$
(33
)
 
$
54

 
$
126

 
$
(89
)
 
$
37


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

The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2013 and 2012:


11


Derivatives in cash flow hedging relationships
 
(Gain) loss recognized in AOCI on derivatives (effective portion)
 
(Gain) loss reclassified from AOCI into income (effective portion)(a)
 
(Gain) loss recognized in income on derivatives (ineffective portion)(b)
 
Three months ended
 
Three months ended
 
Three months ended
 
September 30,
 
September 30,
 
September 30,
(in millions)
2013
 
2012
 
2013
 
2012
 
2013
 
2012
Fuel derivative contracts
$
(105
)
*
$
(167
)
*
$
24

*
$
25

*
$
15

 
$
4

Interest rate derivatives
2

*
7

*
4

*
4

*
—

 
—

Total
$
(103
)
 
$
(160
)
 
$
28

 
$
29

 
$
15

 
$
4

*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives are included in Fuel and oil and Interest expense, respectively.
(b) Amounts are included in Other (gains) losses, net.

Derivatives in cash flow hedging relationships
 
(Gain) loss recognized in AOCI on derivatives (effective portion)
 
(Gain) loss reclassified from AOCI into income (effective portion)(a)
 
(Gain) loss recognized in income on derivatives (ineffective portion)(b)
 
Nine months ended
 
Nine months ended
 
Nine months ended
 
September 30,
 
September 30,
 
September 30,
(in millions)
2013
 
2012
 
2013
 
2012
 
2013
 
2012
Fuel derivative contracts
$
113

*
$
(24
)
*
$
88

*
$
76

*
$
27

 
$
44

Interest rate derivatives
(12
)
*
18

*
14

*
13

*
(1
)
 
—

Total
$
101

 
$
(6
)
 
$
102

 
$
89

 
$
26

 
$
44

*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives are included in Fuel and oil and Interest expense, respectively.
(b) Amounts are included in Other (gains) losses, net.

Derivatives not in cash flow hedging relationships
 
(Gain) loss
 
 
 
recognized in income on
 
 
 
derivatives
 
 
 
Three months ended
 
Location of (gain) loss
 
September 30,
 
recognized in income
(in millions)
2013
 
2012
 
on derivatives
Fuel derivative contracts
$
(93
)
 
$
(32
)
 
Other (gains) losses, net


12


Derivatives not in cash flow hedging relationships
 
(Gain) loss
 
 
 
recognized in income on
 
 
 
derivatives
 
 
 
Nine months ended
 
Location of (gain) loss
 
September 30,
 
recognized in income
(in millions)
2013
 
2012
 
on derivatives
Fuel derivative contracts
$
(122
)
 
$
(200
)
 
Other (gains) losses, net

The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended September 30, 2013 and 2012 of $22 million and $15 million, respectively, and the nine months ended September 30, 2013 and 2012 of $39 million and $33 million, respectively.  These amounts are excluded from the Company’s measurement of effectiveness for related hedges and are included as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income.

The fair values of the derivative instruments, depending on the type of instrument, were determined by the use of present value methods or option value models with assumptions about commodity prices based on those observed in underlying markets or provided by third parties.  Included in the Company’s cumulative net unrealized losses from fuel hedges as of September 30, 2013, were approximately $15 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2013.  In addition, as of September 30, 2013, the Company had already recognized cumulative net gains due to ineffectiveness and derivatives that did not qualify for hedge accounting treatment totaling $69 million, net of taxes.  These net gains were recognized during the three months ended September 30, 2013 and prior periods, and are reflected in Retained earnings as of September 30, 2013, but the underlying derivative instruments will not expire/settle until fourth quarter 2013 or future periods.

