SCHEDULE 14A INFORMATION
PROXY STATEMENT PURSUANT TO SECTION 14(a) OF THE SECURITIES EXCHANGE ACT OF 1934
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SOUTHWEST AIRLINES CO.
-------------------------------------------------
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LETTER TO SHAREHOLDERS
NOTICE OF 2003
ANNUAL MEETING
AND PROXY
STATEMENT
2002 REPORT
TO SHAREHOLDERS
o Management's Discussion and Analysis
o Consolidated Financial Statements
(LOGO)
SOUTHWEST AIRLINES CO.
PROXY STATEMENT AND
2002 REPORT TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
The fall 2002 issue of Money magazine features an article entitled "THE
30 BEST STOCKS." That article begins with the following statement of amaze and
wonderment:
"It was straight out of Ripley's. When MONEY asked Ned David Research
this summer to compile a list of the 30 best performing stocks since
our debut in 1972, it seemed obvious that the No. 1 performer would
reflect the brawn-to-brains transformation of the U.S. economy.
Probably a technology stock. Or maybe a big name in pharmaceuticals.
"WHAT WE WERE NOT EXPECTING WAS AN AIRLINE - SOUTHWEST AIRLINES, TO BE
PRECISE. SINCE AUGUST 1972, SOUTHWEST HAS PRODUCED ANNUALIZED RETURNS
OF 25.99%, WHICH MEANS THAT HAD YOU INVESTED $10,000 IN SOUTHWEST 30
YEARS AGO, YOUR STAKE WOULD BE WORTH A LITTLE OVER $10.2 MILLION TODAY.
SOUTHWEST, OF COURSE, IS NOT YOUR TYPICAL AIRLINE..." (capitalization
added).
Southwest was "not your typical airline" in the year 2002, either. In
2002, Southwest was the only major airline that made a profit; the other major
airlines reported an aggregate net loss in excess of $10 billion, as two of them
filed petitions in bankruptcy. And at the end of 2002, Southwest Airlines market
capitalization (or total stock market value) exceeded that of all other major
airlines, combined.
Viewed in the context of the economic holocaust that continued to
ravage the U.S. airline industry in 2002, Southwest Airlines' attainment of its
30th consecutive annual profit in the amount of $198.1 million, excluding
special items ($241.0 million, including special items), was a triumphant
accomplishment for its Shareholders and Shareholder-Employees, even though it
represented a decline of 52 percent from 2001, excluding special items (52.9
percent, including special items from both years). Moreover, amidst the airline
industry devastation of 2002, Southwest:
1. Expanded its fleet by a net 20 aircraft;
2. Expanded its available seat miles by 5.5 percent;
3. Expanded its share of the domestic airline market (based on
revenue passenger seat miles produced) to 10 percent;
4. Increased Shareholders' equity by $407.6 million;
5. Renegotiated, and extended, five collective bargaining
agreements;
6. Ended the year with excellent liquidity of $1.82 billion in
unrestricted cash and a $575 million available, unsecured,
bank revolving credit line; and
7. Provided complete job security for its 33,705 active Employees
and a $155.6 million contribution to their collective
Profitsharing and savings plans.
Peering ahead, the year 2003 is fraught with event risk and, hence,
uncertainty. If, however, a lengthy war or another terrorist assault should
occur, Southwest is better prepared for such an eventuality than any other major
U.S. airline; if the U.S. economy should decline, rather than advance, Southwest
is better prepared for such an eventuality than any other major U.S. airline;
and if jet fuel prices should rise precipitously, for any reason, Southwest is
better prepared for such an eventuality than any other major U.S. airline (in
addition to our financial strength, we are currently hedged for approximately 83
percent of our presently anticipated requirements for 2003 and 80 percent for
2004).
As 2003 begins, we are planning to expand our available seat mile
capacity for the year by 4 to 5 percent and have already begun, or announced,
the following additional air service: new nonstop flights from
Baltimore/Washington to San Jose and from Phoenix to Detroit; and additional
flights from Baltimore/Washington to Orlando, Long Island/Islip, Manchester,
Hartford, Austin, Phoenix, San Antonio, and West Palm Beach; Chicago Midway to
Cleveland, Las Vegas, and Houston; Long Island/Islip to Orlando and West Palm
Beach; Sacramento to Portland and Orange County; and Phoenix to Raleigh-Durham.
If, beyond the planned 4 to 5 percent increase, serendipitous opportunities for
profitable seat mile expansion should present themselves, we believe that we are
also better prepared to take advantage of such a positive eventuality than any
other major U.S. airline.
Although we cannot predict what external, uncontrollable events might
transpire during 2003, we can forecast with considerable certainty that our
valorous, caring, nimble, good-hearted and resilient People will ensure that
Southwest ends 2003 just the way it ended 2002 - at the forefront of our
industry. For, as we wrote to our Shareholders last year, our wonderful People's
brave hearts are both informed and inspired by Todd Beamer's brave words - and
his devotion to the concept of duty with honor: "LET'S ROLL."
January 20, 2003
Most sincerely,
Herbert D. Kelleher James F. Parker Colleen C. Barrett
Chairman of the Board Vice-Chairman and CEO President and COO
(LOGO)
SOUTHWEST AIRLINES CO.
NOTICE OF ANNUAL MEETING OF SHAREHOLDERS
Wednesday, May 14, 2003
To the Shareholders:
The Annual Meeting of the Shareholders of Southwest Airlines Co. (the
"Company" or "Southwest") will be held at its corporate headquarters, 2702 Love
Field Drive, Dallas, Texas on Wednesday, May 14, 2003, at 10:00 a.m., local
time, for the following purposes:
(1) to elect six directors;
(2) to take action on a shareholder proposal, if the proposal is
presented at the meeting; and
(3) to transact such other business as may properly come before
such meeting.
March 18, 2003, is the date of record for determining shareholders
entitled to receive notice of and to vote at the Annual Meeting.
Our Annual Meeting will be broadcast live on the Internet. To listen to
the broadcast, log on to www.southwest.com at 10:00 a.m., CDT, on May 14, 2003.
We have made the 2002 Annual Report available to you on the Internet at
www.southwest.com (click on "About SWA", "Investor Relations", "Annual
Reports").
If you do not have Internet access and you would like a copy of the
2002 Annual Report, you may request one from Investor Relations, Southwest
Airlines Co., P.O. Box 36611, Dallas, Texas 75235. Additionally, portions of the
Company's Annual Report on Form 10-K, filed with the Securities and Exchange
Commission, are attached to this Proxy Statement under the heading "2002 Report
to Shareholders."
By Order of the Board of Directors,
Colleen C. Barrett
President, Chief Operating Officer,
and Secretary
April 12, 2003
YOUR VOTE IS IMPORTANT. PLEASE SIGN AND RETURN THE ENCLOSED PROXY IN
THE ENCLOSED ENVELOPE TO ENSURE THAT YOUR SHARES ARE REPRESENTED AT THE MEETING.
SOUTHWEST AIRLINES CO.
P.O. BOX 36611
DALLAS, TEXAS 75235-1611
(214) 792-4000
---------------
PROXY STATEMENT
---------------
SOLICITATION AND REVOCABILITY OF PROXIES; VOTING
The enclosed proxy is solicited by and on behalf of the Board of
Directors of the Company for use at the Annual Meeting of Shareholders to be
held on May 14, 2003, at the Company's corporate headquarters, 2702 Love Field
Drive, Dallas, Texas, or any adjournment thereof. The Company will pay the cost
of solicitation. In addition to solicitation by mail, solicitation of proxies
may be made personally or by telephone by the Company's regular Employees, and
arrangements will be made with brokerage houses or other custodian's nominees
and fiduciaries to send proxies and proxy material to their principals. The
proxy statement and form of proxy were first mailed to shareholders of the
Company on or about April 12, 2003.
The enclosed proxy, even though executed and returned, may be revoked
at any time prior to the voting of the proxy by the subsequent execution and
submission of a revised proxy, by written notice to the Secretary of the
Company, or by voting in person at the meeting. Shares represented by proxy will
be voted at the meeting. Cumulative voting is not permitted. An automated system
administered by the Company's transfer agent tabulates the votes. Abstentions
and broker non-votes are each included in the determination of the number of
shares present and voting, for purposes of determining the presence or absence
of a quorum for the transaction of business. Neither abstentions nor broker
non-votes are counted as voted either for or against a proposal. Except as
otherwise stated herein, provided a quorum is present, the affirmative vote of
the holders of a majority of the shares entitled to vote on, and voted for or
against, the matter is required to approve any matter.
In some cases, only one proxy statement is being delivered to multiple
shareholders sharing an address unless the Company has received contrary
instructions from one or more of the shareholders. Upon written or oral request,
the Company will deliver a separate copy of the proxy statement to a shareholder
at a shared address to which a single copy of the proxy statement was delivered.
A shareholder can notify the Company at the above address that it wishes to
receive a separate copy of the proxy statement in the future, or alternatively,
that it wishes to receive a single copy of the materials instead of multiple
copies.
ELECTION OF DIRECTORS
(ITEM 1)
At the Annual Meeting of Shareholders, three directors are to be
elected for a one-year term expiring in 2004 or until their respective
successors are duly elected and qualified, and three directors are to be elected
for a three-year term expiring in 2006 or until their respective successors are
duly elected and qualified, each to serve with the six directors whose terms do
not expire until later years. Provided a quorum is present at the Annual
Meeting, a plurality of the votes cast in person or by proxy by the holders of
shares entitled to vote is required to elect directors.
The persons named in the enclosed proxy have been selected as a proxy
committee by the directors of the Company, and it is the intention of the proxy
committee that, unless otherwise directed therein, proxies will be voted for the
election of the nominees listed below. Although the directors of the Company do
not contemplate that any of the nominees will be unable to serve, if such a
situation arises prior to the meeting, the proxy committee will act in
accordance with its best judgment.
The following table sets forth certain information for each nominee and
present director of the Company, as of January 1, 2003. Each of the nominees for
director named in the following table is now serving as a director of the
Company. There is no family relationship between any of the directors or between
any director and any executive officer of the Company.
NAME DIRECTOR SINCE AGE
---- -------------- ---
Colleen C. Barrett .............................................. 2001 58
Louis E. Caldera* ............................................... March 2003 46
C. Webb Crockett ................................................ 1994 69
William H. Cunningham* .......................................... 2000 59
William P. Hobby ................................................ 1990 70
Travis C. Johnson ............................................... 1978 66
Herbert D. Kelleher* ............................................ 1967 71
Nancy B. Loeffler* .............................................. March 2003 56
Rollin W. King* ................................................. 1967 71
John T. Montford ................................................ 2002 59
June M. Morris* ................................................. 1994 72
James F. Parker ................................................. 2001 56
----------
(*) Current Nominee
CURRENT NOMINEES
Mr. Kelleher, Mr. King, and Mrs. Morris are each to be elected for a
term expiring in 2004. Dr. Cunningham, Mrs. Loeffler, and Mr. Caldera are to be
elected for terms expiring in 2006.
Herbert D. Kelleher has been Chairman of the Board of the Company since
March 29, 1978. Mr. Kelleher became interim President and Chief Executive
Officer of the Company in September 1981, and assumed those offices on a
permanent basis in February 1982, relinquishing those titles on June 19, 2001.
Rollin W. King engaged in executive education and consulting as the
principal of Rollin King Associates from January 1, 1989 until his retirement on
December 31, 1995, and subsequently he has been principally engaged in private
investments.
June M. Morris was a founder of Morris Air Corporation ("Morris"). Mrs.
Morris was Chief Executive Officer of Morris until its operations were absorbed
by Southwest in October 1994, and subsequently she has been principally engaged
in private investments. Morris was a domestic airline operating 21 Boeing 737
aircraft until its acquisition by Southwest in December 1993.
William H. Cunningham, Ph.D., is the James L. Bayless Professor of
Marketing at the University of Texas at Austin Red McCombs School of Business.
Dr. Cunningham was the Chancellor of the University of Texas System from 1992 to
June 2000. He is a director of Jefferson-Pilot Corporation, Introgen
Therapeutics, Inc., LIN TV Corp. and WilTel Communications. He is a
disinterested director of John Hancock Mutual Funds. Dr. Cunningham joined the
Board of an e-learning privately held start-up company, IBT Technologies, in
January 2000 as Chairman of the Board. He was named President and CEO in
December 2000, resigning those positions in September 2001. He remained as
Chairman until December 17, 2001, at which time the company filed for
bankruptcy. It is currently being liquidated.
2
Louis E. Caldera has been the Vice Chancellor for University
Advancement and President, CSU Foundation, at California State University, since
June 2001. He was the Secretary of the Army in the Clinton Administration from
July 1998 until January 2001. Mr. Caldera previously served as the Managing
Director and Chief Operating Officer for the Corporation for National and
Community Service, a federal grant-making agency, from September 1997 to June
1998. He served as a member of the California State Legislature from 1992 to
1997 representing the 46th Assembly District (Los Angeles). Mr. Caldera is a
director of Belo Corp., Indy Mac Bancorp, Inc. and Iomega Corporation.
Nancy B. Loeffler currently serves as a Member of the University of
Texas M.D. Anderson Cancer Center Board of Visitors, on the Board of Regents at
St. Mary's University, The South Texas Community Foundation, the National
Cowgirl Museum and Hall of Fame, the Vice President's Residence Foundation in
Washington, D.C. and the Capitol Advisory Committee for Texas Lutheran
University. She also serves as a member of the Blanton Museum of Art located on
the University of Texas campus.
DIRECTORS WHOSE TERM EXPIRES IN 2004
C. Webb Crockett has been a shareholder in the Phoenix, Arizona law
firm of Fennemore Craig for more than the past five years. Fennemore Craig
performed services for the Company in 2002 and will do so in 2003.
William P. Hobby was lieutenant governor of the State of Texas for 18
years until January 1991. He was Chancellor of the University of Houston System
from September 1995 until March 1997. He has been Chairman of Hobby
Communications, L.L.C., Houston, Texas, a privately owned company, since January
1997, and was Chairman and CEO of H&C Communications, Inc. (a privately owned
broadcasting company) from 1983 until December 1996. He was Executive Editor of
the Houston Post for more than 20 years.
Travis C. Johnson was a partner in the El Paso, Texas law firm of
Johnson & Bowen for more than five years prior to 2001. Since January 2001, Mr.
Johnson has practiced law as Travis Johnson, Attorney at Law. Mr. Johnson is a
director of Chase Bank of Texas - El Paso.
DIRECTORS WHOSE TERM EXPIRES IN 2005
Colleen C. Barrett has been President and Chief Operating Officer of
the Company since June 19, 2001, at which time she was also named to the Board
of Directors. Prior to that time, Ms. Barrett was Executive Vice President -
Customers from 1990 to 2001 and Vice President - Administration from 1986 to
1990. Ms. Barrett has been Secretary of the Company since March 1978.
James F. Parker has been Vice Chairman of the Board of Directors and
Chief Executive Officer of the Company since June 19, 2001. Prior to that time,
Mr. Parker was Vice President - General Counsel since 1986.
John T. Montford has been President - External Affairs, SBC Southwest,
a division of SBC Communications Inc., a global provider of telecommunications
products and services, since July 2002. He was Senior Vice President -
Legislative and Political Affairs of SBC Communications Inc. from September 2001
until July 2002. Prior to September 2001, Mr. Montford served as Chancellor of
the Texas Tech University System from 1996 to 2001. Mr. Montford served in the
Texas Senate from 1983 to 1996. He served as both Chairman of the Senate Finance
Committee and Chairman of the Senate State Affairs Committee. He serves as
President of the Plum Foundation, a private charitable foundation and is a
Director of Fleetwood Enterprises, Inc. He was recently named Chancellor
Emeritus of the Texas Tech University System.
The law firm of Loeffler, Jonas and Tuggey has performed services for
the Company in the past and may do so in 2003. Nancy Loeffler's husband is a
member of the law firm of Loeffler, Jonas and Tuggey.
3
BOARD COMMITTEES
The Board of Directors has appointed an Audit Committee consisting of
Messrs. Crockett, Cunningham (Chairman), Hobby, Johnson, Montford, King and Mrs.
Morris. The Audit Committee held six meetings during 2002. Pursuant to the Audit
Committee Charter adopted by the Board of Directors, it is responsible for the
appointment, compensation, retention and oversight of the work of Southwest's
independent auditors and its principal functions are to give additional
assurance that financial information is accurate and timely and that it includes
all appropriate disclosures; to ascertain the existence of an effective
accounting and internal control system; to pre-approve all services provided by
the independent auditors; and to oversee the entire audit function, both
independent and internal. The Board of Directors of the Company has determined
that all of the members of the Audit Committee are "independent," as currently
required and defined by the New York Stock Exchange.
The Board of Directors has appointed a Compensation Committee
consisting of Messrs. Hobby (Chairman) and Crockett and Mrs. Morris. The
Compensation Committee held two meetings during 2002, and otherwise acted by
unanimous consent. Pursuant to the Compensation Committee Charter adopted by the
Board of Directors, the Compensation Committee studies, advises and consults
with management respecting the compensation of officers of the Company, and
administers the Company's stock-based compensation plans. It recommends for the
Board's consideration any plan for additional compensation that it deems
appropriate.
The Board of Directors has appointed an Executive Committee consisting
of Messrs. Kelleher (Chairman), Johnson, and King to assist the Board in
carrying out its duties. The Executive Committee has authority to act for the
Board on most matters during the intervals between Board meetings. The Executive
Committee held four telephone meetings during 2002, and otherwise acted by
unanimous consent.
The Board of Directors has appointed a Nominating Committee consisting
of Messrs. Crockett, Cunningham, Hobby, Johnson, King, Montford and Mrs. Morris.
Pursuant to the Nominating Committee Charter adopted by the Board of Directors,
the Nominating Committee reviews and interviews possible candidates for Board
membership and recommends a slate of nominees. The Nominating Committee held two
meetings during 2002, and otherwise acted by unanimous consent. See "Other
Matters - Notice Requirements" for details on nominations for directors.
In January 2003, at the recommendation of the Nominating Committee, the
Board of Directors waived the mandatory retirement provision in the Company's
Bylaws for directors Kelleher, King, and Morris, and nominated them for one-
year terms expiring in 2004. The Nominating Committee's recommendation was based
on their perception of the exigent circumstances facing the airline industry and
Southwest, and the need for the experience, leadership, and judgment provided by
these directors.
During 2002, each director attended at least 75 percent of the total of
the Board and committee meetings that he or she was obligated to attend.
DIRECTORS' FEES
Directors' fees are paid on an annual basis from May to May in each
year. Each director of the Company who is not an officer of the Company was paid
$11,400 for the 12-month period ending May 2002 increasing to $11,800 for the
12-month period ending May 2003, for services as a director. During 2002, the
Board of Directors held six meetings and otherwise acted by unanimous consent.
In addition, $2,800 (increasing to $2,900 for the 12-month period ending May
2003) was paid for attendance at each meeting of the Board of Directors, and
$1,150 (increasing to $1,200 for the 12-month period ending May 2003) for
attendance at each meeting of a committee held on the same date as the Board
meetings. Members of the Executive Committee receive an additional $5,500
(increasing to $5,700 for the 12-month period ending May 2003) per year for
their services on such committee. The Chairman of the Audit and Compensation
Committees received annual fees of $5,000 and $3,000, respectively (increasing
to $5,500 and $3,200,
4
respectively for the 12-month period ending May 2003). Officers of the Company
receive no additional renumeration for serving as directors or on committees of
the Board.
Upon initial election to the Board, non-Employee directors receive a
one-time option grant to purchase 10,000 shares of Southwest common stock at the
fair market value of such stock on the date of the grant. These awards are made
under the 1996 Non-Qualified Stock Option Plan, which is administered by the
Compensation Committee of the Board of Directors. These stock options become
exercisable over a period of five years from the grant date and have a term of
10 years.
In 2001, the Board adopted the Southwest Airlines Co. Outside Director
Incentive Plan. The purpose of the plan is to align more closely the interests
of the non-Employee directors with those of the Company's shareholders and to
provide the non-Employee directors with retirement income. To accomplish this
purpose, the plan compensates each non-Employee director based on the
performance of the Company's Common Stock and defers the receipt of such
compensation until after the non-Employee director ceases to be a director of
the Company. Pursuant to the plan, on the date of the 2002 Annual Meeting of
Shareholders, the Company granted 750 non-transferable Performance Shares to
each non-Employee director who had served as a director since at least May 2001.
Thereafter, on the date of each Annual Meeting of Shareholders beginning with
the 2003 Annual Meeting, the Company will grant 750 Performance Shares to each
non-Employee director who has served since the previous Annual Meeting. A
Performance Share is a unit of value equal to the Fair Market Value of a share
of Southwest Common Stock, based on the average closing sale price of the Common
Stock as reported on the New York Stock Exchange. On the 30th calendar day
following the date a non-Employee director ceases to serve as a director of the
Company for any reason, Southwest will pay to such non-Employee director an
amount equal to the Fair Market Value of the Common Stock during the 30 days
preceding such last date of service multiplied by the number of Performance
Shares then held by such director. The plan contains provisions contemplating
adjustments on changes in capitalization of the Company.
Upon retirement from the Board of Directors, a director who has served
at least five years as of the date of retirement will receive $35,000 and a
director who has served at least ten years will receive $75,000.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
C. Webb Crockett, a member of the Board's Compensation Committee, is a
shareholder in the Phoenix, Arizona law firm of Fennemore Craig. Fennemore Craig
performed services for the Company in 2002 and will do so in 2003.
5
VOTING SECURITIES AND PRINCIPAL SHAREHOLDERS
At the close of business on March 18, 2003, the record date of those
entitled to notice of and to vote at the meeting, there were outstanding
778,128,947 shares of common stock, $1.00 par value, each share of which is
entitled to one vote.
CERTAIN BENEFICIAL OWNERS
The following table sets forth information with respect to persons who,
to the Company's knowledge (based on information contained in Schedules 13G
filed with the Securities and Exchange Commission with respect to beneficial
ownership at December 31, 2002), beneficially own more than 5 percent of the
common stock of the Company.
NAME AND ADDRESS OF AMOUNT AND NATURE OF
BENEFICIAL OWNER BENEFICIAL OWNERSHIP PERCENT OF CLASS
---------------------------------------- -------------------- ----------------
Capital Research and Management Company 67,272,760(1) 8.7%
333 South Hope Street
Los Angeles, CA 90071
State Street Bank and Trust Company 94,568,787(2) 12.2%(3)
225 Franklin Street
Boston, MA 02110
(1) As of December 31, 2002, Capital Research and Management Company
reported sole dispositive power with respect to 67,272,760 shares, but
disclaimed beneficial ownership of any shares of common stock.
(2) As of December 31, 2002, State Street Bank and Trust Company reported
sole voting power with respect to 15,643,777 shares, shared voting
power with respect to 77,259,683 shares, sole dispositive power with
respect to 94,469,468 shares, and shared dispositive power with respect
to 99,319 shares.
(3) State Street Bank and Trust Company reported that it beneficially owned
9.9 percent of the shares outstanding at year-end in its capacity as
trustee of the Southwest Airlines Co. ProfitSharing Plan.
6
MANAGEMENT
The following table sets forth as of March 21, 2003, certain
information regarding the beneficial ownership of common stock by the directors,
each of the executive officers of the Company named in the Summary Compensation
Table and by all executive officers and directors as a group.
NUMBER OF BENEFICIALLY
NAME OF DIRECTOR, OFFICER OR IDENTITY OF GROUP OWNED SHARES (1)(2) PERCENT OF CLASS (2)
---------------------------------------------- ----------------------- --------------------
Colleen C. Barrett (3) ............................ 562,298 *
Louis E. Caldera .................................. -- *
C. Webb Crockett(4) ............................... 55,687 *
William H. Cunningham(5) .......................... 11,750 *
William P. Hobby(6) ............................... 210,196 *
Travis C. Johnson ................................. 239,287 *
Herbert D. Kelleher(7) ............................ 8,187,809 1.1%
Rollin W. King(8) ................................. 486,815 *
Nancy B. Loeffler ................................. -- *
John T. Montford(9) ............................... 1,000 *
June M. Morris(10) ................................ 1,848,596 *
James F. Parker(11) ............................... 705,675 *
Gary C. Kelly(12) ................................. 326,999 *
Jim Wimberly(13) .................................. 174,240 *
Executive Officers and Directors as a Group
(18 persons)(14) .................................. 13,077,337 1.7%
* Less than 1%
(1) Unless otherwise indicated, beneficial owners have sole rather than
shared voting and investment power respecting their shares, other than
shared rights created under joint tenancy or marital property laws as
between the Company's directors and officers and their respective
spouses, if any. Such persons also beneficially owned an equal number
and percentage of non-exercisable Common Share Purchase Rights of the
Company that trade in tandem with its common stock.