Interest rate swaps
The Company is party to certain interest rate swap agreements that are accounted for as either fair value hedges or cash flow hedges, as defined in the applicable accounting guidance for derivative instruments and hedging. The interest rate swap agreements accounted for as fair value hedges qualify for the “shortcut” method of accounting for hedges, which dictates that the hedges are assumed to be perfectly effective, and, thus, there is no ineffectiveness to be recorded in earnings.  For the Company’s interest rate swap agreements accounted for as cash flow hedges, ineffectiveness is required to be measured at each reporting period.  The ineffectiveness associated with all of the Company’s, including AirTran’s, interest rate cash flow hedges for all periods presented was not material.
 
Credit risk and collateral
Credit exposure related to fuel derivative instruments is represented by the fair value of contracts that are an asset to the Company at the reporting date.  At such times, these outstanding instruments expose the Company to credit loss in the event of nonperformance by the counterparties to the agreements.  However, the Company has not experienced any significant credit loss as a result of counterparty nonperformance in the past.  To manage credit risk, the Company selects and periodically reviews counterparties based on credit ratings, limits its exposure with respect to each counterparty, and monitors the market position of the fuel hedging program and its relative market position with each counterparty.  At September 30, 2013, the Company had agreements with all of its active counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount based on the counterparty credit rating.  The Company also had agreements with counterparties in which cash deposits, letters of credit, and/or pledged aircraft are required to be posted whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of September 30, 2013, at which such postings are triggered:

13


 
Counterparty (CP)
 
 
(in millions)
A
 
B
 
C
 
D
 
E
 
F
 
Other(a)
 
Total
Fair value of fuel derivatives
$
19

 
$
23

 
$
12

 
$
(3
)
 
$
17

 
$
10

 
$
9

 
$
87

Cash collateral held (by) CP
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Aircraft collateral pledged to CP
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Letters of credit (LC)
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Option to substitute LC for aircraft
(340) to (740)(d)
 
(100) to (500)(d)
 
N/A
 
N/A
 
(250) to (650) (d)
 
N/A
 
 
 
 
Option to substitute LC for cash
N/A
 
>(500)
 
(100) to (150)(e)
 
N/A
 
(50) to (250) or >(650)(d)
 
N/A
 
 
 
 
If credit rating is investment
grade, fair value of fuel
derivative level at which:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash is provided to CP
(40) to (340) or >(740)
 
(50) to (100) or >(500)
 
>(50)
 
>(75)
 
(50) to (250) or >(650)
 
>(50)
 
 
 
 
Cash is received from CP
>75
 
>150
 
>175(c)
 
>125(c)
 
>200
 
>30
 
 
 
 
Aircraft or cash can be pledged to
  CP as collateral
(340) to (740)(d)
 
(100) to (500) (d)
 
N/A
 
N/A
 
(250) to (650) (d)
 
N/A
 
 
 
 
If credit rating is non-investment
grade, fair value of fuel derivative
level at which:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash is provided to CP
(0) to (300) or >(700)
 
(0) to (100) or >(500)
 
(b)
 
(b)
 
(0) to (250) or >(650)
 
(b)
 
 
 
 
Cash is received from CP
(b)
 
(b)
 
(b)
 
(b)
 
(b)
 
(b)
 
 
 
 
Aircraft can be pledged to CP as
  collateral
(300) to (700)
 
(100) to (500)
 
N/A
 
N/A
 
(250) to (650)
 
N/A
 
 
 
 
(a) Individual counterparties with fair value of fuel derivatives <$20 million.
(b) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.
(c) Thresholds may vary based on changes in credit ratings within investment grade.
(d) The Company has the option of providing cash, letters of credit, or pledging aircraft as collateral. No cash, letters of credit, or aircraft were pledged as collateral with such counterparties as of September 30, 2013.
(e) The Company has the option of providing cash or letters of credit as collateral. No cash or letters of credit were pledged as collateral with such counterparties as of September 30, 2013.