(2) The number of shares beneficially owned includes shares that each
beneficial owner and the group had the right to acquire within 60 days
pursuant to stock options. The percentage for each beneficial owner and
for the group is calculated based on the sum of the 778,280,079 shares
of common stock outstanding on March 21, 2003 and any shares shown for
such beneficial owner or group as subject to stock options and
currently exercisable, as if any such stock options had been exercised.
(3) Includes 1,501 shares held for her account under the ProfitSharing Plan
with respect to which she has the right to direct the voting and
426,778 shares which Ms. Barrett had the right to acquire within 60
days pursuant to stock options.
(4) Includes 7,500 shares held in a family trust and 43,125 shares that Mr.
Crockett had the right to acquire within 60 days pursuant to stock
options.
(5) Includes 3,750 shares which Mr. Cunningham had the right to acquire
within 60 days pursuant to stock options.
(6) Includes 6,683 shares held by a testamentary trust of which Governor
Hobby is a co-trustee.
(footnotes continue on next page)
7
(7) Includes 3,988,754 shares which Mr. Kelleher had the right to acquire
within 60 days pursuant to stock options, 225,160 shares held in trust
for unrelated individuals, and 309,180 shares held by a family limited
liability company in which Mr. Kelleher's wife has a beneficial
interest. Mr. Kelleher disclaims any beneficial interest in the limited
liability company shares.
(8) Includes 3,563 shares held by a charitable remainder trust in which Mr.
King has a beneficial interest. Mr. King disclaims any beneficial
interest in the trust shares.
(9) Based on 1,000 shares which Mr. Montford had the right to acquire
within 60 days pursuant to stock options.
(10) Includes 1,814,460 shares held by entities over which Ms. Morris has
investment and voting power, and 15,188 shares which Ms. Morris had the
right to acquire within 60 days pursuant to stock options.
(11) Includes 37,842 shares held for his account under the ProfitSharing
Plan with respect to which he has the right to direct the voting and
397,187 shares which Mr. Parker had the right to acquire within 60 days
pursuant to stock options.
(12) Includes 1,350 shares held in a trust for Mr. Kelly's daughter, and
216,054 shares that Mr. Kelly had the right to acquire within 60 days
pursuant to stock options.
(13) Includes 30,065 shares held for his account under the ProfitSharing
Plan with respect to which he has the right to direct the voting and
114,540 shares which Mr. Wimberly had the right to acquire within 60
days pursuant to stock options.
(14) Includes 129,288 shares held for the accounts of certain officers under
the ProfitSharing Plan with respect to which such persons have the
right to direct voting. All information with respect to the
ProfitSharing Plan is based on a statement dated December 31, 2002.
8
COMPENSATION OF EXECUTIVE OFFICERS
The following table discloses compensation for services rendered by the
Company's Chief Executive Officer and the four remaining most highly paid
executive officers during the three fiscal years ended December 31, 2002.
SUMMARY COMPENSATION TABLE
LONG TERM
COMPENSATION
ANNUAL COMPENSATION (1) AWARDS
------------------------------------- --------------
SECURITIES ALL OTHER
UNDERLYING COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY ($) BONUS ($)(1) OPTIONS (#) ($)(2)
----------------------------------- ---- ---------- ------------ -------------- -------------
Herbert D. Kelleher, 2002 $ 431,396 $ 170,000 8,570 $ 50,898
Chairman of the Board 2001 356,250 196,000 555,844 86,272
2000 447,708 172,000 21,283 116,222
James F. Parker, 2002 $ 305,241 $ 187,000 12,024 $ 43,819
Chief Executive Officer and 2001 198,335 345,000 195,000 77,127
Vice Chairman of the Board 2000 207,802 163,000 33,302 33,887
Colleen C. Barrett, President, 2002 $ 302,308 $ 270,000 7,663 $ 44,052
Chief Operating Officer, and 2001 219,790 400,000 172,050 86,608
Secretary 2000 249,149 275,000 42,267 34,074
Gary C. Kelly, Executive Vice 2002 $ 243,793 $ 184,450 21,598 $ 21,750
President and Chief Financial 2001 213,246 197,000 21,500 31,308
Financial Officer 2000 180,993 146,000 33,001 33,542
Jim Wimberly - Executive Vice 2002 $ 238,864 $ 161,500 17,981 $ 22,209
President, Operations 2001 213,013 176,000 15,000 38,915
2000 186,025 130,000 21,956 28,436
(1) Officers' bonuses are paid in January of each year in respect of
performance for the prior year. The numbers shown in this column
reflect such payments made in January of the specified year.
(2) Consists of amounts contributed by the Company to the Southwest
Airlines Co. ProfitSharing Plan, Excess Benefit Plan and 401(k) Plan in
which all Employees of the Company are eligible to participate, as well
as life insurance premiums. In addition to those amounts, "All Other
Compensation" for Mr. Kelleher includes deferred compensation, bearing
interest at an annual rate of 10 percent, in an amount equal to Company
contributions which would otherwise have been made on behalf of Mr.
Kelleher to the ProfitSharing Plan but which exceed the contributions
permitted by Federal tax laws, totaling $21,262, $53,090, and $88,520
for 2002, 2001, and 2000, respectively. "All Other Compensation" for
Mr. Parker and Ms. Barrett includes deferred compensation, bearing
interest at an annual rate of 10 percent, in an amount equal to Company
contributions which would otherwise have been made on behalf of each of
them to the ProfitSharing Plan but which exceed the contributions
permitted by Federal tax laws, totaling $15,480 and $19,721
respectively, for 2002, and $45,355 and $54,643, respectively, for
2001.
9
OPTION GRANTS IN LAST FISCAL YEAR
The following table provides information on option grants in 2002 to
the named executive officers:
POTENTIAL REALIZABLE VALUE AT
ASSUMED ANNUAL RATES OF STOCK PRICE
INDIVIDUAL GRANTS APPRECIATION FOR OPTION TERM (1)
-------------------------------------------------------- -----------------------------------------
NUMBER OF PERCENT OF
SECURITIES TOTAL OPTIONS
UNDERLYING GRANTED TO EXERCISE
OPTIONS EMPLOYEES IN PRICE EXPIRATION
NAME GRANTED (#) FISCAL YEAR ($/SHARE) DATE 0% ($) 5% ($) 10%($)
----------- ------------- --------- ---------- ---------- ---------- ----------
Herbert D. Kelleher 8,570(2) .02% $ 18.73 01/01/2012 -- $ 100,955 $ 255,815
James F. Parker 12,024(2) .02% $ 18.73 01/01/2012 -- $ 141,643 $ 358,916
Colleen C. Barrett 7,663(2) .01% $ 18.73 01/01/2012 -- $ 90,270 $ 228,741
Gary C. Kelly 4,348(2) .01% $ 18.73 01/01/2012 -- $ 51,219 $ 129,788
17,250(3) .03% $ 17.78 01/18/2012 -- $ 192,855 $ 488,865
Jim Wimberly 1,481(2) .003% $ 18.73 01/01/2012 -- $ 17,446 $ 44,208
16,500(3) .03% $ 17.78 01/18/2012 -- $ 184,470 $ 467,610
(1) These amounts represent assumed rates of appreciation in market value
from the date of grant until the end of the option term, at the rates
set by the Securities and Exchange Commission, and therefore are not
intended to forecast possible future appreciation, if any, in
Southwest's stock price. Southwest did not use an alternative formula
for a grant date valuation, as it is not aware of any formula that will
determine with reasonable accuracy a present value based on future
unknown or volatile factors.
(2) These options were granted to the named individuals under the Company's
1996 Incentive and Non-Qualified Stock Option Plans at fair market
value as of December 31, 2002, and were fully exercisable on the grant
date.
(3) These options were granted to the named individuals under the Company's
1996 Incentive and Non-Qualified Stock Option Plans at fair market
value on the date of the grants and are exercisable as follows:
one-third on the grant date, one-third on the first anniversary of the
grant date and one-third on the second anniversary of the grant date,
subject to continued employment.
At January 18, 2012, the expiration date of the $17.78 options
described above, the stock price for Southwest common stock would be $28.96 or
$46.12 per share, assuming annual appreciation rates from January 18, 2002 at 5
percent or 10 percent, respectively. However, if the price of the common stock
does not appreciate, the value of these options to the named executives, and the
corresponding benefit to all shareholders of the Company, would be zero. All of
the preceding appreciation calculations are compounded annually.
10
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND
FISCAL YEAR-END OPTION VALUES
The following table shows stock option exercises by the named executive
officers during 2002. In addition, this table includes the number of shares
covered by both exercisable and non-exercisable stock options as of December 31,
2002. Also reported are the values for "in-the-money" options that represent the
positive spread between the exercise price of any such existing stock options
and the year-end price of the common stock.
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED IN-THE-
SHARES OPTIONS AT FISCAL MONEY OPTIONS AT FISCAL
ACQUIRED YEAR-END (#) YEAR-END ($)(2)
ON VALUE ---------------------------- ----------------------------
EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
NAME (#) ($)(1) (#) (#) ($) ($)
-------------------- --------- ----------- ----------- ------------- ----------- -------------
Herbert D. Kelleher 852,560 $13,943,075 3,794,903 185,281 $35,287,255 $ 455,125
James F. Parker 31,263 $ 344,783 379,100 65,000 $ 1,585,375 --
Colleen C. Barrett 100,000 $ 1,231,393 411,092 57,350 $ 1,979,400 --
Gary C. Kelly 21,554 $ 261,342 220,168 22,500 $ 1,214,073 --
Jim Wimberly 171,223 $ 1,708,892 96,509 16,000 $ 307,225 --
(1) Aggregate market value of the shares covered by the option less the
aggregate price paid by the executive.
(2) The closing price of the common stock on December 31, 2002, the last
trading day of Southwest's fiscal year, was $13.90 per share.
EMPLOYMENT AND OTHER CONTRACTS
The Company re-employed Herbert D. Kelleher, effective as of January 1,
2001, under a three-year Employment Contract. Mr. Kelleher served as Chairman of
the Board, Chief Executive Officer and President until June 19, 2001. Since
then, Mr. Kelleher has performed the duties and has the responsibilities given
to him by the Board as Chairman, including overseeing the implementation of the
Company's current and long-range business policies and programs. During the term
of the Employment Contract, Mr. Kelleher will serve as Chairman of the Board and
Chairman of the Executive Committee of the Board for as long as he is a member
of the Board. The Employment Contract provides for an annual base salary of
$450,000, except that in 2001 the Company and Mr. Kelleher agreed that he would
receive no salary for the period from October 1, 2001 through December 31, 2001
in light of the severe financial challenges facing the Company as a result of
the terrorist attacks on the United States on September 11, 2001. The Employment
Contract also provides for additional benefits including: (i) discretionary
performance bonuses paid in cash at the times and in the amounts determined by
the Board; (ii) long-term disability insurance providing for disability payments
of $8,000 per month to age 73; (iii) reimbursement for medical and dental
expenses incurred by Mr. Kelleher and his spouse, and for such expenses for
other members of his family to the extent Mr. Kelleher pays in excess of $10,000
per year in such expenses; (iv) deferred compensation bearing interest at 10
percent in an amount equal to any Company contributions which would otherwise
have been made on behalf of Mr. Kelleher to the Company ProfitSharing Plan but
which exceed maximum annual additions under the Plan on his behalf under federal
tax laws; and (v) stock options that vest in equal annual installments during
the term of the Employment Contract. The Employment Contract is terminable by
Mr. Kelleher within 60 days after the occurrence of a change of control of the
Company in which a third party acquires 20 percent or more of the Company's
voting securities or a majority of the directors of the Company are replaced as
a result of a tender offer or merger, sale of assets or contested election. In
the event Mr. Kelleher so terminates his employment, the Employment Contract
provides for a lump sum severance payment equal to Mr. Kelleher's unpaid base
salary for the remaining term of his Employment Contract plus $750,000.
11
The Company employs James F. Parker, effective as of June 19, 2001,
under a three-year Employment Contract as Vice Chairman of the Board and Chief
Executive Officer. The Employment Contract provides for an annual base salary of
$312,000 for the year ending June 19, 2002, except that in 2001 the Company and
Mr. Parker agreed that he would receive no salary for the period from October 1,
2001 through December 31, 2001 in light of the severe financial challenges
facing the Company as a result of the terrorist attacks on the United States on
September 11, 2001. Mr. Parker's annual base salary for the years ending June
19, 2003 and 2004 will be $324,480 and $337,460, respectively. The Employment
Contract also provides for additional benefits including: (i) discretionary
performance bonuses paid in cash at the times and in the amounts determined by
the Board; (ii) long-term disability insurance providing for disability payments
of $10,000 per month to age 70; (iii) reimbursement for medical and dental
expenses incurred by Mr. Parker and his spouse; (iv) deferred compensation
bearing interest at 10 percent in an amount equal to any Company contributions
which would otherwise have been made on behalf of Mr. Parker to the Company
ProfitSharing Plan but which exceed maximum annual additions under the Plan on
his behalf under federal tax laws; and (v) stock options that vest in equal
annual installments during the term of the Employment Contract. The Employment
Contract is terminable by Mr. Parker within 60 days after the occurrence of a
change of control of the Company in which a third party acquires 20 percent or
more of the Company's voting securities or a majority of the directors of the
Company are replaced as a result of a tender offer or merger, sale of assets or
contested election. In the event Mr. Parker so terminates his employment, the
Employment Contract provides for a lump sum severance payment equal to Mr.
Parker's unpaid base salary for the remaining term of his Employment Contract
plus $750,000.
The Company employs Colleen C. Barrett, effective as of June 19, 2001,
under a three-year Employment Contract as President and Chief Operating Officer
of the Company. The Employment Contract provides for an annual base salary of
$309,000 for the year ending June 19, 2002, except that in 2001 the Company and
Ms. Barrett agreed that she would receive no salary for the period from October
1, 2001 through December 31, 2001 in light of the severe financial challenges
facing the Company as a result of the terrorist attacks on the United States on
September 11, 2001. Ms. Barrett's annual base salary for the years ending June
19, 2003 and 2004 will be $321,360 and $334,215, respectively. The Employment
Contract also provides for additional benefits including: (i) discretionary
performance bonuses paid in cash at the times and in the amounts determined by
the Board; (ii) long-term disability insurance providing for disability payments
of $10,000 per month to age 70; (iii) reimbursement for medical and dental
expenses incurred by Ms. Barrett; (iv) deferred compensation bearing interest at
10 percent in an amount equal to any Company contributions which would otherwise
have been made on behalf of Ms. Barrett to the Company ProfitSharing Plan but
which exceed maximum annual additions under the Plan on her behalf under federal
tax laws; and (v) stock options that vest in equal annual installments during
the term of the Employment Contract. The Employment Contract is terminable by
Ms. Barrett within 60 days after the occurrence of a change of control of the
Company in which a third party acquires 20 percent or more of the Company's
voting securities or a majority of the directors of the Company are replaced as
a result of a tender offer or merger, sale of assets or contested election. In
the event Ms. Barrett so terminates her employment, the Employment Contract
provides for a lump sum severance payment equal to Ms. Barrett's unpaid base
salary for the remaining term of her Employment Contract plus $750,000.
The Board of Directors of the Company established in 1987 an Executive
Service Recognition Plan to permit the Company to continue to attract and retain
well-qualified executive personnel and to assure both the Company of continuity
of management and its executives of continued employment in the event of any
actual or threatened change of control of the Company (defined substantially as
described in the following paragraph). As contemplated by the Executive Service
Recognition Plan, the Company has entered into employment agreements with each
of its current executive officers named in the Summary Compensation Table and
certain other executive personnel. The terms of these employment agreements
would be invoked only in the event of a change of control. The executives must
remain in the employment of the Company for one year after a change of control
has occurred. If the executive's employment is terminated other than for cause
(as defined), or if the executive terminates employment for good reason (as
defined), during the one-year term of employment, then the executive would
receive a severance payment equal to a full year's base
12
salary and annual bonus plus a prorated annual bonus for the year of
termination. In addition, the executive's welfare benefits would continue for
the unexpired portion of his or her one-year term of employment.
The Board of Directors established in 1988 a Change of Control
Severance Pay Plan (the "Severance Pay Plan") to provide for severance payments
to qualified Employees whose employment with the Company terminates due to
certain conditions created by a change in control of the Company (as defined in
the Severance Pay Plan). All Employees of the Company are participants in the
Severance Pay Plan except any officer participating in the Executive Service
Recognition Pay Plan and all other Employees who are beneficiaries of an
enforceable contract with the Company providing for severance payments in the
event of a reduction in force or furlough (collective bargaining agreements).
Generally, the Severance Pay Plan provides for severance payments, based upon
the Employee's salary and years of service with the Company, in the event the
Employee is terminated, other than for cause (as defined in the Severance Pay
Plan), death, voluntary retirement or total and permanent disability, within one
year of a "change in control." The Employee would also remain eligible for a
12-month extension of coverage under each "welfare benefit" plan of the Company,
including medical, dental, etc., as in effect immediately prior to any change in
control. For purposes of the Severance Pay Plan, a "change in control" is deemed
to have occurred if 20 percent or more of the combined voting power of the
Company's outstanding voting securities ordinarily having the right to vote for
directors shall have been acquired by a third person or a change in the makeup
of the Board of Directors shall have occurred under certain circumstances
described in the Severance Pay Plan.
BOARD COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION
The Salary Administration Program for Southwest's non-contract people
will be administered in a manner that promotes the attainment by Southwest of
reasonable profits on a consistent basis in order to preserve job protection and
security for such non-contract people; that promotes and rewards productivity
and dedication to the success of Southwest as the collective embodiment of all
of its people; that accomplishes internal equity among its people; and that
responds pragmatically to the actual influence of external market forces.
Southwest Airlines Co.
Salary Administration Manual
The above principles are applied to all Southwest non-contract
Employees, including executive officers. The Compensation Committee of the Board
of Directors reviews the compensation of Southwest's executive officers on an
annual basis. The Committee considers the total compensation (both salary and
incentives), as well as the recommendation of the Company's Chief Executive
Officer, in establishing each element of compensation. Mr. Kelleher, Mr. Parker,
and Ms. Barrett each have employment contracts with the Company. See
"Compensation of Executive Officers - Employment and Other Contracts."
At current cash compensation levels, the Committee does not expect
Internal Revenue Service regulations regarding maximum deductibility of
executive compensation to have any application to the Company.
The principal elements of compensation for Southwest's executive
officers are the following:
Base Salary. As a general rule, base salary for the executive officers
of Southwest falls below the salaries for comparable positions in comparably
sized companies. The Committee bases this determination on comparative
compensation studies for similarly situated businesses; its impression of the
prevailing business climate; and the advice of the Company's Chief Executive
Officer.
Annual salary increases, if any, for executive officers as a group are
not more, on a percentage basis, than those received by other non-contract
Employees.
Annual Incentive Bonus. Only officers of the Company are eligible for
annual incentive bonuses. The Committee determines the amount of each bonus at
the end of each year.
13
In fixing the salary and bonus amounts for 2002, the Committee
considered the very difficult revenue environment faced by the Company and the
industry during 2002, the performance of each individual, his or her level of
responsibility within the Company, the Company's profitability, the longevity in
office of each officer, and each officer's performance as a team member. In
addition, with respect to the bonus amounts, the Committee considered the severe
financial challenges faced by the Company as a result of the terrorist attacks
on the United States on September 11, 2001 and the outstanding performance of
the Company relative to its competitors. As a result, no officer received a
higher bonus in 2002 than for the previous year, except new officers whose
bonuses were annualized. No mathematical weighing formulae were applied with
respect to any of these factors. In evaluating an individual's performance, the
Committee relied on the recommendation of the Chief Executive Officer, whose
recommendation is based on his own perception of such officer's performance.
The Company does not utilize defined performance targets in
establishing compensation, nor does it employ minimum, targeted or maximum
amounts of bonuses or total compensation levels for the executive officers and
the final determination of compensation is subjective.
Stock Options. In an effort to bridge the perceived gap between the
lower level of cash compensation for Company officers as compared to their peers
and to provide a long-term incentive for future performance that aligns
officers' interests with shareholders in general, the Company adopted its 1996
Incentive Stock Option Plan and 1996 Non-Qualified Stock Option Plan. The number
of options initially granted to an officer, as compared to other Southwest
Employees, is dependent on the length of service with the Company and individual
levels of performance and responsibility. Subsequent grants are based on levels
of individual performance and for 2002 reflected the challenging environment
faced by the Company. For 2002, no officer received a grant for more options
than the 2001 grant, except new officers whose grants were annualized. With
respect to all options granted, the precise number of shares is determined on a
subjective basis. All grants under the Stock Option Plans are at current market
value and vest over a number of years, dependent on continued employment. Each
grant is made based upon the individual's compensation package for that year,
without reference to previous grants. Each of the Stock Option Plans limits the
number of options that may be granted to any one individual in any calendar year
to 253,125 shares.
Although it is not contractually obligated to do so, it has been the
practice of the Committee on an annual basis to grant additional options to
Employees (including the named executive officers) who exercise options under
Stock Option Plans and hold the acquired stock. With respect to 2002, such
grants were made on January 2, 2003 and January 7, 2003 in an amount equal to
five percent of the number of shares held by the Employee as of December 31,
2002 as a result of option exercises. The total options granted in January 2003
were 167,130, of which 35,625 were to named executive officers.
Effective as of June 19, 2001, Southwest entered into a three-year
employment agreement with Mr. Parker pursuant to which Mr. Parker will serve as
Chief Executive Officer of the Company, and so long as he is on the Board of
Directors, Vice Chairman of the Board. See "Compensation of Executive Officers -
Employment and Other Contracts." Pursuant to his Employment Contract, Mr. Parker
will receive an annual base salary of $312,000 for the year ending June 19,
2002, except that in 2001 the Company and Mr. Parker agreed that he would
receive no salary for the period from October 1 through December 31 in light of
the severe financial challenges facing the Company as a result of the terrorist
attacks on the United States on September 11, 2001. Mr. Parker's annual base
salary for the years ending June 19, 2003 and 2004 will be $324,480 and
$337,460, respectively. In addition, Mr. Parker was granted fair market value
options to purchase 180,000 shares of Southwest common stock with one-third
vested immediately and the balance vesting in increments of one-third on each of
June 19, 2002 and June 19, 2003.
The Committee relied on information supplied by an independent
consultant in determining that Mr. Parker's cash compensation for the three-year
period covered by his Employment Contract was significantly below the median and
the average for comparable positions. The options granted to Mr. Parker, in
accordance with Company practice, were designed to make up at least a portion of
the difference between his
14
cash compensation and that received by others in comparable positions, dependent
on successful performance by the Company as reflected in the price of its stock.
The number of options granted to Mr. Parker was based on the
Committee's review of compensation for similarly situated individuals in the
transportation industry and the Committee's perception of his expected future
contributions to Southwest's performance over the three-year term of his
contract. At Mr. Parker's recommendation, both his cash compensation and the
number of options granted to him was significantly below the amounts recommended
by the consultant as necessary to make his contract competitive. The Committee
did not consider the amount and value of other options granted to Mr. Parker in
the past, as those options were granted in connection with earlier compensation
packages. The Company has no target ownership levels for Company equity holdings
by executives.
Pursuant to his Employment Contract, Mr. Parker is entitled to a
performance bonus at the discretion of the Board of Directors. As with the other
executive officers of the Company, Mr. Parker's bonus in respect of 2002 (paid
in January 2003) equaled his bonus paid in respect of 2001. While the Company
recorded the sole profit recognized by any domestic major airline, the Committee
determined to avoid increasing officer bonuses in light of the very difficult
revenue environment facing the Company.
Executive officers participate in the Southwest Airlines ProfitSharing
Plan, Deferred Compensation Plan, and 401(k) Plan, which are available to all
Southwest Employees on the same basis. See "Compensation of Executive Officers -
Summary Compensation Table." Southwest makes little use of perquisites for
executive officers.
COMPENSATION COMMITTEE
William P. Hobby, Chair
C. Webb Crockett
June Morris
AUDIT COMMITTEE REPORT
The Audit Committee has reviewed and discussed the audited financial
statements of the Company for the year ended December 31, 2002 (the "Audited
Financial Statements"). In addition, we have discussed with Ernst & Young, the
independent auditing firm for the Company, the matters required by Codification
of Statements on Auditing Standards No. 61.
The Committee also has received the written disclosures and the letter
from Ernst & Young required by Independence Standards Board Standard No. 1, and
we have discussed with that firm its independence from the Company and the
compatibility of its provision of services other than auditing services with
such independence. We also have discussed with management of the Company and the
auditing firm such other matters and received such assurances from them, as we
deemed appropriate.
Based on the foregoing review and discussions and relying thereon, we
have recommended to the Company's Board of Directors the inclusion of the
Audited Financial Statements in the Company's Annual Report for the year ended
December 31, 2002 in the Company's Annual Report on Form 10-K.
AUDIT COMMITTEE
William H. Cunningham, Chair
C. Webb Crockett
William P. Hobby
Travis Johnson
Rollin W. King
John T. Montford
June M. Morris
15
PERFORMANCE GRAPH
The following table compares total shareholder returns for the Company
over the last five years to the Standard & Poor's 500 Stock Index and the
Standard and Poor's Transportation Index assuming a $100 investment made on
December 31, 1997. Each of the three measures of cumulative total return assumes
reinvestment of dividends. The stock performance shown on the graph below is not
necessarily indicative of future price performance.
(GRAPH)
1997 1998 1999 2000 2001 2002
---- ------ ------ ------ ------ ------
SOUTHWEST AIRLINES 100 138.39 147.77 307.62 254.57 191.69
S&P 500 100 128.56 155.58 141.44 124.56 97.00
S&P TRANSPORTATION 100 98.06 88.58 104.87 104.66 91.16
16
SHAREHOLDER PROPOSAL
(ITEM 2)
2 - ALLOW SHAREHOLDER VOTE REGARDING POISON PILLS
OUR YES-VOTE EXCEEDED 57% FOR THREE CONSECUTIVE YEARS
This is to recommend that our Board of Directors redeem any poison pill
previously issued and not adopt or extend any poison pill unless such adoption
or extension has been submitted to a shareholder vote. Our yes-vote on this
topic exceeded 57% in 2000, 2001 and 2002.
This proposal is submitted by John Chevedden, 215 Nelson Avenue, No. 205,
Redondo Beach, Calif. 90278.
HARVARD REPORT
A 2001 Harvard Business School study found that good corporate governance (which
took into account whether a company had a poison pill) was positively related to
company value. This study reviewed the relationship between the corporate
governance index for 1,500 companies and company performance from 1990 to 1999.
The Harvard Business School study is titled, "Corporate Governance and Equity
Prices," July 2001, by Paul A. Gompers, Harvard University, Joy L. Ishii,
Harvard University and Andrew Metrick, The Wharton School, University of
Pennsylvania.
Since the 1980s Fidelity, a mutual fund giant with $800 billion invested, has
withheld votes for directors at companies that approved poison pills, Wall
Street Journal, June 12, 2002.
COUNCIL OF INSTITUTIONAL INVESTORS RECOMMENDATION
The Council of Institutional Investors www.cii.org, an organization of 120
pension funds which invests $1.5 trillion, called for shareholder approval of
poison pills. Institutional investors own 73% of Southwest stock. In recent
years, various companies have been willing to redeem existing poison pills or
seek shareholder approval for their poison pill. This includes Columbia/HCA,
McDermott International and Airborne, Inc. I believe that our company should
follow suit and allow shareholder input.
SERIOUS ABOUT GOOD GOVERNANCE
I believe Enron and the corporate disasters that followed forced many companies
to get serious about good governance. This includes a shareholder vote on poison
pills. When the buoyant stock market burst, I believe the importance of
governance was clear. In a time of crises, I believe a vigorous board can help
minimize damage.
A look at Business Week's inaugural ranking of the best and worst boards in 1996
tells the story. For the 3 years after the list appeared, the stocks of
companies with the best boards outperformed those with the worse boards by 2 to
1. Increasingly, institutional investors are flocking to stocks of companies
perceived as being well governed and punishing stocks of companies seen as lax
in oversight. The source for the preceding three sentences is Business Week,
"The Best and Worst Boards," October 7, 2002.
ALLOW SHAREHOLDER VOTE REGARDING POISON PILLS
OUR YES-VOTE EXCEEDED 57% FOR THREE CONSECUTIVE YEARS
YES ON 2
17
BOARD OF DIRECTORS POSITION
YOUR DIRECTORS RECOMMEND A VOTE AGAINST THE ADOPTION OF THIS PROPOSAL,
FOR THE FOLLOWING REASONS:
The Board of Directors adopted the Company's shareholder rights plan in
1986, and extended its term for ten more years in 1996, in order to protect the
Company's shareholders against abusive takeover tactics and to ensure that each
shareholder is treated fairly in any transaction involving an acquisition of
control of the Company. Plans similar to the Company's plan have been adopted by
a majority of the corporations included in the Standard & Poor's 500.
The purpose of the rights plan is to strengthen the Board's ability, in
the exercise of its fiduciary duties, to protect and maximize the value of
shareholders' investment in the Company in the event of an attempt to acquire
control of the Company. The plan is not intended to, and does not, preclude
unsolicited, non-abusive offers to acquire the Company at a fair price. Nor is
it intended as a deterrent to a shareholder's initiation of a proxy contest. The
plan is designed, instead, to encourage any potential acquirer to negotiate
directly with the Board, which the Company believes is in the best position to
evaluate the adequacy and fairness of proposed offers, to negotiate on behalf of
shareholders and to protect shareholders against abusive tactics during a
takeover process, such as partial or two-tiered tender offers that do not treat
all shareholders fairly and equally or acquisitions in the open market of shares
constituting control without offering fair value to all shareholders. The rights
do not affect any takeover proposal that the Board believes is in the best
interests of the Company's shareholders. The overriding objective of the Board
in adopting and extending the rights plan was, and continues to be, the
preservation and maximization of the Company's value for all shareholders.
A study by Georgeson & Company Inc., analyzing takeover data from
1992-1996, revealed that premiums paid to acquire target companies with poison
pills were on average eight percentage points, or 26 percent, higher than
premiums paid for target companies that did not have poison pills. Georgeson
estimated that poison pills had contributed an additional $13 billion in
shareholder value during the time period in question, and that the shareholders
of acquired companies without pills gave up $14.5 billion in potential premiums.
Finally, Georgeson concluded that the presence of a poison pill at a target
company did not increase the likelihood of the withdrawal of a friendly takeover
bid nor the defeat of a hostile one, and that poison pills did not reduce the
likelihood of a company becoming a takeover target.
However, in response to shareholder concerns, as evidenced by the vote
on this topic at the 2000 Shareholders' Meeting, the Board of Directors of
Southwest in 2001 amended the Company's Rights Plan to include what is commonly
referred to as a "chewable" feature. This amendment makes the Plan inapplicable
to a fully-financed or cash tender offer for all of the Company's shares of
common stock, which remains open for at least 60 calendar days, is at a price
equal to the higher of (a) 65 percent over the average closing price of the
common stock during the 90 days preceding the offer and (b) the highest closing
price during the 52 weeks preceding the offer, and is accompanied by a written
fairness opinion of a nationally recognized investment banking firm. Also, the
Company shortened the term of the Rights Plan so that it now expires on July 30,
2005.
The Board believes that the adoption of a shareholder rights plan is
appropriately within the scope of responsibilities of the Board of Directors,
acting on behalf of all shareholders. The adoption of such a plan accords with
the Board's responsibilities for the management of the Company's affairs and the
issuance of securities and does not require shareholder approval under Texas
corporation law or the rules of the New York Stock Exchange. Redeeming the
rights would remove an important tool that the Board should have for the
protection of shareholders. The Board therefore believes that any decision to
redeem the rights should be made in the context of a specific acquisition
proposal.
THE BOARD OF DIRECTORS RECOMMENDS A VOTE AGAINST THIS SHAREHOLDER
PROPOSAL. PROXIES SOLICITED BY THE BOARD OF DIRECTORS WILL BE SO VOTED UNLESS
SHAREHOLDERS SPECIFY A DIFFERENT CHOICE.
18
RELATIONSHIP WITH INDEPENDENT AUDITORS
The firm of Ernst & Young LLP, independent auditors, has been selected
by the Board of Directors to serve as the Company's auditors for the fiscal year
ending December 31, 2003. Ernst & Young LLP has served as the Company's auditors
since the inception of the Company. A representative of Ernst & Young LLP is
expected to be present at the Annual Meeting in order to make a statement if he
so desires and to respond to appropriate questions.
The following table sets forth the various fees for services provided
to the Company by Ernst & Young in 2002 and 2001:
YEAR AUDIT FEES(1) AUDIT RELATED FEES(2) TAX FEES(3) ALL OTHER FEES(4) TOTAL FEES
---- ------------- --------------------- ----------- ----------------- ----------
2002 $785,382 $108,000 $ 67,772 $4,500 $965,654
2001 $405,630 $102,500 $186,816 $6,400 $701,346
(1) Includes fees for the annual audit and quarterly reviews, SEC
registration statements, accounting and financial reporting
consultations and research work regarding Generally Accepted Accounting
Principles, passenger facility charge audits, audits required by the
Federal Government for security fee payments and government relief, and
consultations and research related to the Sarbanes-Oxley Act of 2002.
(2) Includes fees for benefit plan audits.
(3) Includes services for tax compliance, tax advice and tax planning.
(4) Consists of fees for other products and services.
OTHER MATTERS
NOTICE REQUIREMENTS
To permit the Company and its shareholders to deal with shareholder
proposals in an informed and orderly manner, the Bylaws establish an advance
notice procedure with regard to the nomination (other than by or at the
direction of the Board of Directors) of candidates for election to the Board of
Directors and with regard to certain matters to be brought before an Annual
Meeting of Shareholders. In general, under the Bylaws written notice must be
received by the Secretary of the Company not less than 60 days nor more than 90
days prior to the meeting and must contain certain specified information
concerning the person to be nominated or the matters to be brought before the
meeting as well as the shareholder submitting the proposal. Pursuant to the
Company's Bylaws, a shareholder may nominate a person or persons for election to
the Board by providing written notice to the Secretary of the Company not less
than 60 and not more than 90 days prior to the meeting. The notice must contain
(i) as to each nominee, all information required to be disclosed in
solicitations of proxies for election of directors pursuant to Regulation 14A
under the Securities Exchange Act of 1934, (ii) the name and address of the
shareholder giving the notice, and (iii) the number of shares of the Company
beneficially owned by the shareholder giving the notice. If we do not receive
notice of your proposal before February 24, 2004, it will be considered
"untimely" and we may properly use our discretionary authority to vote for or
against the proposal. A copy of the applicable Bylaw provisions may be obtained,
without charge, upon written request to the Secretary of the Company at the
address set forth on page 1 of this Proxy Statement.
In addition, any shareholder who wishes to submit a proposal for
inclusion in the proxy material and presentation at the 2004 Annual Meeting of
Shareholders must forward such proposal to the Secretary of the
19
Company, at the address indicated on page 1 of this Proxy Statement, so that the
Secretary receives it no later than December 6, 2003.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities and Exchange Act of 1934 requires the
Company's officers and directors to file reports of ownership and changes in
ownership of Company common stock with the Securities and Exchange Commission
and the New York Stock Exchange. During 2002, no reports were filed late.
DISCRETIONARY AUTHORITY
In the event a quorum is present at the meeting but sufficient votes to
approve any of the items proposed by the Board of Directors have not been
received, the persons named as proxies may propose one or more adjournments of
the meeting to permit further solicitation of proxies. A shareholder vote may be
taken on one or more of the proposals in this Proxy Statement prior to such
adjournment if sufficient proxies have been received and it is otherwise
appropriate. Any adjournment will require the affirmative vote of the holders of
a majority of those shares of common stock represented at the meeting in person
or by proxy. If a quorum is present, the persons named as proxies will vote
these proxies which they have been authorized to vote on any other business
properly before the meeting in favor of such an adjournment.
The Board of Directors does not know of any other matters that are to
be presented for action at the meeting. However, if other matters properly come
before the meeting, it is intended that the enclosed proxy will be voted in
accordance with the judgment of the persons voting the proxy.
By Order of the Board of Directors,
Herbert D. Kelleher
Chairman of the Board
April 12, 2003
20
TO: PARTICIPANTS IN THE SOUTHWEST AIRLINES CO. PROFITSHARING PLAN (THE "PLAN")
The accompanying Notice of Annual Meeting of Shareholders and Proxy
Statement relate to shares of common stock of Southwest Airlines Co. held by the
Trustee for your profit sharing account, as well as any shares you may own in
your own name.
Under the Plan, each participant has the right to direct the voting of
stock credited to his or her account. In addition, you and the other
participants are entitled to direct the voting of stock credited to the accounts
of participants who do not give voting instructions.
The Trustee is required to vote the shares held for your account in
accordance with your instructions. If you wish to instruct the Trustee on the
vote of shares held for your account, you should complete and sign the form
enclosed and return it in the addressed, postage-free envelope by May 12, 2003.
If you do not return your proxy card by May 12, 2003, the Trustee will
vote your shares in the same proportions as the shares for which the Trustee
receives voting instructions from other participants.
21
(LOGO)
2002 REPORT TO
SHAREHOLDERS
(INCLUDING PORTIONS OF THE COMPANY'S ANNUAL REPORT ON FORM
10-K FILED WITH THE SECURITIES AND EXCHANGE COMMISSION)
DESCRIPTION OF BUSINESS
Southwest Airlines Co. ("Southwest") is a major domestic airline that
provides predominantly shorthaul, high-frequency, point-to-point, low-fare
service. Southwest was incorporated in Texas and commenced Customer Service on
June 18, 1971 with three Boeing 737 aircraft serving three Texas cities -
Dallas, Houston, and San Antonio.
At year-end 2002, Southwest operated 375 Boeing 737 aircraft and
provided service to 59 airports in 58 cities in 30 states throughout the United
States. Based on data for second quarter 2002 (the latest available data),
Southwest Airlines is the 4th largest carrier in the United States based on
domestic passengers boarded and the second largest based on scheduled domestic
departures.
The business of the Company is somewhat seasonal. Quarterly operating
income and, to a lesser extent, revenues tend to be lower in the first quarter
(January 1 - March 31).
Southwest's filings with the Securities and Exchange Commission,
including its annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and amendments to those reports are accessible free
of charge at www.southwest.com.
FUEL
The cost of fuel is an item having significant impact on the Company's
operating results. The Company's average cost of jet fuel over the past five
years was as follows:
COST AVERAGE COST PERCENT OF
YEAR (Millions) PER GALLON OPERATING EXPENSES
---- --------- ------------ ------------------
1998 $388.3 $ .46 11.2%
1999 $492.4 $ .53 12.5%
2000 $804.4 $ .79 17.4%
2001 $770.5 $ .71 15.6%
2002 $762.1 $ .68 14.9%
From October 1, 2002 through December 31, 2002, the average cost per
gallon was $.71. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" for a discussion of Southwest's fuel
hedging activities.
REGULATION
Economic. The Dallas Love Field section of the International Air
Transportation Competition Act of 1979, as amended in 1997 (commonly known as
the "Wright Amendment"), as it affects Southwest's scheduled service, provides
that no common carrier may provide scheduled passenger air transportation for
compensation between Love Field and one or more points outside Texas, except
that an air carrier may transport individuals by air on a flight between Love
Field and one or more points within the states of Alabama, Arkansas, Kansas,
Louisiana, Mississippi, New Mexico, Oklahoma, and Texas if (a) "such air carrier
does not offer or provide any through service or ticketing with another air
carrier" and (b) "such air carrier does not offer for sale transportation to or
from, and the flight or aircraft does not serve, any point which is outside any
such states." The Wright Amendment does not restrict flights operated with
aircraft having 56 or fewer passenger seats. The
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Wright Amendment does not restrict Southwest's intrastate Texas flights or its
air service from points other than Love Field.
The Department of Transportation ("DOT") has significant regulatory
jurisdiction over passenger airlines. Unless exempted, no air carrier may
furnish air transportation over any route without a DOT certificate of public
convenience and necessity, which does not confer either exclusive or proprietary
rights. The Company's certificates are unlimited in duration and permit the
Company to operate among any points within the United States, its territories
and possessions, except as limited by the Wright Amendment, as do the
certificates of all other U.S. carriers. DOT may revoke such certificates, in
whole or in part, for intentional failure to comply with certain provisions of
the U.S. Transportation Code, or any order or regulation issued thereunder or
any term of such certificate; provided that, with respect to revocation, the
certificate holder has first been advised of the alleged violation and fails to
comply after being given a reasonable time to do so.
DOT prescribes uniform disclosure standards regarding terms and
conditions of carriage and prescribes that terms incorporated into the Contract
of Carriage by reference are not binding upon passengers unless notice is given
in accordance with its regulations.
Safety. The Company is subject to the jurisdiction of the Federal
Aviation Administration ("FAA") with respect to its aircraft maintenance and
operations, including equipment, ground facilities, dispatch, communications,
flight training personnel, and other matters affecting air safety. To ensure
compliance with its regulations, the FAA requires airlines to obtain operating,
airworthiness, and other certificates, which are subject to suspension or
revocation for cause. The Company has obtained such certificates. The FAA,
acting through its own powers or through the appropriate U. S. Attorney, also
has the power to bring proceedings for the imposition and collection of fines
for violation of the Federal Air Regulations.
The Company is subject to various other federal, state, and local laws
and regulations relating to occupational safety and health, including
Occupational Safety and Health Administration (OSHA) and Food and Drug
Administration (FDA) regulations.
Security. On November 19, 2001, President Bush signed into law the
Aviation and Transportation Security Act ("Security Act"). The Security Act
generally provides for enhanced aviation security measures. The Security Act
established a new Transportation Security Administration ("TSA"), which has
recently been moved to the new Office of Homeland Security. The TSA assumed the
aviation security functions previously residing in the FAA and assumed passenger
screening contracts at U.S. airports on February 17, 2002. The TSA now provides
for the screening of all passengers and property, which is performed by federal
employees. Beginning February 1, 2002, a $2.50 per enplanement security fee is
imposed on passengers (maximum of $5.00 per one-way trip). Pursuant to authority
granted to the TSA to impose additional fees on air carriers if necessary to
cover additional federal aviation security costs, the TSA has imposed an annual
Security Infrastructure Fee which approximated $23 million for Southwest in 2002
and is expected to approximate $26 million in 2003. Like the FAA, the TSA may
impose and collect fines for violations of its regulations.
Environmental. Certain airports, including San Diego and Orange County,
have established airport restrictions to limit noise, including restrictions on
aircraft types to be used, and limits on the number of hourly or daily
operations or the time of such operations. In some instances, these restrictions
have caused curtailments in service or increases in operating costs and such
restrictions could limit the ability of Southwest to expand its operations at
the affected airports. Local authorities at other airports may consider adopting
similar noise regulations, but such regulations are subject to the provisions of
the Airport Noise and Capacity Act of 1990 and regulations promulgated
thereunder.
Operations at John Wayne Airport, Orange County, California, are
governed by the Airport's Phase 2 Commercial Airline Access Plan and Regulation
(the "Plan"). Pursuant to the Plan, each airline is allocated
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total annual seat capacity to be operated at the airport, subject to
renewal/reallocation on an annual basis. Service at this airport may be adjusted
annually to meet these requirements.
The Company is subject to various other federal, state, and local laws
and regulations relating to the protection of the environment, including the
discharge or disposal of materials such as chemicals, hazardous waste, and
aircraft deicing fluid. Potential future regulatory developments pertaining to
such things as control of engine exhaust emissions from ground support equipment
and prevention of leaks from underground aircraft fueling systems could increase
operating costs in the airline industry. The Company does not believe, however,
that such environmental regulatory developments will have a material impact on
the Company's capital expenditures or otherwise adversely effect its operations,
operating costs, or competitive position. Additionally, in conjunction with
airport authorities, other airlines, and state and local environmental
regulatory agencies, the Company is undertaking voluntary investigation or
remediation of soil or groundwater contamination at several airport sites. While
the full extent of any contamination at such sites and the parties responsible
for such contamination have not been determined, the Company does not believe
that any environmental liability associated with such sites will have a material
adverse effect on the Company's operations, costs, or profitability.
Customer Service Commitment. During 1999, the airline transportation
industry faced possible legislation dealing with certain customer service
practices. As a compromise with Congress, the industry, working with the Air
Transport Association, responded by adopting and filing with the DOT written
plans disclosing how it would commit to improving performance. Southwest
Airlines formalized its dedication to Customer Satisfaction by adopting its
Customer Service Commitment, a comprehensive plan which embodies the Mission
Statement of Southwest Airlines: dedication to the highest quality of Customer
Service delivered with a sense of warmth, friendliness, individual pride, and
Company Spirit. The Customer Service Commitment can be reviewed by clicking on
"About SWA" at www.southwest.com. Congress is expected to monitor the effects of
the industry's plans, and there can be no assurance that legislation will not be
proposed in the future to regulate airline customer service practices.
MARKETING AND COMPETITION
Southwest focuses principally on point-to-point, rather than
hub-and-spoke, service in markets with frequent, conveniently timed flights and
low fares. For example, Southwest's average aircraft trip stage length in 2002
was 548 miles with an average duration of approximately 1.5 hours. At year-end,
Southwest served 338 nonstop city pairs.
Southwest's point-to-point route system, as compared to hub-and-spoke,
provides for more direct nonstop routings for Customers and, therefore,
minimizes connections, delays, and total trip time. Southwest focuses on
nonstop, not connecting, traffic. As a result, approximately 77 percent of the
Company's Customers fly nonstop. In addition, Southwest serves many conveniently
located satellite or downtown airports such as Dallas Love Field, Houston Hobby,
Chicago Midway, Baltimore-Washington International, Burbank, Manchester,
Oakland, San Jose, Providence, Ft. Lauderdale/Hollywood and Long Island
airports, which are typically less congested than other airlines' hub airports
and enhance the Company's ability to sustain high Employee productivity and
reliable ontime performance. This operating strategy also permits the Company to
achieve high asset utilization. Aircraft are scheduled to minimize the amount of
time the aircraft are at the gate, currently approximately 25 minutes, thereby
reducing the number of aircraft and gate facilities that would otherwise be
required. Southwest does not interline or offer joint fares with other airlines,
nor have any commuter feeder relationships.
Southwest employs a relatively simple fare structure, featuring low,
unrestricted, unlimited, everyday coach fares, as well as even lower fares
available on a restricted basis. The Company operates only one aircraft type,
the Boeing 737, which simplifies scheduling, maintenance, flight operations, and
training activities.
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In January 1995, Southwest was the first major airline to introduce a
Ticketless travel option, eliminating the need to print and then process a paper
ticket altogether. Southwest also entered into an arrangement with SABRE, the
computer reservation system in which Southwest has historically participated to
a limited extent, providing for ticketing and automated booking on Southwest in
a very cost-effective manner. In 1996, Southwest began offering Ticketless
travel through the Company's home page on the Internet at www.southwest.com. For
the year ended December 31, 2002, more than 85 percent of Southwest's Customers
chose the Ticketless travel option and approximately 49 percent of Southwest's
passenger revenues came through its Internet site, which has become a vital part
of the Company's distribution strategy.
The airline industry is highly competitive as to fares, frequent flyer
benefits, routes, and service, and some carriers competing with the Company have
larger fleets and wider name recognition. Certain major United States airlines
have established marketing or codesharing alliances with each other, including
Northwest Airlines/Continental Airlines, American Airlines/Alaska Airlines, and
United Airlines/USAirways. Northwest Airlines and Continental Airlines have
announced plans to add Delta Air Lines to their alliance in a transaction which
is subject to conditions established by the Department of Transportation.
Since the terrorist acts of September 11, 2001, and in the face of weak
demand for air service, most major carriers (not including Southwest) have
significantly reduced service, grounded aircraft, and furloughed employees. UAL,
the parent of United Airlines, and US Airways have sought relief from financial
obligations in bankruptcy and other, smaller carriers have ceased operation
entirely. America West Airlines and others have received federal loan guarantees
(or conditional approval for guarantees) authorized by federal law and
additional airlines may do so in the future.