6.    COMPREHENSIVE INCOME

Comprehensive income includes changes in the fair value of certain financial derivative instruments that qualify for hedge accounting, unrealized gains and losses on certain investments, and actuarial gains/losses arising from the Company’s postretirement benefit obligation.  The differences between Net income and Comprehensive income for the three and nine months ended September 30, 2013 and 2012 were as follows:

 
Three months ended September 30,
(in millions)
2013
 
2012
NET INCOME
$
259

 
$
16

Unrealized gain on fuel derivative instruments, net of
  deferred taxes of $76 and $120
129

 
192

Unrealized gain (loss) on interest rate derivative instruments, net of
  deferred taxes of $2 and ($2)
2

 
(3
)
Other, net of deferred taxes of $2 and $3
3

 
6

Total other comprehensive income
$
134

 
$
195

COMPREHENSIVE INCOME
$
393

 
$
211



14
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


 
Nine months ended September 30,
(in millions)
2013
 
2012
NET INCOME
$
542

 
$
343

Unrealized gain (loss) on fuel derivative instruments, net of
  deferred taxes of ($16) and $63
(25
)
 
100

Unrealized gain (loss) on interest rate derivative instruments, net of
  deferred taxes of $16 and ($3)
26

 
(5
)
Other, net of deferred taxes of $6 and $2
4

 
4

Total other comprehensive income
$
5

 
$
99

COMPREHENSIVE INCOME
$
547

 
$
442


A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three and nine months ended September 30, 2013:

(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at June 30, 2013
$
(349
)
 
$
(70
)
 
$
26

 
$
(3
)
 
$
148

 
(248
)
Changes in fair value
168

 
(3
)
 
—

 
5

 
(64
)
 
106

Reclassification to earnings
37

 
7

 
—

 
—

 
(16
)
 
28

Balance at September 30, 2013
$
(144
)
 
$
(66
)
 
$
26

 
$
2

 
$
68

 
$
(114
)

(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at December 31, 2012
$
(103
)
 
$
(108
)
 
$
26

 
$
(8
)
 
$
74

 
$
(119
)
Changes in fair value
(181
)
 
20

 
—

 
10

 
54

 
(97
)
Reclassification to earnings
140

 
22

 
—

 
—

 
(60
)
 
102

Balance at September 30, 2013
$
(144
)
 
$
(66
)
 
$
26

 
$
2

 
$
68

 
$
(114
)

The following tables illustrate the significant amounts reclassified out of each component of AOCI for the three and nine months ended September 30, 2013:

Three months ended September 30, 2013
(in millions)
 
Amounts reclassified from AOCI
 
Affected line item in the unaudited Condensed Consolidated Statement of Comprehensive Income
AOCI components
 
 
Unrealized gain on fuel derivative instruments
 
$
37

 
Fuel and oil expense
 
 
$
13

 
Less: Tax Expense
 
 
$
24

 
Net of tax
Unrealized gain on interest rate derivative instruments
 
$
7

 
Interest expense
 
 
$
3

 
Less: Tax Expense
 
 
$
4

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
28

 
Net of tax


15
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


Nine months ended September 30, 2013
(in millions)
 
Amounts reclassified from AOCI
 
Affected line item in the unaudited Condensed Consolidated Statement of Comprehensive Income
AOCI components
 