Enhanced security measures have had, and will continue to have, a
significant impact on the airport experience for passengers. Security
requirements are still evolving on a daily basis; however, to date, they have
not impacted Southwest's aircraft utilization. In response to these measures,
the Company has introduced its new Automated Boarding Passes, as well as RAPID
CHECK-IN kiosks in many airports and it will continue to expand the latter
service offering throughout 2003. It is currently not possible to assess the
ultimate impact of all of these events on airline competition.
The Company is also subject to varying degrees of competition from
surface transportation in its shorthaul markets, particularly the private
automobile. In shorthaul air services that compete with surface transportation,
price is a competitive factor, but frequency and convenience of scheduling,
facilities, transportation safety and security procedures, and Customer Service
may be of equal or greater importance to many passengers.
INSURANCE
The Company carries insurance of types customary in the airline
industry and at amounts deemed adequate to protect the Company and its property
and to comply both with federal regulations and certain of the Company's credit
and lease agreements. The policies principally provide coverage for public and
passenger liability, property damage, cargo and baggage liability, loss or
damage to aircraft, engines, and spare parts, and workers' compensation.
Following the terrorist attacks, commercial aviation insurers
significantly increased the premiums and reduced the amount of war-risk coverage
available to commercial carriers. At that time, the federal government stepped
in to provide supplemental third-party war-risk insurance coverage to commercial
carriers for renewable 60-day periods at substantially lower premiums than
prevailing commercial rates and for levels of coverage not available in the
commercial market. In November 2002, Congress passed the Homeland Security Act
of 2002, which mandated the federal government to provide third party, passenger
and hull war-risk insurance coverage to commercial carriers through August 31,
2003, which may be extended by the government through December 31, 2003. The
Company is unable to predict whether the government will extend this insurance
coverage past
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August 31, 2003, whether alternative commercial insurance with comparable
coverage will become available at reasonable premiums, and what impact this will
have on the Company's ongoing operations or future financial performance.
FREQUENT FLYER AWARDS
Southwest's frequent flyer program, Rapid Rewards, is based on trips
flown rather than mileage. Rapid Rewards Customers earn a flight segment credit
for each one-way trip flown or two credits for each round trip flown. Rapid
Rewards Customers can also receive flight segment credits by using the services
of non-airline partners, which include a telephone company, car rental agencies,
hotels, and credit card partners, including the Southwest Airlines First USA (R)
Visa card. Rapid Rewards offers two types of travel awards. The Rapid Rewards
Award Ticket ("Award Ticket") offers one free roundtrip travel award to any
Southwest destination after the accumulation of 16 flight segment credits within
a consecutive twelve-month period. The Rapid Rewards Companion Pass ("Companion
Pass") is granted for flying 50 roundtrips (or 100 one-way trips) on Southwest
within a consecutive twelve-month period. The Companion Pass offers unlimited
free roundtrip travel to any Southwest destination for a companion of the
qualifying Rapid Rewards member. In order for the companion to use this pass,
the Rapid Rewards member must purchase a ticket or use an Award Ticket.
Additionally, the Rapid Rewards member and companion must travel together on the
same flight.
Trips flown are valid for flight segment credits toward Award Tickets
and Companion Passes for twelve months only; Award Tickets and Companion Passes
are automatically generated when earned by the Customer rather than allowing the
Customer to bank credits indefinitely; and Award Tickets and Companion Passes
are valid for one year with an automatic expiration date. "Black out" dates
apply during peak holiday periods.
The Company also sells flight segment credits to business partners
including credit card companies, phone companies, hotels, and car rental
agencies. These credits may be redeemed for Award Tickets having the same
program characteristics as those earned by flying.
Customers redeemed approximately 2.2 million, 1.7 million, and 1.6
million Award Tickets and flights on Companion Passes during 2002, 2001, and
2000, respectively. The amount of free travel award usage as a percentage of
total Southwest revenue passengers carried was 6.8 percent in 2002, 5.4 percent
in 2001, and 4.9 percent in 2000. The number of Award Tickets outstanding at
December 31, 2002 and 2001 was approximately 1.4 million and 1.3 million,
respectively. These numbers do not include partially earned Award Tickets. The
Company currently does not have a system to accurately estimate partially earned
Award Tickets. However, these partially earned Award Tickets may equal 60
percent or more of the current outstanding Award Tickets. Since the inception of
Rapid Rewards in 1987, approximately 14 percent of all Award Tickets have
expired without being used. The number of Companion Passes for Southwest
outstanding at December 31, 2002 and 2001 was approximately 55,000 and 48,000,
respectively. The Company currently estimates that 3 to 4 trips will be redeemed
per outstanding Companion Pass.
The Company accounts for its frequent flyer program obligations by
recording a liability for the estimated incremental cost of flight awards the
Company expects to be redeemed (except for flight segment credits sold to
business partners). This method recognizes an average incremental cost to
provide roundtrip transportation to one additional passenger. The estimated
incremental cost includes direct passenger costs such as fuel, food and other
operational costs, but does not include any contribution to overhead or profit.
The incremental cost is accrued at the time an award is earned and revenue is
subsequently recognized, at the amount accrued, when the free travel award is
used. Revenue from the sale of flight segment credits and associated with future
travel is deferred and recognized when the ultimate free travel award is flown
or the credits expire unused. Accordingly, Southwest does not accrue incremental
cost for the expected redemption of free travel awards for credits sold to
business partners. The liability for free travel awards earned but not used at
December 31, 2002 and 2001 was not material.
A-6
EMPLOYEES
At December 31, 2002, Southwest had 33,705 active employees, consisting
of 10,920 flight, 1,900 maintenance, 16,405 ground customer and fleet service
and 4,480 management, accounting, marketing, and clerical personnel.
Southwest has ten collective bargaining agreements covering
approximately 80.6 percent of its employees. The following table sets forth the
Company's employee groups and collective bargaining status:
EMPLOYEE GROUP REPRESENTED BY AGREEMENT AMENDABLE ON
-------------- -------------- ----------------------
Customer Service and International Association of November 2008 (or 2006 at the
Reservations Machinists and Aerospace Union's option under certain
Workers, AFL-CIO conditions)
Flight Attendants Transportation Workers of In negotiations
America, AFL-CIO ("TWU")
Ramp, Operations and TWU June 2008 (or 2006 at the
Provisioning Union's option under certain
conditions)
Pilots Southwest Airlines Pilots' September 2006
Association
Flight Dispatchers Southwest Airlines Employee November 2009
Association
Aircraft Appearance Aircraft Mechanics Fraternal February 2009
Technicians Association ("AMFA")
Stock Clerks International Brotherhood of August 2008
Teamsters ("Teamsters")
Mechanics AMFA August 2005
Flight Simulator Technicians Teamsters November 2008
Flight/Ground School Southwest Airlines Professional December 2012
Instructors and Flight Crew Instructors Association
Training Instructors
PROPERTIES
AIRCRAFT
Southwest operated a total of 375 Boeing 737 aircraft as of December
31, 2002, of which 90 and 7 were under operating and capital leases,
respectively. The remaining 278 aircraft were owned.
Southwest was the launch customer for the Boeing 737-700 aircraft, the
newest generation of the Boeing 737 aircraft type. The first 737-700 aircraft
was delivered in December 1997 and entered revenue service in January 1998. At
December 31, 2002, Southwest had 129 Boeing 737-700 aircraft in service.
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In total, at February 1, 2003, the Company had firm orders and options
to purchase Boeing 737 aircraft as follows:
FIRM ORDERS AND OPTIONS TO PURCHASE BOEING 737-700 AIRCRAFT
DELIVERY YEAR FIRM ORDERS OPTIONS PURCHASE RIGHTS
------------- ----------- ------- ---------------
2003 17 -- --
------------- ----------- ------- ---------------
2004 23 11 --
------------- ----------- ------- ---------------
2005 24 18 --
------------- ----------- ------- ---------------
2006 22 16 --
------------- ----------- ------- ---------------
2007 25 9 20
------------- ----------- ------- ---------------
2008-2012 6 25 197
------------- ----------- ------- ---------------
TOTALS 117 79 217
------------- ----------- ------- ---------------
The Company currently intends to retire its fleet of 27 Boeing 737-200
aircraft over the next three years.
The average age of the Company's fleet at December 31, 2002 was 9.2
years.
GROUND FACILITIES AND SERVICES
Southwest leases terminal passenger service facilities at each of the
airports it serves, to which it has added various leasehold improvements. The
Company leases land on a long-term basis for its maintenance centers located at
Dallas Love Field, Houston Hobby, Phoenix Sky Harbor, and Chicago Midway, its
training center near Love Field, which houses six 737 simulators, and its
corporate headquarters, also located near Love Field. The maintenance, training
center, and corporate headquarters buildings on these sites were built and are
owned by Southwest. At December 31, 2002, the Company operated nine reservation
centers. The reservation centers located in Little Rock, Arkansas; Chicago,
Illinois; Albuquerque, New Mexico; and Oklahoma City, Oklahoma occupy leased
space. The Company owns its Dallas, Texas; Houston, Texas; Phoenix, Arizona;
Salt Lake City, Utah; and San Antonio, Texas reservation centers.
Southwest has entered into a concession agreement with the Town of
Islip, New York which gives the Company the right to construct, furnish, occupy,
and maintain a new concourse at the airport. Once all phases of the project are
completed, the concourse would have up to a total of eight gates and is expected
to cost approximately $65 million. The Company is currently expected to be able
to begin operations from this new concourse in 2004, at which time the new
concourse will become the property of the Town of Islip. In return for
constructing the new concourse, Southwest will receive fixed-rent abatements for
a total of 25 years; however, the Company will still be required to pay variable
rents for common use areas.
The Company performs substantially all line maintenance on its aircraft
and provides ground support services at most of the airports it serves. However,
the Company has arrangements with certain aircraft maintenance firms for major
component inspections and repairs for its airframes and engines, which comprise
the majority of the annual aircraft maintenance costs.
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LEGAL PROCEEDINGS
The Company is subject to various legal proceedings and claims arising
in the ordinary course of business, including, but not limited to, examinations
by the Internal Revenue Service (IRS). The IRS regularly examines the Company's
federal income tax returns and, in the course of those examinations, proposes
adjustments to the Company's federal income tax liability reported on such
returns. It is the Company's practice to vigorously contest those proposed
adjustments that it deems lacking of merit. The Company's management does not
expect that the outcome in any of its currently ongoing legal proceedings or the
outcome of any proposed adjustments presented to date by the IRS, individually
or collectively, will have a material adverse effect on the Company's financial
condition, results of operations or cash flows.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None to be reported.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of Southwest, their positions, and their
respective ages (as of January 1, 2003) are as follows:
NAME POSITION AGE
---- -------- ---
Herbert D. Kelleher Chairman of the Board 71
James F. Parker Vice Chairman of the Board and 56
Chief Executive Officer
Colleen C. Barrett Director, President and Chief Operating Officer 58
Donna D. Conover Executive Vice President- Customer Service 49
Gary C. Kelly Executive Vice President and Chief Financial Officer 47
James C. Wimberly Executive Vice President- Chief Operations Officer 49
Joyce C. Rogge Senior Vice President - Marketing 45
Ron Ricks Vice President-Governmental Affairs 53
Dave Ridley Vice President-Ground Operations 49
Executive officers are elected annually at the first meeting of
Southwest's Board of Directors following the annual meeting of shareholders or
appointed by the Chief Executive Officer pursuant to Board authorization. Each
of the above individuals has worked for Southwest Airlines Co. for more than the
past five years.
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MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Southwest's common stock is listed on the New York Stock Exchange and
is traded under the symbol LUV. The high and low sales prices of the common
stock on the Composite Tape and the quarterly dividends per share paid on the
common stock were:
PERIOD DIVIDEND HIGH LOW
------ -------- ---- ---
2002
1ST QUARTER $0.00450 $22.00 $17.17
2ND QUARTER 0.00450 19.35 14.85
3RD QUARTER 0.00450 16.08 10.90
4TH QUARTER 0.00450 16.70 11.23
2001
1ST QUARTER $0.00450 $23.27 $16.00
2ND QUARTER 0.00450 20.03 16.55
3RD QUARTER 0.00450 20.23 11.25
4TH QUARTER 0.00450 20.00 14.52
AS OF DECEMBER 31, 2002, THERE WERE 11,858 HOLDERS OF RECORD OF THE
COMPANY'S COMMON STOCK.
RECENT SALES OF UNREGISTERED SECURITIES
During 2002, Herbert D. Kelleher, Chairman of the Board, exercised
unregistered options to purchase Southwest Common Stock as follows:
NUMBER OF SHARES PURCHASED EXERCISE PRICE DATE OF EXERCISE
-------------------------- -------------- ----------------
415,528 $1.00 1/15/02
437,032 $2.24 1/15/02
The issuances of the above options and shares to Mr. Kelleher were
deemed exempt from the registration provisions of the Securities Act of 1933, as
amended (the "Securities Act"), by reason of the provision of Section 4(2) of
the Securities Act because, among other things, of the limited number of
participants in such transactions and the agreement and representation of Mr.
Kelleher that he was acquiring such securities for investment and not with a
view to distribution thereof. The certificates representing the shares issued to
Mr. Kelleher contain a legend to the effect that such shares are not registered
under the Securities Act and may not be transferred except pursuant to a
registration statement which has become effective under the Securities Act or to
an exemption from such registration. The issuance of such shares was not
underwritten.
A-10
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table provides information as of December 31, 2002
regarding compensation plans (including individual compensation arrangements)
under which equity securities of Southwest are authorized for issuance.
EQUITY COMPENSATION PLAN INFORMATION
NUMBER OF SECURITIES
REMAINING AVAILABLE FOR
NUMBER OF SECURITIES TO FUTURE ISSUANCE UNDER EQUITY
BE ISSUED UPON EXERCISE COMPENSATION PLANS
OF OUTSTANDING OPTIONS, WEIGHTED-AVERAGE EXERCISE (EXCLUDING SECURITIES
WARRANTS AND RIGHTS PRICE OF OUTSTANDING OPTIONS, REFLECTED IN COLUMN (A))
(in thousands) WARRANTS AND RIGHTS* (in thousands)
----------------------- ----------------------------- -----------------------------
PLAN CATEGORY (a) (b) (c)
------------- ----------------------- ----------------------------- -----------------------------
Equity Compensation
Plans Approved by
Security Holders 31,151 $9.76 22,538
Equity Compensation
Plans not Approved by
Security Holders 110,160 9.94 41,767
Total 141,311 $9.90 64,305
*As adjusted for stock splits.
See Note 12 to the Consolidated Financial Statements for information
regarding the material features of the above plans. Each of the above plans
provides that the number of shares with respect to which options may be granted,
and the number of shares of Common Stock subject to an outstanding option, shall
be proportionately adjusted in the event of a subdivision or consolidation of
shares or the payment of a stock dividend on Common Stock, and the purchase
price per share of outstanding options shall be proportionately revised.
A-11
SELECTED FINANCIAL DATA
The following financial information for the five years ended December
31, 2002 has been derived from the Company's Consolidated Financial Statements.
This information should be read in conjunction with the Consolidated Financial
Statements and related notes thereto included elsewhere herein.
YEARS ENDED DECEMBER 31,
---------------------------------------------------------------
2002 2001 2000
------------ ------------ ------------
FINANCIAL DATA:
(in thousands except per share amounts)
Operating revenues ........................... $ 5,521,771 $ 5,555,174 $ 5,649,560
Operating expenses ........................... 5,104,433 4,924,052 4,628,415
------------ ------------ ------------
Operating income ............................. 417,338 631,122 1,021,145
Other expenses(income), net .................. 24,656 (196,537) 3,781
------------ ------------ ------------
Income before income taxes ................... 392,682 827,659 1,017,364
Provision for income taxes ................... 151,713 316,512 392,140
------------ ------------ ------------
Net income ................................... $ 240,969 $ 511,147 $ 625,224(3)
============ ============ ============
Net income per share, basic .................. $ .31 $ .67 $ .84(3)
Net income per share, diluted ................ $ .30 $ .63 $ .79(3)
Cash dividends per common share .............. $ .0180 $ .0180 $ .0147
Total assets at period-end ................... $ 8,953,750 $ 8,997,141 $ 6,669,572
Long-term obligations at period-end .......... $ 1,552,781 $ 1,327,158 $ 760,992
Stockholders' equity at period-end ........... $ 4,421,617 $ 4,014,053 $ 3,451,320
OPERATING DATA:
Revenue passengers carried ................... 63,045,988 64,446,773 63,678,261
Revenue passenger miles (RPMs) (000s) ........ 45,391,903 44,493,916 42,215,162
Available seat miles (ASMs) (000s) ........... 68,886,546 65,295,290 59,909,965
Load factor (1) .............................. 65.9% 68.1% 70.5%
Average length of passenger haul (miles) .... 720 690 663
Trips flown .................................. 947,331 940,426 903,754
Average passenger fare ....................... $ 84.15(5) $ 83.93(4) $ 85.87
Passenger revenue yield per RPM .............. 11.69(cent)(5) 12.16(cent)(4) 12.95(cent)
Operating revenue yield per ASM.......... 7.96(cent)(5) 8.55(cent)(4) 9.43(cent)
Operating expenses per ASM............... 7.41(cent) 7.48(cent)(4) 7.73(cent)
Fuel cost per gallon (average)........... 68.01(cent) 70.86(cent) 78.69(cent)
Number of Employees at year-end.......... 33,705 31,580 29,274
Size of fleet at year-end (2)............ 375 355 344
YEARS ENDED DECEMBER 31,
----------------------------------
1999 1998
------------ ------------
FINANCIAL DATA:
(in thousands except per share amounts)
Operating revenues ........................... $ 4,735,587 $ 4,163,980
Operating expenses ........................... 3,954,011 3,480,369
------------ ------------
Operating income ............................. 781,576 683,611
Other expenses(income), net .................. 7,965 (21,501)
------------ ------------
Income before income taxes ................... 773,611 705,112
Provision for income taxes ................... 299,233 271,681
------------ ------------
Net income ................................... $ 474,378 $ 433,431
============ ============
Net income per share, basic .................. $ .63 $ .58
Net income per share, diluted ................ $ .59 $ .55
Cash dividends per common share .............. $ .0143 $ .0126
Total assets at period-end ................... $ 5,653,703 $ 4,715,996
Long-term obligations at period-end .......... $ 871,717 $ 623,309
Stockholders' equity at period-end ........... $ 2,835,788 $ 2,397,918
OPERATING DATA:
Revenue passengers carried ................... 57,500,213 52,586,400
Revenue passenger miles (RPMs) (000s) ........ 36,479,322 31,419,110
Available seat miles (ASMs) (000s) ........... 52,855,467 47,543,515
Load factor (1) .............................. 69.0% 66.1%
Average length of passenger haul (miles) .... 634 597
Trips flown .................................. 846,823 806,822
Average passenger fare ....................... $ 79.35 $ 76.26
Passenger revenue yield per RPM .............. 12.51(cent) 12.76(cent)
Operating revenue yield per ASM.......... 8.96(cent) 8.76(cent)
Operating expenses per ASM............... 7.48(cent) 7.32(cent)
Fuel cost per gallon (average)........... 52.71(cent) 45.67(cent)
Number of Employees at year-end.......... 27,653 25,844
Size of fleet at year-end (2)............ 312 280
-----------
(1) Revenue passenger miles divided by available seat miles.
(2) Includes leased aircraft.
(3) Excludes cumulative effect of accounting change of $22.1 million ($.03
per share).
(4) Excludes special items related to the September 11, 2001 terrorist
attacks. Including these items, average passenger fare would decrease
by $.47, passenger revenue yield per RPM would decrease by .07 cents,
operating revenue yield per ASM would decrease by .04 cents, and
operating expenses per ASM would increase by .06 cents.
(5) Excludes $36 million in revenue from second quarter 2002 related to a
reduction in air traffic liability. Including the $36 million, average
passenger fare would increase by $.57, passenger revenue yield per RPM
would increase by .08 cents, and operating revenue yield per ASM would
increase by .06 cents.
A-12
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATION
YEAR IN REVIEW
In 2002, Southwest posted a profit for the 30th consecutive year. While the
Company's 2002 profitability fell short of our historical standards, this
performance was remarkable given that the major airlines collectively reported
losses in the billions of dollars. From a financial perspective, 2002 was one of
the worst years, if not the worst, in the history of commercial aviation. It was
a year that included dramatic increases in aviation insurance costs, increased
passenger security costs resulting from continually evolving security laws and
directives, airline industry downsizing, rising energy prices, and a
recessionary airline revenue environment. However, the Company's business
strategy - predominantly shorthaul, high frequency, low-fare, point-to-point,
high-quality Customer Service, low costs - continued to serve Southwest well
throughout the year. The Company has been able to combat many of these higher
exogenous costs by lowering distribution costs and implementing other cost
reduction measures. Throughout the difficult period beginning with the September
11, 2001 terrorist attacks the Company has been profitable every quarter.
During 2002, Southwest successfully met the challenge of dramatic changes in
airport security. Initially, these security changes dramatically altered airport
checkin procedures resulting in longer checkin times for Customers. The Company
invested in additional airport facilities, new technology, changed processes and
added Employees. These actions, at most airports, restored checkin times to
normal durations. Specific changes to the way Customers and baggage are
processed included the implementation of computer-generated baggage tags to
electronically track bags checked by Customers, computer-generated boarding
passes from multiple points in the airport, and the installation of self-service
RAPID CHECK-IN kiosks at airports. Although the Transportation Security
Administration has successfully assumed responsibility for passenger and baggage
screening, and has complied with all federal security mandates as required by
the Aviation and Transportation Security Act, the Company is currently unable to
predict what impact future mandates, if any, will have on the Company's ongoing
operations and future financial performance.
Although the Company did not open any new cities in 2002, it did improve its
quality of service between cities already served and added 23 new 737-700
aircraft to facilitate this growth. These additions, along with the retirement
of three older 737-200 aircraft, resulted in a net capacity increase of 5.5
percent, and brought the Company's all-737 fleet to 375 aircraft at the end of
2002. The Company ended 2002 serving 59 airports in 30 states.
Available seat mile (ASM) capacity is expected to grow approximately four
percent in 2003 with the planned net addition of 11 aircraft. The Company
currently has 17 new Boeing 737-700s scheduled for delivery during the year and
plans to retire six of the Company's older 737-200s.
RESULTS OF OPERATIONS
2002 COMPARED WITH 2001. The Company's consolidated net income for 2002 was
$241.0 million ($.30 per share, diluted), as compared to 2001 net income of
$511.1 million ($.63 per share, diluted), a decrease of $270.1 million or 52.9
percent. Operating income for 2002 was $417.3 million, a decrease of $213.8
million, or 33.9 percent compared to 2001.
Consolidated results for 2002 and 2001 included $48 million and $235 million,
respectively, in gains that the Company recognized from grants under the Air
Transportation Safety and System Stabilization Act (Air Stabilization Act).
Consolidated results for 2002 also included $36 million in additional passenger
revenue from a reduction in estimated refunds and exchanges, contributing to an
A-13
increase in forfeited tickets included in "Air traffic liability." Consolidated
results for 2001 also included special pre-tax charges of approximately $48
million arising from the terrorist attacks. See Note 1 and Note 3 to the
Consolidated Financial Statements.
The Company believes that comparative analysis of results can be enhanced by
excluding the impact of these special items. The following table reconciles
results reported in accordance with Generally Accepted Accounting Principles
(GAAP) with results adjusted for special items that are not expected to recur:
(In thousands) 2002 2001
-------------- --------- ---------
Consolidated net income, as reported $ 240,969 $ 511,147
Government grant proceeds, net * (24,796) (123,510)
Passenger revenue adjustments, net * (18,103) 15,749
Special charges arising from terrorist attacks, net * -- 9,563
--------- ---------
Adjusted consolidated net income, excluding
special charges and unusual items (non-GAAP) $ 198,070 $ 412,949
========= =========
Net income per share, basic, as reported $ .31 $ .67
Government grant proceeds, net * (.03) (.16)
Passenger revenue adjustments, net * (.02) .02
Special charges arising from terrorist attacks, net * -- .01
--------- ---------
Adjusted net income per share, basic, excluding
special charges and unusual items (non-GAAP) $ .26 $ .54
========= =========
Net income per share, diluted, as reported $ .30 $ .63
Government grant proceeds, net * (.03) (.15)
Passenger revenue adjustments, net * (.03) .02
Special charges arising from terrorist attacks, net * -- .01
--------- ---------
Adjusted net income per share, diluted, excluding
special charges and unusual items (non-GAAP) $ .24 $ .51
========= =========
* Net of income tax and Company profitsharing effects
Following the terrorist attacks, all U.S. commercial flight operations were
suspended for approximately three days. However, the Company continued to incur
nearly all of its normal operating expenses (with the exception of certain
direct trip-related expenditures such as fuel, landing fees, etc.). The Company
canceled approximately 9,000 flights before resuming flight operations on
September 14, although it did not resume its normal pre-September 11 flight
schedule until September 18, 2002. After operations were fully resumed, load
factors and passenger yields were severely impacted, and ticket refund activity
increased. The Company estimates that from September 11 through September 30,
2001, it incurred operating losses in excess of $130 million.
Operating Revenues. Consolidated operating revenues decreased $33.4 million, or
..6 percent, primarily due to a $37.4 million, or .7 percent, decrease in
passenger revenues.
The decrease in passenger revenues was due to lower load factors (revenue
passenger miles or RPMs divided by available seat miles or ASMs) attributable to
the post-September 11, 2001 reduction in demand for air travel, and from lower
passenger yields (passenger revenue divided by RPMs) caused by a decline in
full-fare traffic. The Company's load factor for 2002 was 65.9 percent, compared
to 68.1 percent for 2001, resulting from a capacity (ASM) increase of 5.5
percent versus an RPM increase of only 2.0 percent. Excluding special items,
passenger yields for 2002 were $.1169 compared to $.1216 in 2001, a
A-14
decrease of 3.9 percent. In 2002, there continued to be heavy fare discounting
by the Company and the airline industry in general to stimulate demand. The
increase in capacity, as measured by ASMs, was due to the net addition of 20
aircraft during 2002 (net of three aircraft retirements). For the full year, the
Company experienced a 2.2 percent decrease in revenue passengers carried and a
4.3 percent increase in average length of passenger haul (RPMs divided by
revenue passengers carried).
The Company's 2002 load factor was attained only through heavy promotional
activities and aggressive revenue management. Load factors thus far in January
2003 and bookings for February and March 2003 have been satisfactory. However,
we expect the air fare environment to continue to be weak, relative to
pre-September 11, 2001 performance, through the first quarter 2003. If current
booking and revenue trends continue, first quarter 2003 unit revenues should,
however, exceed first quarter 2002's unit revenue of $.0761.
Consolidated freight revenues decreased $6.6 million, or 7.2 percent, primarily
due to a 40.3 percent decrease in mail revenues. Following the terrorist
attacks, the United States Postal Service shifted a portion of the mail that
commercial carriers had previously carried to freight carriers. The mail
decrease more than offset an 11.4 percent increase in other freight revenues.
Other revenues increased $10.5 million, or 12.4 percent, primarily due to an
increase in commissions earned from programs the Company sponsors with certain
business partners, such as the Company-sponsored First USA(R) Visa card.
Operating Expenses. Consolidated operating expenses for 2002 increased $180.4
million, or 3.7 percent, compared to the 5.5 percent increase in capacity.
Operating expenses per ASM decreased 1.7 percent to $.0741, primarily due to
decreases in profitsharing expense, average jet fuel costs, and commission
expense. Excluding 2001 special items, operating expenses per ASM decreased .9
percent. For 2003, the Company currently expects an increase in operating
expenses per ASM primarily due to higher fuel costs and salaries, wages, and
benefits.
To a large extent, changes in operating expenses for airlines are driven by
changes in capacity, or ASMs. The following presents Southwest's operating
expenses per ASM for 2002 and 2001 followed by explanations of these changes on
a per ASM basis:
Increase Percent
2002 2001 (decrease) change
---- ---- ---------- -------
Salaries, wages, and benefits 2.89 (cent) 2.84 (cent) .05 (cent) 1.8%
Fuel and oil 1.11 1.18 (.07) (5.9)
Maintenance materials and repairs .57 .61 (.04) (6.6)
Agency commissions .08 .16 (.08) (50.0)
Aircraft rentals .27 .29 (.02) (6.9)
Landing fees and other rentals .50 .48 .02 4.2
Depreciation .52 .49 .03 6.1
Other 1.47 1.49 (.02) (1.3)
---- ---- ---- -----
Total 7.41 (cent) 7.54 (cent) (.13) (cent) (1.7)%
==== ==== ==== =====
Salaries, wages, and benefits expense per ASM increased 1.8 percent due to a 5.7
percent increase in salaries and wages per ASM and a 7.6 percent increase in
benefits expense per ASM, partially offset by a 30.3 percent decrease in
Employee retirement plans expense per ASM. The majority of the increase in
salaries and wages was due to headcount additions outpacing the Company's
capacity growth in several
A-15
operational areas, due in part to additional security requirements at airports.
The remaining portion of the increase in salaries and wages per ASM was
primarily due to increases in average wage rates.
The increase in benefits expense per ASM was primarily due to higher health care
costs. Employee retirement plans expense per ASM decreased primarily due to the
decrease in Company earnings available for profitsharing. In 2002 and 2001,
earnings available for profitsharing included $48 million and $235 million,
respectively, from grants recognized under the Air Stabilization Act. See Note 3
to the Consolidated Financial Statements. The Company also expects to experience
an increase in salaries, wages, and benefits per ASM in 2003 due to the
continued impact of headcount additions in excess of capacity growth, higher
average wage rates, and higher anticipated health care costs.
The Company's Mechanics are subject to an agreement negotiated with the
International Brotherhood of Teamsters (the Teamsters), that became amendable in
August 2001. The Company reached a tentative agreement with the Teamsters, which
was ratified by its membership in October 2002 (on January 27, 2003, the
Aircraft Mechanics Fraternal Association was certified by the National Mediation
Board as the new representative of the Mechanics). The new contract, which
includes the issuance of stock options, becomes amendable in August 2005.
The Company's Customer Service and Reservations Agents are subject to an
agreement with the International Association of Machinists and Aerospace Workers
(IAM) that became amendable in November 2002. The Company reached a tentative
agreement with the IAM in December 2002, which was approved by IAM membership in
January 2003. The new contract includes the issuance of stock options and
becomes amendable in November 2008 (or 2006 at the Union's option under certain
conditions as defined in the agreement).
The Company's Pilots are subject to an agreement with the Southwest Airlines
Pilots' Association (SWAPA). Although the contract between Southwest and SWAPA
was not amendable until September 2004, during 2002 the Company negotiated an
extension with SWAPA that was ratified by its membership in August 2002. The
extended contract, which includes the issuance of stock options, becomes
amendable in September 2006.
The Company's Ramp, Operations, and Provisioning Agents are represented by the
Transport Workers Union of America (TWU). Although the contract between
Southwest and TWU was not amendable until June 2006, during 2002 the Company
negotiated a two-year contract extension with TWU that was ratified by its
membership in December 2002. The contract extension included the issuance of
stock options. The contract with TWU now becomes amendable in June 2008 (or 2006
at the Union's option under certain conditions as defined in the agreement).
The Company's Flight Attendants are subject to an agreement with the TWU that
became amendable in June 2002. Southwest is currently in negotiations with the
TWU for a new contract.
Fuel and oil expense per ASM decreased 5.9 percent, primarily due to a 4.0
percent decrease in the average jet fuel cost per gallon. The average cost per
gallon of jet fuel in 2002 was $.6801 compared to $.7086 in 2001, excluding fuel
related taxes but including the effects of hedging activities. The Company's
2002 and 2001 average jet fuel costs are net of approximately $44.5 million and
$79.9 million in gains from hedging activities, respectively. See Note 2 and
Note 9 to the Consolidated Financial Statements. As detailed in Note 9 to the
Consolidated Financial Statements, the Company has hedges in place for
approximately 83 percent of its anticipated fuel consumption in 2003, including
all of its anticipated requirements for first quarter 2003. Considering current
market prices and the continued effectiveness of the Company's fuel hedges, the
Company is forecasting first quarter 2003 average fuel cost per gallon to be in
the $.70 to $.75 range. The majority of the Company's near term hedge
A-16
positions are in the form of option contracts, which protect the Company in the
event of rising jet fuel prices. The Company should also benefit, to a large
extent, in the event of a decline in jet fuel prices.
Maintenance materials and repairs per ASM decreased 6.6 percent. This decrease
was primarily due to a decrease in airframe expense resulting from fewer
outsourced heavy maintenance events versus 2001. More heavy maintenance events
were performed internally in 2002, resulting in the costs associated with those
events being reflected in salaries and wages. Currently, the Company expects an
increase in maintenance materials and repairs expense per ASM in first quarter
and full year 2003, versus 2002, due to an increase in contract rates from
outside vendors as well as the number of engine inspections and repairs
scheduled. The majority of the Company's engine maintenance work is outsourced.
Agency commissions per ASM decreased 50.0 percent, primarily due to a change in
the Company's commission rate policy. Effective October 15, 2001, the Company
reduced the commission paid to travel agents from eight percent for Ticketless
bookings and five percent for paper ticket bookings, to five percent (with no
cap), regardless of the type of ticket sold. In addition, the mix of tickets
sold through travel agents declined from 25 percent in 2001 to 20 percent in
2002, thereby reducing commissionable revenues and commission expense.
Aircraft rentals per ASM decreased 6.9 percent primarily due to a lower
percentage of the aircraft fleet being leased. Approximately 24.0 percent of the
Company's aircraft were under operating lease at December 31, 2002, compared to
25.9 percent at December 31, 2001. Based on the Company's current new aircraft
delivery schedule, scheduled aircraft retirements for 2003, and financing plans,
the Company expects a decline in aircraft rental expense per ASM in 2003,
including the first quarter.
Landing fees and other rentals per ASM increased 4.2 percent primarily as a
result of airport rate increases throughout the Company's system. Moreover,
following the terrorist attacks, most other major airlines reduced their flight
schedules due to the drop in air travel. Since Southwest did not reduce its
flights, the Company incurred higher airport costs based on a greater relative
share of total flights and passengers.
Depreciation expense per ASM increased 6.1 percent primarily due to growth in
the Company's owned aircraft fleet. The Company received delivery of 23 new
737-700 aircraft during 2002, all of which were purchased.
Other operating expenses per ASM decreased 1.3 percent despite a per-ASM
increase of more than 175 percent in aviation insurance costs. (The insurance
cost increases were more than offset through various cost control measures
implemented immediately following the prior year terrorist attacks, including
reductions in personnel related expenses and office expenses: excluding
insurance expense, other operating expenses per ASM decreased 8.5 percent).
Following the terrorist attacks, commercial aviation insurers significantly
increased the premiums and reduced the amount of war-risk coverage available to
commercial carriers. The federal government then stepped in to provide
supplemental third-party war-risk insurance coverage to commercial carriers, for
renewable 60-days periods, at substantially lower premiums than prevailing
commercial rates during 2002 and for levels of coverage not available in the
commercial market. In November 2002, Congress passed the Homeland Security Act
of 2002, which mandated the federal government provide third party, passenger
and hull war-risk insurance coverage to commercial carriers through August 31,
2003, and which permits such coverage to be extended by the government through
December 31, 2003. The Company is unable to predict whether the government will
extend this insurance coverage past August 31, 2003; whether alternative
commercial insurance with comparable coverage will become available at
reasonable premiums; and what impact the outcome will have on the Company's
ongoing operations or future financial performance. As a result of recently
concluded negotiations for 2003 commercial insurance coverage and
A-17
the additional coverage provided by the government, the Company currently
expects per-ASM insurance costs to decrease compared to 2002 for at least the
near term, including first quarter 2003.
Other. "Other expenses (income)" included interest expense, capitalized
interest, interest income, and other gains and losses. Interest expense
increased $36.2 million, or 51.8 percent compared to the prior year, due to
higher debt levels. In fourth quarter 2001, the Company issued $614.3 million in
long-term debt in the form of Pass Through Certificates. In first quarter 2002,
the Company issued $385 million in unsecured notes. See Note 7 to the
Consolidated Financial Statements for more information on these two borrowings.
The increase in expense caused by these borrowings was partially offset by a
decrease in interest rates on the Company's floating rate debt and the July 2001
redemption of $100 million of unsecured notes. Capitalized interest decreased
$3.9 million, or 18.7 percent, primarily as a result of lower 2002 progress
payment balances for scheduled future aircraft deliveries, compared to 2001.
Based on the Company's current schedule of progress payments and aircraft
deliveries, the Company expects progress payment balances, and corresponding
capitalized interest, to increase in 2003 compared to 2002. Interest income
decreased $5.6 million, or 13.2 percent, as higher invested cash balances for
the year were more than offset by lower rates. Other gains in 2002 and 2001
primarily resulted from $48 million and $235 million, respectively, received as
the Company's share of government grant funds under the Air Stabilization Act.
See Note 3 to the Company's Consolidated Financial Statements for further
discussion of the Air Stabilization Act and grants from the government.
Income Taxes. The provision for income taxes, as a percentage of income before
taxes, increased to 38.64 percent in 2002 from 38.24 percent in 2001 primarily
due to the Company's lower earnings in 2002.
2001 COMPARED WITH 2000. Consolidated net income for 2001 was $511.1 million
($.63 per share, diluted), as compared to 2000 net income, before the cumulative
effect of change in accounting principle, of $625.2 million ($.79 per share,
diluted), a decrease of $114.1 million, or 18.2 percent. Consolidated results
for 2001 included $235 million in gains that the Company recognized from grants
under the Air Stabilization Act and special pre-tax charges of approximately $48
million arising from the terrorist attacks (see Note 3 to the Consolidated
Financial Statements). Excluding the grant and special charges related to the
terrorist attacks, net income for 2001 was $412.9 million ($.51 per share,
diluted). The cumulative effect of change in accounting principle for 2000 was
$22.1 million, net of taxes of $14.0 million (see Note 2 to the Consolidated
Financial Statements). Net income and net income per share, diluted, for 2000,
after the cumulative change in accounting principle, were $603.1 million and
$.76, respectively. Operating income for 2001 was $631.1 million, a decrease of
$390.0 million, or 38.2 percent, compared to 2000.
Operating Revenues. Consolidated operating revenues decreased $94.4 million, or
1.7 percent, primarily due to a 1.6 percent decrease in passenger revenues. The
decrease in passenger revenues was a direct result of the terrorist attacks.
From January through August 2001, passenger revenues were higher by $314.9
million, or 8.7 percent, than the same period in 2000 primarily due to an
increase in capacity, as measured by ASMs, of 11.6 percent. This capacity
increase was due to the addition of 14 aircraft during 2001 (all prior to
September 11) and its revenue effects were partially offset by a decrease of 1.9
percent in passenger yield. Passenger yield decreased as a result of fare
discounting by the Company and the airline industry in general as the United
States economy weakened throughout 2001. The Company's load factor (RPMs divided
by ASMs) over this time period was 71.2 percent, compared to 71.7 percent for
the same period in 2000.
From September through December 2001, passenger revenues were $404.2 million, or
21.7 percent, lower than the same period of 2000. Capacity increased 4.0 percent
and the Company's load factor fell to 62.0 percent, compared to 68.2 percent
during the same period of 2000. Passenger yields were 17.2 percent
A-18
lower during this period, versus the same period in 2000, due to aggressive fare
sales following the terrorist attacks.
For the full year 2001, the Company experienced a 1.2 percent increase in
revenue passengers carried, a 5.4 percent increase in revenue passenger miles
(RPMs), and a 9.0 percent increase in ASMs. The Company's load factor for 2001
was off 2.4 points, to 68.1 percent, and there was a 6.6 percent decrease in
2001 passenger yield.
As a result of weak economic conditions throughout 2001, consolidated freight
revenues decreased $19.5 million, or 17.6 percent. There were decreases in both
the number of freight shipments and revenue per shipment. Other revenues
increased $14.3 million, or 20.3 percent, primarily due to an increase in
commissions earned from programs the Company sponsors with certain business
partners, such as the Company-sponsored First USA Visa card.
Operating Expenses. Consolidated operating expenses for 2001 increased $295.6
million, or 6.4 percent, compared to the 9.0 percent increase in capacity.
Operating expenses per ASM decreased 2.5 percent to $.0754, compared to $.0773
in 2000, primarily due to a decrease in average jet fuel prices. The average
fuel cost per gallon in 2001 was $.7086, 10.0 percent lower than the average
cost per gallon in 2000 of $.7869. Excluding fuel expense, operating expenses
per ASM decreased .3 percent.
Operating expenses per ASM for 2001 and 2000 were as follows:
Increase Percent
2001 2000 (decrease) change
---- ---- ---------- -------
Salaries, wages, and benefits 2.84 (cent) 2.81 (cent) .03 (cent) 1.1%
Fuel and oil 1.18 1.34 (.16) (11.9)
Maintenance materials and repairs .61 .63 (.02) (3.2)
Agency commissions .16 .27 (.11) (40.7)
Aircraft rentals .29 .33 (.04) (12.1)
Landing fees and other rentals .48 .44 .04 9.1
Depreciation .49 .47 .02 4.3
Other 1.49 1.44 .05 3.5
---- ---- ---- -----
Total 7.54 (cent) 7.73 (cent) (.19)(cent) (2.5)%
==== ==== ==== =====
Salaries, wages, and benefits per ASM increased 1.1 percent due to a 3.2 percent
increase in salaries and wages per ASM, and a 9.8 percent increase in benefits
expense per ASM, partially offset by a 17.5 percent decrease in Employee
retirement plans expense per ASM. The increase in salaries and wages per ASM was
primarily due to higher average wage rates within certain workgroups and
increased headcount due, in part, to the increased security requirements
following the September terrorist attacks.
The increase in benefits expense per ASM was primarily due to higher benefits
costs, primarily health care. The decrease in Employee retirement plans expense
per ASM was primarily due to the decrease in Company earnings available for
profitsharing. This decrease in earnings more than offset an increase in expense
due to a fourth quarter amendment made to the Company's profitsharing plan. This
amendment enabled the Company to take into consideration federal grants under
the Act and special charges resulting from the terrorist attacks in the
calculation of profitsharing.
A-19
Fuel and oil expense per ASM decreased 11.9 percent, primarily due to a 10.0
percent decrease in the average jet fuel cost per gallon. The average cost per
gallon of jet fuel in 2001 was $.7086 compared to $.7869 in 2000, including the
effects of hedging activities. The Company's 2001 and 2000 average jet fuel
prices are net of approximately $79.9 million and $113.5 million in gains from
hedging activities, respectively.
Maintenance materials and repairs per ASM decreased 3.2 percent. This decrease
was primarily due to the Company's capacity growth exceeding the increase in
expense. Virtually all of the Company's 2001 capacity growth versus the prior
year was accomplished with new aircraft, most of which have not yet begun to
incur any meaningful repair costs. A decrease in engine expense was partially
offset by an increase in expense for airframe inspections and repairs. In
addition to an increase in the number of airframe inspections and repairs, the
cost per event increased compared to 2000.
Agency commissions per ASM decreased 40.7 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. Effective October 15, 2001, the Company reduced the commission
paid to travel agents to five percent (with no cap), regardless of the type of
ticket sold. In addition, the mix of tickets sold through travel agents declined
from 28 percent in 2000 to 25 percent in 2001, thereby reducing commissionable
revenues and commission expense.
Aircraft rentals per ASM decreased 12.1 percent primarily due to a lower
percentage of the aircraft fleet being leased. Approximately 25.9 percent of the
Company's aircraft were under operating lease at December 31, 2001, compared to
27.3 percent at December 31, 2000.
Landing fees and other rentals per ASM increased 9.1 percent primarily as a
result of the Company's expansion of facilities at several airports, including
Baltimore/Washington International Airport and Chicago Midway Airport.
Depreciation expense per ASM increased 4.3 percent primarily due to the growth
in the Company's aircraft fleet prior to the terrorist attacks. The Company had
received delivery of 14 new 737-700 aircraft prior to September 11, bringing the
percentage of owned aircraft in the Company's fleet to 74.1 percent by the end
of 2001 compared to 72.7 percent at the end of 2000.
Other operating expenses per ASM increased 3.5 percent primarily due to a
significant increase in aviation insurance costs following the terrorist
attacks. The Company's insurance carriers canceled their war risk and terrorism
insurance policies following the terrorist attacks and reinstated such coverage
at significantly higher rates than before.
Other. "Other expenses (income)" included interest expense, capitalized
interest, interest income, and other gains and losses. Interest expense was flat
compared to 2000. Following the terrorist attacks, the Company borrowed the full
$475 million available under its revolving credit facility and issued $614.3
million in long-term debt in the form of Pass-Through Certificates. See Note 7
to the Consolidated Financial Statements. The increase in expense caused by
these borrowings was offset by a decrease in interest rates on the Company's
floating rate debt and the July 2001 redemption of $100 million of unsecured
notes. Capitalized interest decreased $7.0 million, or 25.3 percent, primarily
as a result of lower 2001 progress payment balances for scheduled future
aircraft deliveries as compared to 2000. The lower progress payments were due in
part to the deferral of Boeing 737 aircraft firm orders and options following
the terrorist attacks. Interest income increased $2.5 million, or 6.2 percent,
primarily due to higher invested cash balances, partially offset by lower rates.
Other gains in 2001 primarily resulted from $235 million received as the
Company's share of government grant funds under the Air
A-20
Stabilization Act, intended to offset the Company's direct and incremental
losses caused by the terrorist attacks, through the end of 2001. See Note 3 to
the Company's Consolidated Financial Statements for further discussion of the
Air Stabilization Act and grants from the government.
Income Taxes. The provision for income taxes, as a percentage of income before
taxes, decreased slightly to 38.24 percent in 2001 from 38.54 percent in 2000.
The decrease primarily resulted from lower effective state tax rates in 2001.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $520.2 million in 2002 compared to
$1.5 billion in 2001. The decrease in operating cash flows was primarily due to
the decrease in net income and the deferral of approximately $186 million in
2001 excise tax payments until January 2002, as provided for in the Air
Stabilization Act.
Cash flows used in investing activities in 2002 totaled $603.1 million compared
to $997.8 million in 2001. Investing activities in both years consisted
primarily of payments for new 737-700 aircraft delivered to the Company and
progress payments for future aircraft deliveries. Of the 23 new aircraft the
Company put into service during 2002, 11 were recorded (on the Consolidated
Statement of Cash Flows and on the Consolidated Balance Sheet) through the
consolidation of a special purpose trust (the Trust) during 2001. See Note 4 to
the Consolidated Financial Statements for more information on the Trust. A total
of eight new 737-700 aircraft were recorded through consolidation of the Trust
during 2002. The remaining four new 737-700 aircraft delivered to the Company in
2002 were purchased directly from Boeing. The Trust was dissolved prior to
December 31, 2002.
Net cash used in financing activities was $381.7 million in 2002 compared to
cash generated by financing activities of $1.3 billion in 2001. Cash used in
financing activities during 2002 was primarily for the repayment of the
Company's $475 million revolving credit facility that the Company drew down in
September 2001 and for the repayment of the Trust. These uses were partially
offset by cash generated from the issuance of $385 million in unsecured notes in
March 2002. Financing cash flows in 2001 were generated from borrowings the
Company made from its $475 million revolving credit facility and the issuance of
$614.3 million in long-term debt. These borrowings were partially offset by the
redemption of $100 million unsecured notes in 2001. See Note 6 and Note 7 to the
Consolidated Financial Statements for more information on these financing
activities. Cash generated in 2002 and in 2001 was primarily used to finance
aircraft-related capital expenditures and provide working capital.
The Company has various options available to meet its capital and operating
commitments, including cash on hand at December 31, 2002, of $1.82 billion,
internally generated funds, and a $575 million bank revolving line of credit. In
addition, the Company will also consider various borrowing or leasing options to
maximize earnings and supplement cash requirements. The Company believes it has
access to a wide variety of financing arrangements because of its excellent
credit ratings, unencumbered assets, modest leverage, and consistent
profitability.
The Company has an available revolving credit facility from which it can borrow
up to $575 million from a group of banks. One-half of the facility is short term
and expires on April 23, 2003 if not drawn before that date. The other one-half
expires on April 23, 2005. The Company expects that it will be able to renew the
expiring 365-day facility for an additional 365-day period at reasonable terms.
If the Company is unable to renew, the Company's available credit facility will
be reduced.
A-21
The Company currently has outstanding shelf registrations for the issuance of up
to $1.0 billion in public debt securities and pass through certificates, which
it may utilize for aircraft financings in the future.