 
Unrealized gain on fuel derivative instruments
 
$
140

 
Fuel and oil expense
 
 
$
52

 
Less: Tax Expense
 
 
$
88

 
Net of tax
Unrealized gain on interest rate derivative instruments
 
$
22

 
Interest expense
 
 
$
8

 
Less: Tax Expense
 
 
$
14

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
102

 
Net of tax

7.    SUPPLEMENTAL FINANCIAL INFORMATION

 
September 30,
 
December 31,
(in millions)
2013
 
2012
Fuel derivative contracts
$
58

 
$
221

Interest rate derivative contracts
22

 
31

Receivable from third parties for fuel contracts - noncurrent
14

 
54

Intangible assets
123

 
138

Non-current investments
44

 
41

Other
157

 
148

Other assets
$
418

 
$
633


 
September 30,
 
December 31,
(in millions)
2013
 
2012
Retirement plans
$
173

 
$
135

Aircraft rentals
171

 
139

Vacation pay
286

 
270

Health
62

 
70

Fuel derivative contracts
3

 
50

Workers compensation
158

 
159

Accrued taxes
116

 
67

Other
203

 
212

Accrued liabilities
$
1,172

 
$
1,102



16
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


 
September 30,
 
December 31,
(in millions)
2013
 
2012
Postretirement obligation
$
169

 
$
148

Non-current lease-related obligations
312

 
376

Airport construction obligation
420

 
331

Other deferred compensation
153

 
141

Fuel derivative contracts
18

 
—

Interest rate derivative contracts
54

 
37

Other
72

 
91

Other non-current liabilities
$
1,198

 
$
1,124


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

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

8.    LEASES

On July 9, 2012, the Company signed an agreement with Delta Air Lines, Inc. and Boeing Capital Corp. to lease or sublease all 88 of AirTran's Boeing 717-200 aircraft (“B717s”) to Delta. The first converted B717 was delivered to Delta during late September 2013, and a total of 16 B717s are expected to be delivered to Delta by the end of 2013. Over the expected term of the transition period for all B717s, the Company expects to average approximately three B717 conversions per month. A total of 78 of the B717s are on operating lease, eight are owned, and two are currently classified as capital leases.

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

The Company will lease and/or sublease all 88 of the B717s to Delta at agreed-upon lease rates. In addition, the Company will pay the majority of the costs to convert the aircraft to the Delta livery and perform certain maintenance checks prior to the delivery of each aircraft. The agreement to pay these conversion and maintenance costs is a “lease incentive” under applicable accounting guidance. The sublease terms for the 78 B717s currently on operating lease and the two B717s currently classified as capital leases coincide with the Company's remaining lease terms for these aircraft from the original lessor, which range from approximately five years to approximately 11 years. The lease terms for the eight B717s that are owned by the Company are for a period of seven years, after which Delta will have the option to purchase the aircraft at the then-prevailing market value. The Company will account for the lease and sublease transactions with Delta as operating leases, except for the two aircraft classified by the Company as capital leases. The subleases of these two aircraft will be accounted for as direct financing leases. There are no contingent payments and no significant residual value conditions associated with the transaction.

The accounting for this transaction is based on the guidance provided for lease transactions. For the components of this transaction finalized in third quarter 2012 and with respect to which the lease inception has been deemed to occur, the Company recorded a charge of approximately $137 million during third quarter 2012. The charge represents the remaining estimated cost, at the scheduled date of delivery of each B717 to Delta (including the conversion, maintenance, and other contractual costs to be incurred), of the Company's lease of the 78 B717s that are currently accounted for as operating leases, net of the future sublease income from Delta and the remaining unfavorable aircraft

17
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


lease liability established as of the acquisition date. The charges recorded by the Company for this transaction were included as a component of Acquisition and integration costs in the Company's unaudited Condensed Consolidated Statement of Comprehensive Income and were included as a component of Other, net in Cash flows from operating activities in the Company's unaudited Condensed Consolidated Statement of Cash Flows, and the corresponding liability for this transaction is included as a component of Current liabilities and Other noncurrent liabilities in the Company's unaudited Condensed Consolidated Balance Sheet. See Note 2 for further information on the Company's Acquisition and integration costs. The Company may also incur other costs associated with this transaction, such as contract termination costs with certain aircraft maintenance vendors. Two of these vendor maintenance contracts have stated termination penalties totaling approximately $106 million if the Company were to terminate such contracts; however, termination of these contracts has not occurred, and any charges would only be recorded at the time of contract termination or at the time any associated charges become probable and estimable.