In 1999, the Company's Board of Directors authorized the repurchase of up to
$250 million of the Company's common stock. Repurchases are made in accordance
with applicable securities laws in the open market or in private transactions
from time to time, depending on market conditions, and may be discontinued at
any time. As of December 31, 2002, in aggregate, 18.3 million shares had been
repurchased at a total cost of $199.2 million, of which $108.7 million was
completed in 2000. No shares were repurchased in 2001 or in 2002.
CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS
Southwest has contractual obligations and commitments primarily with regards to
future purchases of aircraft, payment of debt, and lease arrangements.
As of February 1, 2003, Southwest is scheduled to take delivery of 17 new
737-700 aircraft from Boeing in 2003, 23 in 2004, 24 in 2005, 22 in 2006, 25 in
2007, and six in 2008. The Company also has a total of 79 purchase options for
new 737-700 aircraft for years 2004 through 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.
The following table aggregates the Company's expected contractual obligations
and commitments subsequent to December 31, 2002:
PAYMENTS DUE BY PERIOD (IN THOUSANDS)
------------------------------------------------------------------
2004 - 2006 - BEYOND
Contractual obligations (1) 2003 2005 2007 2007 TOTAL
--------------------------- ---------- ---------- ---------- ---------- ----------
Long-term debt $ 120,797 $ 320,320 $ 637,588 $ 516,980 $1,595,685
Capital lease commitments (2) 17,751 41,160 26,758 52,016 137,685
Operating lease commitments 281,042 496,371 365,403 1,459,961 2,602,777
Aircraft purchase commitments 597,097 1,394,569 1,139,891 104,924 3,236,481
---------- ---------- ---------- ---------- ----------
Total contractual cash obligations $1,016,687 $2,252,420 $2,169,640 $2,133,881 $7,572,628
========== ========== ========== ========== ==========
----------
(1) Does not include other commitments for the purchase of goods and services
which in the aggregate are immaterial.
(2) Includes amounts classified as interest.
There were no outstanding borrowings under the revolving credit facility at
December 31, 2002. See Note 6 to the consolidated financial statements for more
information.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company's consolidated financial statements have been prepared in accordance
with United States generally accepted accounting principles (GAAP). The
Company's significant accounting policies are described in Note 1 to the
Consolidated Financial Statements. The preparation of financial statements in
accordance with GAAP requires the Company's management to make estimates and
assumptions that affect the amounts reported in the consolidated financial
statements and accompanying footnotes. The Company's estimates and assumptions
are based on historical experiences and changes in the business environment.
However, actual results may differ from estimates under different conditions,
sometimes materially. Critical accounting policies and estimates are defined as
those that are both most important to the portrayal of the Company's financial
condition
A-22
and results and require management's most subjective judgments. The Company's
most critical accounting policies and estimates are described below.
Revenue Recognition
As described in Note 1 to the Consolidated Financial Statements, tickets sold
are initially deferred as "Air traffic liability." Passenger revenue is
recognized and air traffic liability is reduced when the service is provided
(i.e., when the flight takes place). "Air traffic liability" primarily
represents tickets sold for future travel dates and estimated future refunds,
exchanges, or forfeitures of tickets sold for past travel dates. The Company's
air traffic liability balance at December 31, 2002 was $412.2 million.
The majority of the Company's tickets sold are nonrefundable, which is the
primary source of forfeited tickets. Tickets that are sold but not flown on the
travel date can be reused for another flight, up to a year from the date of
sale, or can be refunded (if the ticket is refundable). A small percentage of
tickets (or partial tickets) expire unused. Fully refundable tickets are rarely
forfeited. "Air traffic liability" includes an estimate of the amount of future
refunds, exchanges, and forfeitures for all unused tickets once the flight date
has passed. These estimates are based on historical experience over many years.
The Company and members of the airline industry have consistently applied this
accounting method to estimate revenue from forfeited tickets at the date travel
is provided. Estimated future refunds and exchanges included in the air traffic
liability account are constantly evaluated based on subsequent refund and
exchange activity to validate the accuracy of the Company's estimates with
respect to forfeited tickets. Events and circumstances outside of historical
fare sale activity or historical Customer travel patterns can result in actual
refunds, exchanges or forfeited tickets differing significantly from estimates;
however, these differences have historically not been material. Additional
factors that may affect estimated refunds include, but may not be limited to,
the Company's refund and exchange policy, the mix of refundable and
nonrefundable fares, and fare sale activity. The Company's estimation techniques
have been consistently applied from year to year; however, as with any
estimates, actual refund and exchange activity may vary from estimated amounts.
Since September 2001, the Company has experienced fluctuations in estimated
refunds and exchanges, and correspondingly, forfeited tickets, due to many of
the factors described above. Following the terrorist events of September 11,
2001, and the subsequent temporary shutdown of U.S. air space, Southwest
temporarily suspended its normal refund policy in order to provide the highest
Service to the Company's Customers, including the refunding of nonrefundable
tickets upon Customer request. As a result, the Company experienced refunds
during September 2001 and through December 2001 far above historical refund
levels and in excess of the Company's contractual obligations. In evaluating
passenger revenue through third quarter 2001, based on these unusually high
refund levels, the Company estimated that approximately $30 million of these
refunds related to revenue previously recognized for estimated forfeited
tickets. As a result, the Company reduced third quarter 2001 "Passenger revenue"
by $30 million and restored "Air traffic liability", accordingly.
Subsequent to third quarter 2001 and through second quarter 2002, the Company
experienced a higher than usual mix of low-fare, nonrefundable ticket sales. The
Company also experienced changes in Customer travel patterns resulting from
various factors including new airport security measures, concerns about further
terrorist attacks, and an uncertain economy. Consequently, the Company recorded
$36 million in additional passenger revenue in second quarter 2002 as Customers
required fewer refunds and exchanges, resulting in more forfeited tickets.
A-23
While the Company believes the current estimates included in "Air traffic
liability" and "Passenger revenue" are reasonable, these estimates may continue
to change based on refund, exchange and forfeiture activity varying from
pre-September 2001 patterns.
Accounting for Long-Lived Assets
As of December 31, 2002, the Company had approximately $9.46 billion of
long-lived assets, including $8.02 billion in flight equipment and related
assets. In accounting for long-lived assets, the Company must make estimates
about the expected useful lives of the assets, the expected residual values of
the assets, and the potential for impairment based on the fair value of the
assets and the cash flows they generate.
In estimating the lives and expected residual values of its aircraft, the
Company has primarily relied upon actual experience with the same or similar
aircraft types and recommendations from Boeing, the manufacturer of the
Company's aircraft. Subsequent revisions to these estimates, which can be
significant, could be caused by changes to the Company's maintenance program,
changes in utilization of the aircraft (actual flight hours during a given
period of time), governmental regulations on aging aircraft, and changing market
prices of new and used aircraft of the same or similar types. The Company
evaluates its estimates and assumptions each reporting period and, when
warranted, adjusts these estimates and assumptions. Generally, these adjustments
are accounted for on a prospective basis through depreciation expense, as
required by GAAP.
The Company periodically evaluates its long-lived assets for impairment. Factors
that would indicate potential impairment include, but are not limited to,
significant decreases in the market value of the long-lived asset(s), a
significant change in the long-lived asset's physical condition, and operating
or cash flow losses associated with the use of the long-lived asset. While the
airline industry as a whole has experienced many of these indicators, Southwest
has continued to operate all of its aircraft and continues to experience
positive cash flow. Consequently, the Company has not identified any impairments
related to its existing aircraft fleet. The Company will continue to monitor its
long-lived assets and the airline operating environment.
Financial Derivative Instruments
The Company utilizes financial derivative instruments to manage its risk
associated with changing jet fuel prices, and accounts for them under Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (SFAS 133.) See "Qualitative and
Quantitative Disclosures about Market Risk" for more information on these risk
management activities. SFAS 133 requires that all derivatives be marked to
market (fair value) and recorded on the Consolidated Balance Sheet. The fair
value of the Company's financial derivative instruments recorded on the
Company's Consolidated Balance Sheet as of December 31, 2002, was $157.2
million.
Since the majority of the Company's financial derivative instruments are not
traded on a market exchange, the Company estimates their fair values. Depending
on the type of instrument, the values are determined by the use of present value
methods or standard option value models with assumptions about commodity prices
based on those observed in underlying markets. Also, since there is not a
reliable forward market for jet fuel, the Company must estimate the future
prices of jet fuel in order to measure the effectiveness of the hedging
instruments in offsetting changes to those prices, as required by SFAS 133.
Forward jet fuel prices are estimated through the observation of similar
commodity futures prices (such as crude oil and heating oil) and adjusted based
on historical variations to those like commodities.
A-24
Fair values for financial derivative instruments and forward jet fuel prices are
both estimated prior to the time that the financial derivative instruments
settle, and the time that jet fuel is purchased and consumed, respectively.
However, once settlement of the financial derivative instruments occur and the
hedged jet fuel is purchased and consumed, all values and prices are known and
are realized in the financial statements. Based on these actual results once all
values and prices become known, the Company's estimates have proved to be
materially accurate. Furthermore, since the majority of the Company's hedges
settle within 12 to 24 months from the time the Company enters into the contract
for the derivative financial instrument, the estimates being made are relatively
short-term.
Estimating the fair value of these fuel hedging derivatives and forward prices
for jet fuel will also result in changes in their values from period to period
and thus determine how they are accounted for under SFAS 133. To the extent that
the period to period change in the estimated fair value of a fuel hedging
instrument differs from a period to period change in the estimated price of the
associated jet fuel to be purchased, ineffectiveness of the fuel hedge will
result, as defined by SFAS 133. This could result in the immediate recording of
charges or income, even though the derivative instrument may not expire until a
future period. Historically, the Company has not experienced significant
ineffectiveness in its fuel hedges accounted for under SFAS 133.
See Note 2 and Note 9 to the Consolidated Financial Statements for more
information on SFAS 133 and the Company's fuel hedging activities.
FORWARD-LOOKING STATEMENTS
Some statements in this Form 10-K (or otherwise made by the Company or on the
Company's behalf from time to time in other reports, filings with the Securities
and Exchange Commission, news releases, conferences, World Wide Web postings or
otherwise) which are not historical facts may be "forward-looking statements"
within the meaning of Section 21E of the Securities Exchange Act of 1934 and the
Private Securities Litigation Reform Act of 1995. Forward-looking statements
include statements about Southwest's estimates, expectations, beliefs,
intentions or strategies for the future, and the assumptions underlying these
forward-looking statements. Southwest uses the words "anticipates," "believes,"
"estimates," "expects," "intends," "forecasts", "may," "will," "should" and
similar expressions to identify these forward-looking statements.
Forward-looking statements involve risks and uncertainties that could cause
actual results to differ materially from historical experience or the Company's
present expectations. Factors that could cause these differences include, but
are not limited to:
o Items directly linked to the September 11, 2001 terrorist attacks, such
as the adverse impact of new airline and airport security directives on
the Company's costs and Customer demand for travel, changes in the
Transportation Security Administration's scope for managing U.S.
airport security, the availability and cost of war-risk and other
aviation insurance, including the federal government's provision of
third party war-risk coverage, and the possibility of additional
incidents that could cause the public to question the safety and/or
efficiency of air travel.
o War or other military actions by the U.S. or others.
o Competitive factors, such as fare sales and capacity decisions by the
Company and its competitors, changes in competitors' flight schedules,
mergers and acquisitions, codesharing programs, and airline
bankruptcies.
A-25
o General economic conditions, which could adversely affect the demand
for travel in general and consumer ticket purchasing habits, as well as
decisions by major freight Customers on how they allocate freight
deliveries among different types of carriers.
o Factors that could affect the Company's ability to control its costs,
such as the results of Employee labor contract negotiations, Employee
hiring and retention rates, costs for health care, the largely
unpredictable prices of jet fuel, crude oil, and heating oil, the
continued effectiveness of the Company's fuel hedges, changes in the
Company's overall fuel hedging strategy, capacity decisions by the
Company and its competitors, unscheduled required aircraft airframe or
engine repairs and regulatory requirements, changes in commission
policy, availability of capital markets, and future financing decisions
made by the Company.
o Disruptions to operations due to adverse weather conditions and air
traffic control-related constraints.
Caution should be taken not to place undue reliance on the Company's
forward-looking statements, which represent the Company's views only as of the
date this report is filed. The Company undertakes no obligation to update
publicly or revise any forward-looking statement, whether as a result of new
information, future events or otherwise.
QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Southwest has interest rate risk in that it holds floating rate debt instruments
and has commodity price risk in that it must purchase jet fuel to operate its
aircraft fleet. The Company purchases jet fuel at prevailing market prices, but
seeks to minimize its average jet fuel cost through execution of a documented
hedging strategy. Southwest has market sensitive instruments in the form of
fixed rate debt instruments and derivative instruments used to hedge its
exposure to jet fuel price increases. The Company also operates 97 aircraft
under operating and capital leases. However, leases are not considered market
sensitive financial instruments and, therefore, are not included in the interest
rate sensitivity analysis below. Commitments related to leases are disclosed in
Note 8 to the Consolidated Financial Statements. The Company does not purchase
or hold any derivative financial instruments for trading purposes. See Note 2 to
the Consolidated Financial Statements for information on the Company's
accounting for its hedging program and Note 9 to the Consolidated Financial
Statements for further details on the Company's financial derivative
instruments.
Fuel hedging. The fair values of outstanding financial derivative instruments
related to the Company's jet fuel market price risk at December 31, 2002, were a
net asset of $157.2 million. The current portion of these financial derivative
instruments, or $112.8 million, is classified as "Fuel hedge contracts" in the
Consolidated Balance Sheet. The long-term portion of these financial derivative
instruments, or $44.4 million, is included in "Other assets." The fair values of
the derivative instruments, depending on the type of instrument, were determined
by use of present value methods or standard option value models with assumptions
about commodity prices based on those observed in underlying markets. An
immediate ten percent increase or decrease in underlying fuel-related commodity
prices from the December 31, 2002, prices would correspondingly change the fair
value of the commodity derivative instruments in place by approximately $135
million. Changes in the related commodity derivative instrument cash flows may
change by more or less than this amount based upon further fluctuations in
futures prices as well as related income tax effects. This sensitivity analysis
uses industry standard valuation models and holds all inputs constant at
December 31, 2002 levels, except underlying futures prices.
A-26
Financial market risk. Airline operators are inherently capital intensive as the
vast majority of the Company's assets are expensive aircraft, which are
long-lived. The Company's strategy is to capitalize conservatively and grow
capacity steadily and profitably. While the Company uses financial leverage, it
has maintained a strong balance sheet and an "A" credit rating on its senior
unsecured fixed-rate debt with Standard & Poor's and Fitch ratings agencies, and
a "Baa1" credit rating with Moody's rating agency. The Company's Aircraft
Secured Notes and French Credit Agreements do not give rise to significant fair
value risk but do give rise to interest rate risk because these borrowings are
floating-rate debt. Although there is interest rate risk associated with these
secured borrowings, the risk is somewhat mitigated by the fact that the Company
may prepay this debt on any of the semi-annual principal and interest payment
dates. See Note 6 and Note 7 to the Consolidated Financial Statements for more
information on the material terms of the Company's short-term and long-term
debt.
As disclosed in Note 7 to the Consolidated Financial Statements, the Company had
outstanding senior unsecured notes totaling $785 million at December 31, 2002.
In addition, as disclosed in Note 7, the Company had outstanding long-term
fixed-rate debt totaling $585.7 million in the form of Pass Through Certificates
(Certificates), which are secured by aircraft the Company owns. The total of the
Company's long-term unsecured notes represented 11.7 percent of total noncurrent
assets at December 31, 2002. The unsecured long-term debt currently has a
weighted-average maturity of 8.2 years at fixed rates averaging 7.3 percent at
December 31, 2002, which is comparable to average rates prevailing for similar
debt instruments over the last ten years. The Certificates bear interest at a
combined weighted-average rate of 5.5 percent. The Company does not have
significant exposure to changing interest rates on its unsecured long-term debt
or its Certificates because the interest rates are fixed and the financial
leverage is modest.
The Company also has some risk associated with changing interest rates due to
the short-term nature of its invested cash, which was $1.82 billion at December
31, 2002. The Company invests available cash in certificates of deposit, highly
rated money markets, and investment grade commercial paper that generally have
maturities of three months or less; therefore, the returns earned on these
investments parallel closely with floating interest rates. The Company has not
undertaken any additional actions to cover interest rate market risk and is not
a party to any other material market interest rate risk management activities.
A hypothetical ten percent change in market interest rates as of December 31,
2002, would not have a material effect on the fair value of the Company's fixed
rate debt instruments. See Note 9 to the Consolidated Financial Statements for
further information on the fair value of the Company's financial instruments. A
change in market interest rates could, however, have a corresponding effect on
the Company's earnings and cash flows associated with its Aircraft Secured
Notes, French Credit Agreements, and invested cash because of the floating-rate
nature of these items. Assuming floating market rates in effect as of December
31, 2002, were held constant throughout a 12-month period, a hypothetical ten
percent change in those rates would correspondingly change the Company's net
earnings and cash flows associated with these items by approximately $1.3
million. Using these assumptions and considering the Company's cash balance and
floating-rate debt outstanding at December 31, 2002, an increase in rates would
have a net positive effect on the Company's earnings and cash flows, while a
decrease in rates would have a net negative effect on the Company's earnings and
cash flows. However, a ten percent change in market rates would not impact the
Company's earnings or cash flow associated with the Company's publicly traded
fixed-rate debt, or its Certificates.
The Company is also subject to various types of liquidity and financing risk
included in agreements with financial institutions that process credit card
transactions on behalf of the Company, the Company's revolving credit facility,
and outstanding debt agreements. Such risks included the
A-27
Company maintaining minimum credit ratings, the Company's assets (for secured
debt) maintaining minimum fair values, and the Company achieving minimum
covenant ratios with regard to its available or outstanding debt agreements. The
Company met or exceeded the minimum standards set forth in these agreements as
of December 31, 2002. However, if conditions change and the Company failed to
meet the minimum standards set forth in the agreements, it could reduce the
availability of cash under the agreements or increase the costs to keep the
agreements intact as written.
A-28
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
SOUTHWEST AIRLINES CO.
CONSOLIDATED BALANCE SHEET
(In thousands, except per share amounts) DECEMBER 31,
------------------------
2002 2001
---------- ----------
ASSETS
Current assets:
Cash and cash equivalents $1,815,352 $2,279,861
Accounts and other receivables 174,393 71,283
Inventories of parts and supplies, at cost 86,016 70,561
Deferred income taxes -- 46,400
Fuel hedge contracts 112,847 --
Prepaid expenses and other current assets 43,352 52,114
---------- ----------
Total current assets 2,231,960 2,520,219
Property and equipment, at cost:
Flight equipment 8,024,719 7,534,119
Ground property and equipment 1,041,844 899,421
Deposits on flight equipment purchase contracts 389,094 468,154
---------- ----------
9,455,657 8,901,694
Less allowance for depreciation 2,810,193 2,456,207
---------- ----------
6,645,464 6,445,487
Other assets 76,326 31,435
---------- ----------
$8,953,750 $8,997,141
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 362,027 $ 504,831
Accrued liabilities 529,109 547,540
Air traffic liability 412,238 450,407
Aircraft purchase obligations -- 221,840
Short-term borrowings -- 475,000
Current maturities of long-term debt 130,454 39,567
---------- ----------
Total current liabilities 1,433,828 2,239,185
Long-term debt less current maturities 1,552,781 1,327,158
Deferred income taxes 1,227,475 1,058,143
Deferred gains from sale and leaseback of aircraft 183,797 192,342
Other deferred liabilities 134,252 166,260
Commitments and contingencies
Stockholders' equity:
Common stock, $1.00 par value: 2,000,000 shares authorized;
776,663 and 766,774 shares issued in 2002
and 2001, respectively 776,663 766,774
Capital in excess of par value 135,848 50,409
Retained earnings 3,455,448 3,228,408
Accumulated other comprehensive income (loss) 53,658 (31,538)
---------- ----------
Total stockholders' equity 4,421,617 4,014,053
---------- ----------
$8,953,750 $8,997,141
========== ==========
See accompanying notes
A-29
SOUTHWEST AIRLINES CO.
CONSOLIDATED STATEMENT OF INCOME
YEARS ENDED DECEMBER 31,
----------------------------------------
(In thousands, except per share amounts) 2002 2001 2000
---------- ---------- ----------
OPERATING REVENUES:
Passenger $5,341,349 $5,378,702 $5,467,965
Freight 84,675 91,270 110,742
Other 95,747 85,202 70,853
---------- ---------- ----------
Total operating revenues 5,521,771 5,555,174 5,649,560
OPERATING EXPENSES:
Salaries, wages, and benefits 1,992,485 1,856,288 1,683,689
Fuel and oil 762,096 770,515 804,426
Maintenance materials and repairs 390,216 397,505 378,470
Agency commissions 54,669 103,014 159,309
Aircraft rentals 186,992 192,110 196,328
Landing fees and other rentals 344,660 311,017 265,106
Depreciation 356,304 317,831 281,276
Other operating expenses 1,017,011 975,772 859,811
---------- ---------- ----------
Total operating expenses 5,104,433 4,924,052 4,628,415
---------- ---------- ----------
OPERATING INCOME 417,338 631,122 1,021,145
OTHER EXPENSES (INCOME):
Interest expense 106,023 69,827 69,889
Capitalized interest (16,720) (20,576) (27,551)
Interest income (36,964) (42,562) (40,072)
Other (gains) losses, net (27,683) (203,226) 1,515
---------- ---------- ----------
Total other expenses (income) 24,656 (196,537) 3,781
---------- ---------- ----------
INCOME BEFORE TAXES AND CUMULATIVE EFFECT
OF CHANGE IN ACCOUNTING PRINCIPLE 392,682 827,659 1,017,364
PROVISION FOR INCOME TAXES 151,713 316,512 392,140
---------- ---------- ----------
INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE 240,969 511,147 625,224
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
PRINCIPLE, NET OF INCOME TAXES -- -- (22,131)
---------- ---------- ----------
NET INCOME $ 240,969 $ 511,147 $ 603,093
========== ========== ==========
NET INCOME PER SHARE, BASIC BEFORE CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE $ .31 $ .67 $ .84
CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE -- -- (.03)
---------- ---------- ----------
NET INCOME PER SHARE, BASIC $ .31 $ .67 $ .81
========== ========== ==========
NET INCOME PER SHARE, DILUTED BEFORE CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE $ .30 $ .63 $ .79
CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE -- -- (.03)
---------- ---------- ----------
NET INCOME PER SHARE, DILUTED $ .30 $ .63 $ .76
========== ========== ==========
See accompanying notes.
A-30
SOUTHWEST AIRLINES CO.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
------------------------------------------------------------------------------------
ACCUMULATED
CAPITAL IN OTHER
COMMON EXCESS OF RETAINED COMPREHENSIVE TREASURY
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) STOCK PAR VALUE EARNINGS INCOME (LOSS) STOCK TOTAL
--------------------------------------- ---------- ---------- ---------- ------------- ---------- ----------
BALANCE AT DECEMBER 31, 1999 $ 505,005 $ 35,436 $2,385,854 $ -- $ (90,507) $2,835,788
Purchase of shares of treasury stock -- -- -- -- (108,674) (108,674)
Issuance of common and treasury stock
pursuant to Employee stock plans 2,892 6,667 (75,952) -- 136,817 70,424
Tax benefit of options exercised -- 61,677 -- -- -- 61,677
Cash dividends, $.015 per share -- -- (10,988) -- -- (10,988)
Net income -- -- 603,093 -- -- 603,093
---------- ---------- ---------- ---------- ---------- ----------
BALANCE AT DECEMBER 31, 2000 507,897 103,780 2,902,007 -- (62,364) 3,451,320
Three-for-two stock split 253,929 (136,044) (117,885) -- -- --
Issuance of common and treasury stock
pursuant to Employee stock plans 4,948 28,982 (52,753) -- 62,364 43,541
Tax benefit of options exercised -- 53,691 -- -- -- 53,691
Cash dividends, $.018 per share -- -- (14,108) -- -- (14,108)
Comprehensive income (loss)
Net income -- -- 511,147 -- -- 511,147
Unrealized loss on derivative instruments -- -- -- (31,063) -- (31,063)
Other -- -- -- (475) -- (475)
----------
TOTAL COMPREHENSIVE INCOME 479,609
---------- ---------- ---------- ---------- ---------- ----------
BALANCE AT DECEMBER 31, 2001 766,774 50,409 3,228,408 (31,538) -- 4,014,053
Issuance of common stock pursuant
to Employee stock plans 9,889 46,868 -- -- -- 56,757
Tax benefit of options exercised -- 38,571 -- -- -- 38,571
Cash dividends, $.018 per share -- -- -- -- (13,929) (13,929)
Comprehensive income (loss)
Net income -- -- 240,969 -- -- 240,969
Unrealized gain on derivative instruments -- -- -- 87,213 -- 87,213
Other -- -- -- (2,017) -- (2,017)
----------
TOTAL COMPREHENSIVE INCOME 326,165
---------- ---------- ---------- ---------- ---------- ----------
BALANCE AT DECEMBER 31, 2002 $ 776,663 $ 135,848 $3,455,448 $ 53,658 $ -- $4,421,617
========== ========== ========== ========== ========== ==========
See accompanying notes.
A-31
SOUTHWEST AIRLINES CO.
CONSOLIDATED STATEMENT OF CASH FLOWS
YEARS ENDED DECEMBER 31,
(In thousands) 2002 2001 2000
---------- ---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 240,969 $ 511,147 $ 603,093
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 356,304 317,831 281,276
Deferred income taxes 169,629 207,922 153,447
Amortization of deferred gains on sale and
leaseback of aircraft (15,181) (15,180) (15,178)
Amortization of scheduled airframe inspections
and repairs 46,311 43,121 36,328
Income tax benefit from Employee stock
option exercises 38,571 53,691 61,677
Changes in certain assets and liabilities
Accounts and other receivables (103,110) 66,787 (63,032)
Other current assets (10,159) (9,027) (24,657)
Accounts payable and accrued liabilities (148,850) 202,506 129,438
Air traffic liability (38,169) 73,346 120,119
Other (16,106) 32,464 15,775
---------- ---------- ----------
Net cash provided by operating activities 520,209 1,484,608 1,298,286
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (603,060) (997,843) (1,134,644)
---------- ---------- ----------
Net cash used in investing activities (603,060) (997,843) (1,134,644)
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of long-term debt 385,000 614,250 --
Proceeds from revolving credit facility -- 475,000 --
Proceeds from trust arrangement 119,142 266,053 --
Proceeds from Employee stock plans 56,757 43,541 70,424
Payments of long-term debt and capital
lease obligations (64,568) (110,600) (10,238)
Payments of trust arrangement (385,195) -- --
Payment of revolving credit facility (475,000) -- --
Payments of cash dividends (13,872) (13,440) (10,978)
Repurchases of common stock -- -- (108,674)
Other, net (3,922) (4,703) --
---------- ---------- ----------
Net cash provided by (used in) financing activities (381,658) 1,270,101 (59,466)
---------- ---------- ----------
NET INCREASE (DECREASE) IN CASH
AND CASH EQUIVALENTS (464,509) 1,756,866 104,176
CASH AND CASH EQUIVALENTS AT
BEGINNING OF PERIOD 2,279,861 522,995 418,819
---------- ---------- ----------
CASH AND CASH EQUIVALENTS AT
EMD OF PERIOD $1,815,352 $2,279,861 $ 522,995
---------- ---------- ----------
CASH PAYMENTS FOR:
Interest, net of amount capitalized $ 79,998 $ 47,682 $ 36,946
Income taxes $ 2,693 $ 65,905 $ 150,000
See accompanying notes.
A-32
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION Southwest Airlines Co. (Southwest) is a major domestic
airline that provides predominantly shorthaul, high-frequency, point-to-point,
low-fare service. The Consolidated Financial Statements include the accounts of
Southwest and its wholly owned subsidiaries (the Company). All significant
intercompany balances and transactions have been eliminated. The preparation of
financial statements in conformity with accounting principles generally accepted
in the United States (GAAP) requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from these estimates.
CASH AND CASH EQUIVALENTS Cash equivalents consist of certificates of deposit,
money market funds, and investment grade commercial paper issued by major
corporations and financial institutions. Cash and cash equivalents are highly
liquid and generally have original maturities of three months or less. Cash and
cash equivalents are carried at cost, which approximates market value.
INVENTORIES Inventories of flight equipment expendable parts, materials, and
supplies are carried at average cost. These items are generally charged to
expense when issued for use.
PROPERTY AND EQUIPMENT Depreciation is provided by the straight-line method to
estimated residual values over periods ranging from 20 to 25 years for flight
equipment and 3 to 30 years for ground property and equipment once the asset is
placed in service. Property under capital leases and related obligations are
recorded at an amount equal to the present value of future minimum lease
payments computed on the basis of the Company's incremental borrowing rate or,
when known, the interest rate implicit in the lease. Amortization of property
under capital leases is on a straight-line basis over the lease term and is
included in depreciation expense.
In estimating the lives and expected residual values of its aircraft, the
Company has primarily relied upon actual experience with the same or similar
aircraft types and recommendations from Boeing, the manufacturer of the
Company's aircraft. Subsequent revisions to these estimates, which can be
significant, could be caused by changes to the Company's maintenance program,
changes in utilization of the aircraft (actual flight hours or cycles during a
given period of time), governmental regulations on aging aircraft, changing
market prices of new and used aircraft of the same or similar types, etc. The
Company evaluates its estimates and assumptions each reporting period and, when
warranted, adjusts these estimates and assumptions. Generally, these adjustments
are accounted for on a prospective basis through depreciation expense, as
required by GAAP.
The Company periodically evaluates its long-lived assets used in operations for
impairment. Impairment losses would be recorded when events and circumstances
indicate that an asset might be impaired and the undiscounted cash flows to be
generated by that asset are less than the carrying amounts of the asset. Factors
that would indicate potential impairment include, but are not limited to,
significant decreases in the market value of the long-lived asset(s), a
significant change in the long-lived asset's physical condition, operating or
cash flow losses associated with the use of the long-lived asset, etc. While the
airline industry as a whole has experienced many of these indicators, Southwest
has continued to operate all of its aircraft and continues to experience
positive cash flow.
AIRCRAFT AND ENGINE MAINTENANCE The cost of scheduled engine inspections and
repairs and routine maintenance costs for aircraft and engines are charged to
maintenance expense as incurred. Scheduled airframe inspections and repairs,
known as "D" checks, are generally performed every ten years. Costs related to
"D" checks are capitalized and amortized over the estimated period benefited,
presently the least of ten years, the time until the next "D" check, or the
remaining life of the aircraft. Modifications that significantly enhance
A-33
the operating performance or extend the useful lives of aircraft or engines are
capitalized and amortized over the remaining life of the asset.
In 2001, the American Institute of Certified Public Accountants (AICPA) issued a
Proposed Statement of Position entitled "Accounting for Certain Costs and
Activities Related to Property, Plant, and Equipment" (Proposed SOP). The
Proposed SOP, as originally written, would require that all "D" checks be
expensed as incurred. In fourth quarter 2002, the AICPA announced it would be
transitioning this project to the Financial Accounting Standards Board (FASB),
although the AICPA may retain and address certain components of the Proposed
SOP. The FASB and the AICPA have not determined which components, if any, will
be retained by the AICPA for potential issuance in a future SOP. In addition,
the FASB has not set a timetable for addressing the issues raised by the
proposed SOP.
REVENUE RECOGNITION Tickets sold are initially deferred as "Air traffic
liability". Passenger revenue is recognized when transportation is provided.
"Air traffic liability" primarily represents tickets sold for future travel
dates and estimated refunds and exchanges of tickets sold for past travel dates.
The majority of the Company's tickets sold are nonrefundable. Tickets that are
sold but not flown on the travel date can be reused for another flight, up to a
year from the date of sale, or refunded (if the ticket is refundable). A small
percentage of tickets (or partial tickets) expire unused. The Company estimates
the amount of future refunds, exchanges, and forfeitures for all unused tickets
once the flight date has passed. These estimates are based on historical
experience over many years. The Company and members of the airline industry have
consistently applied this accounting method to estimate revenue from forfeited
tickets at the date travel is provided. Estimated future refunds and exchanges
included in the air traffic liability account are constantly evaluated based on
subsequent refund and exchange activity to validate the accuracy of the
Company's revenue recognition method with respect to forfeited tickets.
Events and circumstances outside of historical fare sale activity or historical
Customer travel patterns can result in actual refunds, exchanges or forfeited
tickets differing significantly from estimates; however, these differences have
historically not been material. Additional factors that may affect estimated
refunds include, but may not be limited to, the Company's refund and exchange
policy, the mix of refundable and nonrefundable fares, and fare sale activity.
The Company's estimation techniques have been consistently applied from year to
year; however, as with any estimates, actual refund and exchange activity may
vary from estimated amounts.
Subsequent to third quarter 2001 and through second quarter 2002, the Company
experienced a higher than usual mix of low-fare, nonrefundable ticket sales. The
Company also experienced changes in Customer travel patterns resulting from
various factors including new airport security measures, concerns about further
terrorist attacks, and an uncertain economy. Consequently, the Company recorded
$36 million in additional passenger revenue in second quarter 2002 as Customers
required fewer refunds and exchanges, resulting in more forfeited tickets.
While actual results may vary from these estimates, the Company believes it is
unlikely that materially different estimates for future refunds, exchanges, and
forfeited tickets would be reported based on other reasonable assumptions or
conditions suggested by actual historical experience and other data available at
the time estimates were made.
FREQUENT FLYER PROGRAM The Company accrues the estimated incremental cost of
providing free travel for awards earned under its Rapid Rewards frequent flyer
program. The Company also sells frequent flyer credits and related services to
companies participating in its Rapid Rewards frequent flyer program. Funds
received from the sale of flight segment credits and associated with future
travel are deferred and recognized as Passenger revenue when the ultimate free
travel awards are flown or the credits expire unused. See Note 2 for additional
information on frequent flyer program accounting.
A-34
ADVERTISING The Company expenses the costs of advertising as incurred.
Advertising expense for the years ended December 31, 2002, 2001, and 2000 was
$156.4 million, $147.6 million, and $141.3 million, respectively.
STOCK-BASED EMPLOYEE COMPENSATION The Company has stock-based compensation plans
covering the majority of its Employee groups, including a plan covering the
Company's Board of Directors and plans related to employment contracts with
certain Executive Officers of the Company. The Company accounts for stock-based
compensation utilizing the intrinsic value method in accordance with the
provisions of Accounting Principles Board Opinion No. 25 (APB 25), "Accounting
for Stock Issued to Employees" and related Interpretations. Accordingly, no
compensation expense is recognized for fixed option plans because the exercise
prices of Employee stock options equal or exceed the market prices of the
underlying stock on the dates of grant. Compensation expense for other stock
options is not material.
The following table represents the effect on net income and earnings per share
if the Company had applied the fair value based method and recognition
provisions of Statement of Financial Accounting Standards (SFAS) No. 123,
"Accounting for Stock-Based Compensation", to stock-based Employee compensation:
(In thousands, except per share amounts) 2002 2001 2000
---------------------------------------- ---------- ---------- ----------
Net income, as reported $ 240,969 $ 511,147 $ 603,093
Add: Stock-based Employee compensation
expense included in reported income,
net of related tax effects 399 402 339
Deduct: Total stock-based Employee
compensation expense determined under
fair value based methods for all awards,
net of related tax effects (53,489) (25,603) (19,725)
---------- ---------- ----------
Pro forma net income $ 187,879 $ 485,946 $ 583,707
========== ========== ==========
Net income per share
Basic, as reported $ .31 $ .67 $ .81
Basic, pro forma $ .24 $ .64 $ .78
Diluted, as reported $ .30 $ .63 $ .76
Diluted, pro forma $ .23 $ .61 $ .74
As required, the pro forma disclosures above include options granted since
January 1, 1995. Consequently, the effects of applying SFAS 123 for providing
pro forma disclosures may not be representative of the effects on reported net
income for future years until all options outstanding are included in the pro
forma disclosures. For purposes of pro forma disclosures, the estimated fair
value of stock-based compensation plans and other options is amortized to
expense primarily over the vesting period. See Note 12 for further discussion of
the Company's stock-based Employee compensation.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure". SFAS No. 148 amends the transition and
disclosure provisions of SFAS No. 123. The Company is currently evaluating SFAS
No. 148 to determine if it will adopt SFAS No. 123 to account for Employee stock
options using the fair value method and, if so, when to begin transition to that
method.
A-35
FINANCIAL DERIVATIVE INSTRUMENTS The Company utilizes a variety of derivative
instruments, including both crude oil and heating oil based derivatives, to
hedge a portion of its exposure to jet fuel price increases. These instruments
consist primarily of purchased call options, collar structures, and fixed price
swap agreements. Prior to 2001, the net cost paid for option premiums and gains
and losses on all financial derivative instruments, including those terminated
or settled early, were deferred and charged or credited to "Fuel and oil"
expense in the same month that the underlying jet fuel being hedged was used.
However, beginning January 1, 2001, the Company adopted Statement of Financial
Accounting Standards No. 133 (SFAS 133), "Accounting for Derivative Instruments
and Hedging Activities", as amended, which changed the way it accounts for
financial derivative instruments. See Note 2 and Note 9.
Since the majority of the Company's financial derivative instruments are not
traded on a market exchange, the Company estimates their fair values. Depending
on the type of instrument, the values are determined by the use of present value
methods or standard option value models with assumptions about commodity prices
based on those observed in underlying markets. Also, since there is not a
reliable forward market for jet fuel, the Company must estimate the future
prices of jet fuel in order to measure the effectiveness of the hedging
instruments in offsetting changes to those prices, as required by SFAS 133.
Forward jet fuel prices are estimated through the observation of similar
commodity futures prices (such as crude oil and heating oil) and adjusted based
on historical variations to those like commodities.
RECENT ACCOUNTING DEVELOPMENTS In November 2002 the Financial Accounting
Standards Board (FASB) issued Interpretation No. 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others," which disclosures are effective for financial
statements issued after December 15, 2002. While the Company has various
guarantees included in contracts in the normal course of business, primarily in
the form of indemnities, these guarantees would only result in immaterial
increases in future costs, but do not represent significant commitments or
contingent liabilities of the indebtedness of others.
In January 2003, FASB issued Interpretation No. 46, "Consolidation of Variable
Interest Entities" (FIN 46) which requires the consolidation of variable
interest entities, as defined. FIN 46 is applicable to financial statements to
be issued by the Company after 2002; however, disclosures are required currently
if the Company expects to consolidate any variable interest entities. The
Company does not currently believe that any material entities will be
consolidated with Southwest as a result of FIN 46.
2. ACCOUNTING CHANGES
Effective January 1, 2001, the Company adopted 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 a derivative is designated as a hedge, depending
on the nature of the hedge, changes in its fair value 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 (loss)" 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, net" in the 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.
Under the rules established by SFAS 133, the Company has alternatives in
accounting for its financial derivative instruments. The Company primarily uses
financial derivative instruments to hedge its exposure to jet fuel price
increases and accounts for these derivatives as cash flow hedges, as defined. In
accordance with SFAS 133, the Company must comply with detailed rules and strict
documentation requirements prior to beginning hedge accounting. As required by
SFAS 133, the Company assesses the effectiveness of each of its individual
hedges on a quarterly basis. The Company also examines the effectiveness of its
entire hedging program on a quarterly basis utilizing statistical analysis. This
analysis involves utilizing regression
A-36
and other statistical analyses that compare changes in the price of jet fuel to
changes in the prices of the commodities used for hedging purposes (crude oil
and heating oil). If these statistical techniques do not produce results within
certain predetermined confidence levels, the Company could lose its ability to
utilize hedge accounting, which could cause the Company to recognize all gains
and losses on financial derivative instruments in earnings in the periods
following the determination that the Company no longer qualified for hedge
accounting. This could, in turn, depending on the materiality of periodic
changes in derivative fair values, increase the volatility of the Company's
future earnings.
Upon adoption of SFAS 133, the Company recorded the fair value of its fuel
derivative instruments in the Consolidated Balance Sheet and a deferred gain of
$46.1 million, net of tax, in "Accumulated other comprehensive income (loss)".
See Note 10 for further information on Accumulated other comprehensive income
(loss). During 2002 and 2001, the Company recognized $4.5 million in additional
income, and $8.2 million in expense, respectively, in "Other (gains) losses,
net", related to the ineffectiveness of its hedges. During 2002 and 2001, the
Company recognized approximately $25.6 million and $17.5 million, respectively,
of net expense, related to amounts excluded from the Company's measurements of
hedge effectiveness, in "Other (gains) losses, net". The 2001 adoption of SFAS
133 has resulted in more volatility in the Company's financial statements than
in the past due to the changes in market values of its derivative instruments
and some ineffectiveness that has been experienced in its fuel hedges. See Note
9 for further information on the Company's derivative instruments.
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 in "Other revenue" when flight segment credits were sold.
Beginning January 1, 2000, the Company recognizes Passenger revenue when free
travel awards resulting from the flight segment credits sold are flown or
credits expire unused. Due to this change, the Company recorded a cumulative
effect charge in first quarter 2000 of $22.1 million (net of income taxes of
$14.0 million) or $.03 per share, basic and diluted.
3. FEDERAL GRANTS AND SPECIAL CHARGES RELATED TO TERRORIST ATTACKS
On September 11, 2001, terrorists hijacked and used two American Airlines, Inc.
aircraft and two United Air Lines, Inc. aircraft in terrorist attacks on the
United States (terrorist attacks). As a result of these terrorist attacks, the
Federal Aviation Administration (FAA) immediately suspended all commercial
airline flights. The Company resumed flight activity on September 14, 2001, and
was operating its normal pre-September 11 flight schedule by September 18, 2001.
From September 11 until the Company resumed flight operations on September 14,
Southwest cancelled approximately 9,000 flights.
On September 22, 2001, President Bush signed into law the Air Transportation
Safety and System Stabilization Act (Air Stabilization Act). The Air
Stabilization Act provided for up to $5 billion in cash grants to qualifying
U.S. airlines and freight carriers to compensate for direct and incremental
losses, as defined in the Air Stabilization Act, from September 11, 2001 through
December 31, 2001, associated with the terrorist attacks. Each airline's total
eligible grant was determined based on that airline's percentage of available
seat miles (ASMs) during August 2001 to total eligible carriers' ASMs for August
2001, less an amount set aside for eligible carriers for whom the use of an ASM
formula would result in an insufficient representation of their share of direct
and incremental losses.
In 2001, the Department of Transportation (DOT) made a final determination of
the amount of eligible direct and incremental losses incurred by Southwest, and
the Company was allotted 100 percent of its eligible grants, totaling $283
million. The Company recognized $235 million in "Other gains" from grants under
the Air Stabilization Act during the second half of 2001 and recognized an
additional $48 million as "Other gains" from grants under the Air Stabilization
Act in third quarter 2002 coincident with the receipt of its final payment.
Representatives of the DOT or other governmental agencies may perform additional
audit
A-37
and/or review(s) of the Company's previously submitted final application. While
the Air Stabilization Act is subject to significant interpretation as to what
constitutes direct and incremental losses, management believes the Company's
eligible direct and incremental losses are sufficient to retain 100 percent of
its eligible grant following additional audits or reviews, should they occur.
The Company recorded total special charges of $48 million in 2001 arising from
the terrorist attacks, which included a $30 million reduction in "Passenger
revenue." Following the terrorist events of September 11, 2001, and the
subsequent temporary shutdown of U.S. air space, Southwest temporarily suspended
its normal refund policy in order to provide the highest Service to the
Company's Customers, including refunding nonrefundable tickets upon Customer
request. As a result, the Company's refunds during September 2001 and through
December 2001 were far above historical refund levels and in excess of the
Company's contractual obligations. Refunds are recorded as a reduction in "Air
traffic liability." Based on these unusually high refunds, the Company estimated
that approximately $30 million of these refunds related to revenue previously
recognized for estimated forfeited tickets. As a result, the Company reduced
third quarter 2001 "Passenger revenue" by $30 million and restored "Air traffic
liability" accordingly. Total special charges also included $13 million in
"Other operating expenses", primarily related to write-downs of various assets
due to impairment. Other miscellaneous charges totaling approximately $5 million
were also included in "Other (gains) losses, net."
4. COMMITMENTS
The Company's contractual purchase commitments consist primarily of scheduled
aircraft acquisitions from Boeing. The Company has contractual purchase
commitments with Boeing for 17 737-700 aircraft deliveries in 2003, 23 scheduled
for delivery in 2004, 24 in 2005, 22 in 2006, 25 in 2007, and 6 in 2008. In
addition, the Company has options to purchase up to 79 737-700s during 2004-2008
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. As of
February 1, 2003, aggregate funding needed for firm commitments is approximately
$3.2 billion, subject to adjustments for inflation, due as follows: $597 million
in 2003, $676 million in 2004, $719 million in 2005, $632 million in 2006, $508
million in 2007, and $105 million thereafter.
In November 2001, in response to decreased demand for air travel following the
terrorist attacks, the Company modified its schedule for future aircraft
deliveries to defer the acquisition of 19 new 737-700 aircraft that were either
already in production at Boeing or were scheduled to be built through April
2002. The Company accomplished this by entering into a trust arrangement with a
special purpose entity (the Trust) and assigned its purchase agreement with
Boeing to the Trust with respect to the 19 aircraft originally scheduled for
delivery between September 2001 and April 2002. Southwest subsequently entered
into a purchase agreement with the Trust to purchase the aircraft at new
delivery dates from January 2002 to April 2003. The Trust was formed primarily
to facilitate the financing of the Company's near-term aircraft purchase
obligations with Boeing. The Trust purchased 11 of the aircraft in 2001 and
eight aircraft in 2002. For these 19 Trust aircraft, the Company recorded the
associated assets ("Flight equipment") and liabilities ("Aircraft purchase
obligations") in its financial statements as the aircraft were completed by
Boeing and delivered to the Trust. In the Consolidated Statement of Cash Flows,
the Trust's receipt of these aircraft was recorded as "Purchases of property and
equipment" and "Proceeds from trust arrangement." During 2002, the Company
accelerated the deliveries from the Trust and accepted delivery of all 19
aircraft, thereby terminating the Trust. The receipt of the aircraft from the
Trust was reflected in the Consolidated Statement of Cash Flows as "Payments of
trust arrangement". The cost of financing these aircraft obligations,
approximately $5 million, was expensed.
A-38
5. ACCRUED LIABILITIES
(In thousands) 2002 2001
-------------- ---------- ----------
Retirement plans (Note 13) $ 71,233 $ 147,110
Aircraft rentals 120,856 120,554
Vacation pay 95,664 83,105
Advances and deposits 80,458 4,557
Other 160,898 192,214
---------- ----------
$ 529,109 $ 547,540
========== ==========
6. SHORT-TERM BORROWINGS
Following the terrorist attacks in September 2001, the Company borrowed the full
$475 million available under its unsecured revolving credit line with a group of
banks. Borrowings under the credit line bore interest at six-month LIBOR plus
15.5 basis points. The Company repaid this unsecured revolving credit line in
full, plus accrued interest, in March 2002. The $475 million borrowing was
classified as a current liability in the Consolidated Balance Sheet at December
31, 2001. There were no outstanding borrowings under this credit facility at
December 31, 2000. This credit facility was replaced in April 2002.
In April 2002, the Company entered into new unsecured revolving credit facility
agreements from which it can borrow up to $575 million from a group of banks.
One-half of the facility is short term and expires on April 23, 2003 if not
drawn before that date. The other one-half expires on April 23, 2005. The
Company expects that it will be able to renew the expiring 365-day facility for
an additional 365-day period at reasonable terms. If the Company is unable to
renew, the Company's available credit facility will be reduced. The effective
borrowing rate of the credit facility would vary depending on factors in place
at the time funds were drawn, as defined in the agreements.