9.    COMMITMENTS AND CONTINGENCIES

Commitments
The Company signed a Memorandum of Agreement (“MOA”) with the City of Houston (“City”), effective June 2012, to expand the existing Houston Hobby airport facility.  As provided in the MOA, the Company and the City negotiated an Airport Use and Lease Agreement (“Lease”) to control the execution of this expansion and the financial terms thereof. Per the MOA and Lease, this project will consist of a new five-gate international terminal with international passenger processing facilities, expansion of the existing security checkpoint, and upgrades to the Southwest ticketing counter area. The project is estimated to cost $156 million, and the Company has agreed to provide the funding for, as well as management over, the project. In return, the Company will receive a monthly credit for the capital cost portions of the international terminal, from the date of initial occupancy of the terminal until expiration of the Lease.  Additionally, some portion of the project is expected to qualify for rental credits that would be utilized upon completion of the facility against the Company’s current lease space at the airport. At any time after the completion of the project, the City may buy out the Company’s investment in the international terminal for the then-unamortized cost of the project. Construction began during third quarter 2013 and is estimated to be completed during the second half of 2015.

As a result of its significant involvement in the project, the Company has evaluated its ongoing accounting requirements in consideration of accounting guidance provided for lessees involved in asset construction, and has determined that it qualifies as the accounting owner of the facility during the construction period. As such, during construction, the Company will record an asset within Ground property and equipment in the unaudited Condensed Consolidated Balance Sheet, and will account for these expenditures as part of capital expenditures within Investing activities in the unaudited Condensed Consolidated Statement of Cash Flows. The amounts recorded for third quarter 2013 were not material.

During 2008, the City of Dallas approved the Love Field Modernization Program (“LFMP”), a project to reconstruct Dallas Love Field (“Airport”) with modern, convenient air travel facilities. Pursuant to a Program Development Agreement (“PDA”) with the City of Dallas and the Love Field Airport Modernization Corporation (or “LFAMC,” a Texas non-profit “local government corporation” established by the City of Dallas to act on the City of Dallas' behalf to facilitate the development of the LFMP), the Company is managing this project. Major construction commenced during 2010. New ticketing and checkin areas opened during fourth quarter 2012, and 11 new gates and new concessions opened in April 2013. Another new gate opened in July 2013, and full completion of the project is scheduled for second half 2014. The project consists of the complete replacement of gate facilities with a new 20-gate facility, including infrastructure, systems and equipment, aircraft parking apron, fueling system, roadways and terminal curbside, baggage handling systems, passenger loading bridges and support systems, and other supporting infrastructure.

It is currently expected that the total construction costs associated with the LFMP project will be approximately $519 million. Although the City of Dallas has received commitments from various sources that are helping to fund portions of the LFMP project, including the Federal Aviation Administration (“FAA”), the Transportation Security Administration, and the City of Dallas' Aviation Fund, the majority of the funds used are from the issuance of bonds. During fourth quarter 2010, $310 million of such bonds were issued by the LFAMC, and the Company has guaranteed

18
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


principal and interest payments on the bonds. An additional tranche of such bonds totaling $146 million was issued during second quarter 2012, and the Company has guaranteed the principal and interest payments on these bonds as well. The Company currently expects that as a result of the funding commitments from the above mentioned sources and the bonds that have been issued thus far, no further bond issuances and related guarantees from the Company will be required to complete the LFMP project.

In conjunction with the Company's significant presence at Dallas Love Field, its rights to occupy 16 of the available gates upon completion of the facility, and other factors, the Company agreed to manage the majority of the LFMP project. Based on these facts, the Company has evaluated its ongoing accounting requirements in consideration of accounting guidance provided for lessees involved in asset construction. The Company has recorded and will continue to record an asset and corresponding obligation for the cost of the LFMP project as the construction of the facility occurs. As of September 30, 2013, the Company had recorded LFMP construction costs of $415 million classified as an asset within Ground property and equipment and $420 million classified as a liability within Other non-current liabilities in its unaudited Condensed Consolidated Balance Sheet. Upon completion of different phases of the LFMP project, the Company has placed the associated assets in service and has begun depreciating the assets over their estimated useful lives. The amount of depreciation recorded for the three and nine months ended September 30, 2013, associated with the LFMP project was $3 million and $6 million, respectively. The corresponding LFMP liabilities will be reduced primarily through the Company's airport rental payments to the City of Dallas as the construction costs of the project are passed through to the Company via recurring airport rates and charges.

Contingencies
The Company is from time to time subject to various legal proceedings and claims arising in the ordinary course of business, including, but not limited to, examinations by the IRS. The Company's management does not expect that the outcome in any of its currently ongoing legal proceedings or the outcome of any adjustments presented by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow.

10.    FAIR VALUE MEASUREMENTS

Accounting standards pertaining to fair value measurements establish a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value.  These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

As of September 30, 2013, the Company held certain items that are required to be measured at fair value on a recurring basis.  These included cash equivalents, short-term investments (primarily treasury bills, commercial paper, and certificates of deposit), certain noncurrent investments, interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities.  The majority of the Company’s short-term investments consist of instruments classified as Level 1.  However, the Company has certificates of deposit, commercial paper, and Eurodollar time deposits that are classified as Level 2, due to the fact that the fair value for these instruments is determined utilizing observable inputs in non-active markets.  Noncurrent investments consist of certain auction rate securities, primarily those collateralized by student loan portfolios, which are guaranteed by the U.S. Government. Other available-for-sale securities primarily consist of investments associated with the Company’s excess benefit plan.

The Company’s fuel and interest rate derivative instruments consist of over-the-counter contracts, which are not traded on a public exchange.  Fuel derivative instruments include swaps, as well as different types of option contracts, whereas interest rate derivatives consist solely of swap agreements.  See Note 5 for further information on the Company’s derivative instruments and hedging activities.  The fair values of swap contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets.  Therefore, the Company has categorized these swap contracts as Level 2.  The Company’s Treasury Department, which reports to the Chief Financial Officer, determines the value of option contracts utilizing an option

19
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


pricing model based on inputs that are either readily available in public markets, can be derived from information available in publicly quoted markets, or are provided by financial institutions that trade these contracts. The option pricing model used by the Company is an industry standard model for valuing options and is the same model used by the broker/dealer community (i.e., the Company’s counterparties). The inputs to this option pricing model are the option strike price, underlying price, risk free rate of interest, time to expiration, and volatility. Because certain inputs used to determine the fair value of option contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as Level 3. Volatility information is obtained from external sources, but is analyzed by the Company for reasonableness and compared to similar information received from other external sources. The fair value of option contracts considers both the intrinsic value and any remaining time value associated with those derivatives that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model, on a monthly basis, the Company compares its option valuations to third party valuations. If any significant differences were to be noted, they would be researched in order to determine the reason. However, historically, no significant differences have been noted. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds.

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

All of the Company’s auction rate security instruments, totaling $39 million (net) at September 30, 2013, are classified as available-for-sale securities and are reflected at their estimated fair value in the unaudited Condensed Consolidated Balance Sheet.  In prior periods, due to the auction process which took place every 30-35 days for most securities, quoted market prices were readily available, which would have qualified as Level 1. However, due to events in credit markets beginning during first quarter 2008, the auction events for these remaining instruments failed, and have continued to fail through the current period.  Therefore, the Company’s Treasury Department determines the estimated fair values of these securities utilizing a discounted cash flow analysis.  The Company has performed, and routinely updates, a valuation for each of its auction rate security instruments, considering, among other items, the collateralization underlying the security investments, the expected future cash flows, including the final maturity, associated with the securities, estimates of the next time the security is expected to have a successful auction or return to full par value, forecasted reset rates based on the London Interbank Offered Rate (“LIBOR”) or the issuer’s net loan rate, and a counterparty credit spread.  To validate the reasonableness of the Company’s discounted cash flow analyses, the Company compares its valuations to third party valuations on a quarterly basis.

In association with its estimate of fair value related to auction rate security instruments as of September 30, 2013, the Company has previously recorded a temporary unrealized decline in fair value of $11 million, with an offsetting entry to AOCI.  The Company continues to believe that this decline in fair value is due entirely to market liquidity issues, because the underlying assets for the majority of these auction rate securities held by the Company are currently rated investment grade by Moody’s, Standard and Poor’s, and Fitch and are almost entirely backed by the U.S. Government. The range of maturities for the Company’s auction rate securities are from 5 years to 34 years. Considering the relative insignificance of these securities in comparison to the Company’s liquid assets and other sources of liquidity, the Company has no current intention of selling these securities nor does it expect to be required to sell these securities before a recovery in their cost basis.  At the time of the first failed auctions during first quarter 2008, the Company held a total of $463 million in auction rate securities and, since that time, has been able to sell $413 million of these instruments at par value.

20
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)




The following tables present the Company’s assets and liabilities that are measured at fair value on a recurring basis at September 30, 2013, and December 31, 2012:

 
 
 
 
Fair value measurements at reporting date using:
 
 
 
 
Quoted prices in
active markets
for identical assets
 
Significant
other observable
inputs
 
Significant
unobservable
inputs
Description
 
September 30, 2013
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,107

 
$
1,107

 
$
—

 
$
—

Commercial paper
 
215

 
—

 
215

 
—

Certificates of deposit
 
11

 
—

 
11

 
—

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,760

 
1,760

 
—

 
—

Certificates of deposit
 
235

 
—

 
235

 
—

Noncurrent investments (b)
 
 
 
 
 
 
 
 
Auction rate securities
 
39

 
—

 
—

 
39

Interest rate derivatives (see Note 5)
 
22

 
—

 
22

 
—

Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
46

 
—

 
46

 
—

Option contracts (c)
 
435

 
—

 
—

 
435

Option contracts (d)
 
20

 
—

 
—

 
20

Other available-for-sale securities
 
58

 
53

 
—

 
5

Total assets
 
$
3,948

 
$
2,920

 
$
529

 
$
499

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
(38
)
 
—

 
(38
)
 
—

Option contracts (c)
 
(335
)
 
—

 
—

 
(335
)
Option contracts (d)
 
(41
)
 
—

 
—

 
(41
)
Interest rate derivatives (see Note 5)
 
(87
)
 
—

 
(87
)
 
—

Deferred compensation
 
(149
)
 
(149
)
 
—

 
—

Total liabilities
 
$
(650
)
 
$
(149
)
 
$
(125
)
 
$
(376
)

(a) Cash equivalents are primarily composed of money market investments.
(b) Noncurrent investments are included in Other assets in the unaudited Condensed Consolidated Balance Sheet.
(c) In the unaudited Condensed Consolidated Balance Sheet amounts are presented as a net asset. See Note 5.
(d) In the unaudited Condensed Consolidated Balance Sheet amounts are presented as a net liability. See Note 5.


21
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


 
 
 
 
Fair value measurements at reporting date using:
 
 
 
 
Quoted prices in
active markets
for identical assets
 
Significant
other observable
inputs
 
Significant
unobservable
inputs
Description
 
December 31, 2012
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
829

 
$
829

 
$
—

 
$
—

Commercial paper
 
170

 
—

 
170

 
—

Certificates of deposit
 
34

 
—

 
34

 
—

Eurodollar Time Deposits
 
80

 
—

 
80

 
—

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,624

 
1,624

 
—

 
—

Certificates of deposit
 
233

 
—

 
233

 
—

Noncurrent investments (b)
 
 
 
 
 
 
 
 
Auction rate securities
 
36

 
—

 
—

 
36

Interest rate derivatives (see Note 5)
 
31

 
—

 
31

 
—

Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
113

 
—

 
113

 
—

Option contracts (c)
 
850

 
—

 
—

 
850

Option contracts (d)
 
10

 
—

 
—

 
10

Other available-for-sale securities
 
49

 
44

 
—

 
5

Total assets
 
$
4,059

 
$
2,497

 
$
661

 
$
901

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
$
(57
)
 
$
—

 
$
(57
)
 
$
—

Option contracts (c)
 
(637
)
 
—

 
—

 
(637
)
Swap contracts (d)
 
(56
)
 
—

 
(56
)
 
—