7. LONG-TERM DEBT
(In thousands) 2002 2001
-------------- ---------- ----------
8 3/4% Notes due 2003 $ 100,000 $ 100,000
Aircraft Secured Notes due 2004 175,000 200,000
8% Notes due 2005 100,000 100,000
Pass Through Certificates 585,661 614,250
7 7/8% Notes due 2007 100,000 100,000
French Credit Agreements 50,024 52,310
6 1/2% Notes due 2012 385,000 --
7 3/8% Debentures due 2027 100,000 100,000
Capital leases (Note 8) 100,563 109,268
---------- ----------
1,696,248 1,375,828
Less current maturities 130,454 39,567
Less debt discount and issue costs 13,013 9,103
---------- ----------
$1,552,781 $1,327,158
========== ==========
On March 1, 2002, the Company issued $385 million senior unsecured Notes (Notes)
due March 1, 2012. The Notes bear interest at 6.5 percent, payable semi-annually
beginning on September 1, 2002. Southwest used the net proceeds from the
issuance of the Notes, approximately $380.2 million, for general corporate
purposes, including the repayment of the Company's credit facility in March
2002. See Note 6.
A-39
On October 30, 2001, the Company issued $614.3 million Pass Through Certificates
consisting of $150.0 million 5.1% Class A-1 certificates, $375.0 million 5.5%
Class A-2 certificates, and $89.3 million 6.1% Class B certificates. A separate
trust was established for each class of certificates. The trusts used the
proceeds from the sale of certificates to acquire equipment notes, which were
issued by Southwest on a full recourse basis. Payments on the equipment notes
held in each trust will be passed through to the holders of certificates of such
trust. The equipment notes were issued for each of 29 Boeing 737-700 aircraft
owned by Southwest and are secured by a mortgage on such aircraft. Interest on
the equipment notes held for the certificates is payable semiannually, beginning
May 1, 2002. Beginning May 1, 2002, principal payments on the equipment notes
held for the Class A-1 certificates are due semiannually until the balance of
the certificates mature on May 1, 2006. The entire principal of the equipment
notes for the Class A-2 and Class B certificates are scheduled for payment on
November 1, 2006.
In July 2001, the Company redeemed $100 million of senior unsecured 9.4% Notes
originally issued in 1991.
In fourth quarter 1999, the Company issued $200 million of floating rate
Aircraft Secured Notes (the Notes), due 2004. The Notes are funded by a bank
through a commercial paper conduit program and are secured by eight aircraft.
Interest rates on the Notes are based on the conduit's actual commercial paper
rate, plus fees, for each period and are expected to average approximately LIBOR
plus 36 basis points over the term of the Notes. Interest is payable monthly and
the Company can prepay the Notes in whole or in part prior to maturity. The
Company prepaid $25 million of the Notes during 2002.
Also in fourth quarter 1999, the Company entered into two identical 13-year
floating rate financing arrangements, whereby it effectively borrowed a total of
$56 million from French banking partnerships. For presentation purposes, the
Company has classified these identical borrowings as one $56 million
transaction. The effective rate of interest over the 13-year term of the loans
is LIBOR plus 32 basis points. Principal and interest are payable semi-annually
on June 30 and December 31 for each of the loans and the Company may terminate
the arrangements in any year on either of those dates, with certain conditions.
The Company has pledged two aircraft as collateral for the transactions.
On February 28, 1997, the Company issued $100 million of senior unsecured 7 3/8%
Debentures due March 1, 2027. Interest is payable semi-annually on March 1 and
September 1. The Debentures may be redeemed, at the option of the Company, in
whole at any time or in part from time to time, at a redemption price equal to
the greater of the principal amount of the Debentures plus accrued interest at
the date of redemption or the sum of the present values of the remaining
scheduled payments of principal and interest thereon, discounted to the date of
redemption at the comparable treasury rate plus 20 basis points, plus accrued
interest at the date of redemption.
During 1995, the Company issued $100 million of senior unsecured 8% Notes due
March 1, 2005. Interest is payable semi-annually on March 1 and September 1. The
Notes are not redeemable prior to maturity.
During 1992, the Company issued $100 million of senior unsecured 7 7/8% Notes
due September 1, 2007. Interest is payable semi-annually on March 1 and
September 1. The Notes are not redeemable prior to maturity.
During 1991, the Company issued $100 million of senior unsecured 8 3/4% Notes
due October 15, 2003. Interest on the Notes is payable semi-annually. The Notes
are not redeemable prior to maturity.
The net book value of the assets pledged as collateral for the Company's secured
borrowings, primarily aircraft and engines, was $926.1 million at December 31,
2002. As of December 31, 2002, aggregate annual principal maturities (not
including interest on capital leases) for the five-year period ending December
31, 2007 were $130 million in 2003, $207 million in 2004, $142 million in 2005,
$542 million in 2006, $114 million in 2007, and $561 million thereafter.
A-40
8. LEASES
The Company had seven aircraft classified as capital leases at December 31,
2002. The amounts applicable to these aircraft included in property and
equipment were:
(In thousands) 2002 2001
-------------- ---------- ----------
Flight equipment $ 165,467 $ 165,085
Less accumulated depreciation 106,876 99,801
---------- ----------
$ 58,591 $ 65,284
========== ==========
Total rental expense for operating leases charged to operations in 2002, 2001,
and 2000 was $371.4 million, $358.6 million, and $330.7 million, respectively.
The majority of the Company's terminal operations space, as well as 90 aircraft,
were under operating leases at December 31, 2002. Future minimum lease payments
under capital leases and noncancelable operating leases with initial or
remaining terms in excess of one year at December 31, 2002, were:
CAPITAL OPERATING
(In thousands) LEASES LEASES
-------------- ---------- ----------
2003 $ 17,751 $ 281,042
2004 17,651 263,343
2005 23,509 233,028
2006 13,379 189,498
2007 13,379 175,905
After 2007 52,016 1,459,961
---------- ----------
Total minimum lease payments 137,685 $2,602,777
==========
Less amount representing interest 37,122
----------
Present value of minimum
lease payments 100,563
Less current portion 9,657
----------
Long-term portion $ 90,906
==========
The aircraft leases generally can be renewed at rates based on fair market value
at the end of the lease term for one to five years. Most aircraft leases have
purchase options at or near the end of the lease term at fair market value,
generally limited to a stated percentage of the lessor's defined cost of the
aircraft.
9. DERIVATIVE AND FINANCIAL INSTRUMENTS
Airline operators are inherently dependent upon energy to operate and,
therefore, are impacted by changes in jet fuel prices. Jet fuel and oil consumed
in 2002, 2001, and 2000 represented approximately 14.9, 15.6 percent, and 17.4
percent of Southwest's operating expenses, respectively. The Company endeavors
to acquire jet fuel at the lowest possible cost. Because jet fuel is not traded
on an organized futures exchange, liquidity for hedging is limited. However, the
Company has found that both crude oil 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. As of January 22, 2003, the Company had a mixture of purchased call
options, collar structures, and fixed price swap agreements in place to hedge
A-41
approximately 83 percent of its 2003 total anticipated jet fuel requirements,
approximately 80 percent of its 2004 total anticipated jet fuel requirements,
and portions of its 2005-2008 total anticipated jet fuel requirements. As of
December 31, 2002, the majority of the Company's first quarter 2003 hedges are
effectively heating oil-based positions in the form of option contracts. The
majority of the remaining hedge positions are crude oil-based positions.
During 2002, 2001, and 2000, the Company recognized gains in "Fuel and oil"
expense of $44.5 million, $79.9 million, and $113.5 million, respectively, from
hedging activities. At December 31, 2002 and 2001, approximately $13.1 million
and $8.2 million, respectively, due from third parties from expired derivative
contracts, is included in "Accounts and other receivables" in the accompanying
Consolidated Balance Sheet. The Company accounts for its fuel hedge derivative
instruments as cash flow hedges, as defined. Therefore, all changes in fair
value that are considered to be effective are recorded in "Accumulated other
comprehensive income (loss)" until the underlying jet fuel is consumed. The fair
value of the Company's financial derivative instruments at December 31, 2002,
was a net asset of approximately $157.2 million. The current portion of these
financial derivative instruments is classified as "Fuel hedge contracts" and the
long-term portion is classified as "Other assets" in the Consolidated Balance
Sheet. The fair value of the derivative instruments, depending on the type of
instrument, was determined by the use of present value methods or standard
option value models with assumptions about commodity prices based on those
observed in underlying markets.
As of December 31, 2002, the Company had approximately $56.2 million in
unrealized gains, net of tax, in "Accumulated other comprehensive income (loss)"
related to fuel hedges. Included in this total are approximately $49.4 million
in net unrealized gains that are expected to be realized in earnings during
2003.
Outstanding financial derivative instruments expose the Company to credit loss
in the event of nonperformance by the counterparties to the agreements. However,
the Company does not expect any of the counterparties to fail to meet their
obligations. The credit exposure related to these financial instruments is
represented by the fair value of contracts with a positive fair value at the
reporting date. To manage credit risk, the Company selects and periodically
reviews counterparties based on credit ratings, limits its exposure to a single
counterparty, and monitors the market position of the program and its relative
market position with each counterparty. At December 31, 2002, the Company had
agreements with seven counterparties containing early termination rights and/or
bilateral collateral provisions whereby security is required if market risk
exposure exceeds a specified threshold amount or credit ratings fall below
certain levels. The Company is in the process of negotiating similar agreements
with other counterparties.
The carrying amounts and estimated fair values of the Company's long-term debt
at December 31, 2002 were as follows:
ESTIMATED FAIR
(In thousands) CARRYING VALUE VALUE
-------------- -------------- --------------
8 3/4% Notes due 2003 $ 100,000 $ 104,380
Aircraft Secured Notes due 2004 175,000 175,000
8% Notes due 2005 100,000 109,222
Pass Through Certificates 585,661 603,953
7 7/8% Notes due 2007 100,000 112,872
French Credit Agreements 50,024 50,024
6 1/2% Notes due 2012 385,000 402,213
7 3/8% Debentures due 2027 100,000 104,446
The estimated fair values of the Company's long-term debt were based on quoted
market prices. The carrying values of all other financial instruments
approximate their fair value.
A-42
10. 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. Comprehensive income totaled $326.2 million
and $479.6 million for 2002 and 2001, respectively. The differences between Net
income and Comprehensive income for 2002 and 2001 are as follows:
(In thousands) 2002 2001
-------------- -------- --------
NET INCOME $240,969 $511,147
Unrealized gain (loss) on derivative
instruments, net of deferred taxes of
$56,338 and ($20,719) 87,213 (31,063)
Other, net of deferred taxes of ($1,302)
and ($320) (2,017) (475)
-------- --------
Total other comprehensive income 85,196 (31,538)
-------- --------
COMPREHENSIVE INCOME $326,165 $479,609
======== ========
A rollforward of the amounts included in "Accumulated other comprehensive income
(loss)", net of taxes for 2002 and 2001, is shown below:
Fuel Accumulated other
hedge comprehensive
(In thousands) derivatives Other income (loss)
-------------- ----------- -------- ------------------
Balance at December 31, 2000 $ -- $ -- $ --
January 1, 2001 transition adjustment 46,089 -- 46,089
2001 changes in fair value (31,665) (475) (32,140)
Reclassification to earnings (45,487) -- (45,487)
-------- -------- --------
Balance at December 31, 2001 (31,063) (475) (31,538)
2002 changes in fair value 109,571 (2,017) 107,554
Reclassification to earnings (22,358) -- (22,358)
-------- -------- --------
Balance at December 31, 2002 $ 56,150 $ (2,492) $ 53,658
======== ======== ========
11. COMMON STOCK
The Company has one class of common stock. Holders of shares of common stock are
entitled to receive dividends when and if declared by the Board of Directors and
are entitled to one vote per share on all matters submitted to a vote of the
shareholders.
At December 31, 2002, the Company had common stock reserved for issuance
pursuant to Employee stock benefit plans (218 million shares authorized of which
57.8 million shares have not yet been granted) and upon exercise of rights
(474.0 million shares) pursuant to the Common Share Purchase Rights Agreement,
as amended (Agreement).
A-43
Pursuant to the Agreement, each outstanding share of the Company's common stock
is accompanied by one common share purchase right (Right). Each Right is
exercisable only in the event of a proposed takeover, as defined by the
Agreement. The Company may redeem the Rights at $.0022 per Right prior to the
time that 15 percent of the common stock has been acquired by a person or group.
The Agreement is not applicable to a fully-financed or cash tender offer for all
of the Company's shares of common stock, which remains open for at least 60
calendar days, is at a price equal to the higher of (a) 65% over the average
closing price of the common stock during the 90 days preceding the offer and (b)
the highest closing price during the 52 weeks preceding the offer, and is
accompanied by a written fairness opinion of a nationally recognized investment
banking firm. If the Company is acquired, as defined in the Agreement, each
Right will entitle its holder to purchase for $3.29 that number of the acquiring
company's or the Company's common shares, as provided in the Agreement, having a
market value of two times the exercise price of the Right. The Rights will
expire no later than July 30, 2005.
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. Unless
otherwise stated, all share and per share data presented in the accompanying
consolidated financial statements and notes thereto have been restated to give
effect to this stock split.
In 1999, the Company's Board of Directors authorized the repurchase of up to
$250 million of its outstanding common stock. This program resulted in the
repurchase of 18.3 million shares at an average cost of $10.85 per share between
October 1999 and December 2000. All of these acquired shares were subsequently
reissued under Employee stock plans. No shares were repurchased in 2002 or 2001.
12. STOCK PLANS
The Company has stock plans covering Employees subject to collective bargaining
agreements (collective bargaining plans) and stock plans covering Employees not
subject to collective bargaining agreements (other Employee plans.) None of the
collective bargaining plans were required to be approved by shareholders.
Options granted to Employees under collective bargaining plans are granted at or
above the fair market value of the Company's common stock on the date of grant,
generally have terms ranging from six to twelve years, and vest primarily in
accordance with the period covered by the respective collective bargaining
agreement. Neither Executive Officers nor members of the Company's Board of
Directors are eligible to participate in any of these collective bargaining
plans. Options granted to Employees through other Employee plans are granted at
the fair market value of the Company's common stock on the date of grant, have
ten-year terms and vest and become fully exercisable over three, five, or ten
years of continued employment, depending upon the grant type. All of these other
Employee plans have been approved by shareholders except the plan covering
non-management, non-contract Employees, which had 6.8 million options
outstanding to purchase the Company's common stock and an additional 2.0 million
shares available to grant as of December 31, 2002.
A-44
Aggregated information regarding the Company's fixed stock option plans, as
adjusted for stock splits, is summarized below:
COLLECTIVE BARGAINING PLANS OTHER EMPLOYEE PLANS
--------------------------------- ----------------------------------
(In thousands, except exercise prices) OPTIONS AVERAGE EXERCISE PRICE OPTIONS AVERAGE EXERCISE PRICE
-------------------------------------- ------- ---------------------- ------- ----------------------
Outstanding December 31, 1999 67,274 $ 4.32 33,331 $ 4.61
Granted 4,707 18.23 11,904 13.86
Exercised (7,895) 4.47 (7,416) 3.47
Surrendered (686) 5.15 (1,461) 8.67
------- -------
Outstanding December 31, 2000 63,400 5.59 36,358 8.66
Granted 1,665 19.05 4,022 18.75
Exercised (4,166) 4.48 (4,135) 4.77
Surrendered (349) 8.71 (1,394) 10.87
------- -------
Outstanding December 31, 2001 60,550 6.05 34,851 10.20
Granted 48,414 13.37 4,423 16.90
Exercised (4,211) 4.48 (3,805) 5.75
Surrendered (733) 8.69 (1,317) 12.48
------- -------
Outstanding December 31, 2002 104,020 $ 9.51 34,152 $ 11.47
======= =======
Exercisable December 31, 2002 52,733 $ 6.77 12,924 $ 11.33
Available for granting in future periods 39,850 17,982
The following table summarizes information about stock options outstanding under
the fixed option plans at December 31, 2002:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------------- ------------------------------------
WTD-AVERAGE
OPTIONS OUTSTANDING REMAINING WTD-AVERAGE OPTIONS EXERCISABLE WTD-AVERAGE
RANGE OF EXERCISE PRICES AT 12/31/02 (000'S) CONTRACTUAL LIFE EXERCISE PRICE AT 12/31/02 (000'S) EXERCISE PRICE
------------------------ ------------------- ---------------- -------------- ------------------- --------------
$ 3.30 to $ 4.99 50,811 3.9 yrs $ 4.05 38,717 $ 4.01
$ 5.11 to $ 7.41 3,341 3.0 yrs 5.85 2,586 5.91
$ 7.86 to $11.73 14,247 5.9 yrs 9.84 6,548 9.94
$12.11 to $18.07 61,369 8.4 yrs 13.85 14,738 14.01
$18.26 to $23.94 8,404 7.2 yrs 19.65 3,068 19.91
======= ======
$ 3.30 to $23.94 138,172 6.3 yrs $ 9.99 65,657 $ 7.67
======= ======
Under the amended 1991 Employee Stock Purchase Plan (ESPP), which has been
approved by shareholders, as of December 31, 2002, the Company is authorized to
issue up to a remaining balance of 6.5 million shares of common stock to
Employees of the Company. These shares may be issued at a price equal to 90
percent of the market value at the end of each purchase period. Common stock
purchases are paid for through periodic payroll deductions. Participants under
the plan received 1.4 million shares in 2002, 1.0 million shares in 2001, and
1.0 million shares in 2000 at average prices of $14.70, $16.42, and $13.34,
respectively. The weighted-average fair value of each purchase right under the
ESPP granted in 2002, 2001, and 2000, which is equal to the ten percent discount
from the market value of the common stock at the end of each purchase period,
was $1.63, $1.82, and $1.48, respectively.
Pro forma information regarding net income and net income per share, as
disclosed in Note 1, has been determined as if the Company had accounted for its
Employee stock-based compensation plans and other stock options under the fair
value method of SFAS 123.
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants under the fixed option plans:
A-45
2002 2001 2000
---- ---- ----
Wtd-average risk-free interest rate 3.4% 4.5% 5.0%
Expected life of option (years) 5.0 5.9 6.0
Expected stock volatility 34.0% 34.8% 34.9%
Expected dividend yield 0.13% 0.07% 0.10%
The Black-Scholes option valuation model was developed for use in estimating the
fair value of short-term traded options that have no vesting restrictions and
are fully transferable. In addition, option valuation models require the input
of highly subjective assumptions including expected stock price volatility.
Because the Company's Employee stock options have characteristics significantly
different from those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion the existing models do not necessarily provide a reliable single measure
of the fair value of its Employee stock options.
The fair value of options granted under the fixed option plans during 2002
ranged from $3.54 to $8.52. The fair value of options granted under the fixed
option plans during 2001 ranged from $5.69 to $9.11. The fair value of options
granted under the fixed option plans during 2000 ranged from $4.47 to $9.79.
13. EMPLOYEE RETIREMENT PLANS
The Company has defined contribution plans covering substantially all of
Southwest's Employees. The Southwest Airlines Co. Profitsharing Plan is a money
purchase defined contribution plan and Employee stock purchase plan. The Company
also sponsors Employee savings plans under section 401(k) of the Internal
Revenue Code, which include Company matching contributions. The 401(k) plans
cover substantially all Employees. Contributions under all defined contribution
plans are based primarily on Employee compensation and performance of the
Company.
Company contributions to all retirement plans expensed in 2002, 2001, and 2000
were $155.6 million, $214.6 million, and $241.5 million, respectively.
A-46
14. INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. The components of
deferred tax assets and liabilities at December 31, 2002 and 2001, are as
follows:
(In thousands) 2002 2001
-------------- ---------- ----------
DEFERRED TAX LIABILITIES:
Accelerated depreciation $1,440,565 $1,246,009
Scheduled airframe maintenance 70,843 89,292
Other 25,854 31,770
---------- ----------
Total deferred tax liabilities 1,537,262 1,367,071
DEFERRED TAX ASSETS:
Deferred gains from sale and
leaseback of aircraft 95,823 101,755
Capital and operating leases 77,033 76,990
Accrued employee benefits 86,227 83,450
State taxes 43,151 37,715
Other 1,722 55,418
---------- ----------
Total deferred tax assets 303,956 355,328
---------- ----------
Net deferred tax liability $1,233,306 $1,011,743
========== ==========
The provision for income taxes is composed of the following:
(In thousands) 2002 2001 2000
-------------- ---------- ---------- ----------
CURRENT:
Federal $ (19,018) $ 98,378 $ 197,875
State 1,102 10,212 26,671
---------- ---------- ----------
Total current (17,916) 108,590 224,546
DEFERRED:
Federal 156,545 187,296 151,694
State 13,084 20,626 15,900
---------- ---------- ----------
Total deferred 169,629 207,922 167,594
---------- ---------- ----------
$ 151,713 $ 316,512 $ 392,140
========== ========== ==========
A-47
The effective tax rate on income before income taxes differed from the federal
income tax statutory rate for the following reasons:
(In thousands) 2002 2001 2000
-------------- -------- -------- --------
Tax at statutory
U.S. tax rates $137,439 $289,681 $356,077
Nondeductible items 6,418 7,318 6,801
State income taxes,
net of federal benefit 9,221 20,045 27,671
Other, net (1,365) (532) 1,591
-------- -------- --------
Total income
tax provision $151,713 $316,512 $392,140
======== ======== ========
At December 31, 2002, Southwest Airlines Co. had an estimated tax net operating
loss of $145 million for federal income tax purposes. The Company estimates that
a federal tax refund of $51 million will be realized as a result of utilizing
this net operating loss as a carryback to prior taxable years. The Company has
included this refund in "Accounts and other receivables" in the Consolidated
Balance Sheet at December 31, 2002.
The Internal Revenue Service (IRS) regularly examines the Company's federal
income tax returns and, in the course of which, may propose adjustments to the
Company's federal income tax liability reported on such returns. It is the
Company's practice to vigorously contest those proposed adjustments that it
deems lacking of merit. The Company's management does not expect that the
outcome of any proposed adjustments presented to date by the IRS, individually
or collectively, will have a material adverse effect on the Company's financial
condition, results of operations, or cash flows.
A-48
15. NET INCOME PER SHARE
The following table sets forth the computation of net income per share, basic
and diluted:
(In thousands, except per share amounts) 2002 2001 2000
---------------------------------------- ---------- ---------- ----------
Net income before cumulative effect
of change in accounting principle $ 240,969 $ 511,147 $ 625,224
Cumulative effect of change in
accounting principle -- -- (22,131)
---------- ---------- ----------
Net income $ 240,969 $ 511,147 $ 603,093
========== ========== ==========
Weighted-average shares
outstanding, basic 772,556 762,973 748,617
Dilutive effect of Employee
stock options 36,864 44,142 47,699
---------- ---------- ----------
Adjusted weighted-average
shares outstanding, diluted 809,420 807,115 796,316
========== ========== ==========
Net income per share, basic, before cumulative
effect of change in accounting principle $ .31 $ .67 $ .84
Cumulative effect of change
in accounting principle -- -- (.03)
---------- ---------- ----------
Net income per share, basic $ .31 $ .67 $ .81
========== ========== ==========
Net income per share, diluted, before cumulative
effect of change in accounting principle $ .30 $ .63 $ .79
Cumulative effect of change
in accounting principle -- -- (.03)
---------- ---------- ----------
Net income per share, diluted $ .30 $ .63 $ .76
========== ========== ==========
The Company has excluded 11.0 million, 5.7 million, and 11.7 million shares from
its calculations of net income per share, diluted, in 2002, 2001, and 2000,
respectively, as they represent antidilutive stock options for the respective
periods presented.
A-49
REPORT OF INDEPENDENT AUDITORS
THE BOARD OF DIRECTORS AND SHAREHOLDERS
SOUTHWEST AIRLINES CO.
We have audited the accompanying consolidated balance sheets of Southwest
Airlines Co. as of December 31, 2002 and 2001, and the related consolidated
statements of income, stockholders' equity, and cash flows for each of the three
years in the period ended December 31, 2002. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Southwest Airlines
Co. at December 31, 2002 and 2001, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles generally accepted
in the United States.
As discussed in Note 2 to the financial statements, in 2001 the Company changed
its method of accounting for derivative financial instruments and in 2000 the
Company changed its method of accounting for the sale of flight segment credits.
ERNST & YOUNG LLP
Dallas, Texas
January 21, 2003
A-50
QUARTERLY FINANCIAL DATA (UNAUDITED)
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED
-----------------------------------------------------
2002 MARCH 31 JUNE 30 SEPT. 30 DEC. 31
---- ---------- ---------- ---------- ----------
Operating revenues $1,257,243 $1,472,798 $1,391,191 $1,400,539
Operating income 49,365 188,999 91,141 87,833
Income before income 35,196 169,238 124,324 63,924
taxes
Net income 21,385 102,298 74,887 42,399
Net income per share, basic .03 .13 .10 .05
Net income per share, .03 .13 .09 .05
diluted
2001 MARCH 31 JUNE 30 SEPT. 30 DEC. 31
---- ---------- ---------- ---------- ----------
Operating revenues $1,428,617 $1,553,785 $1,335,125 $1,237,647
Operating income 210,157 290,862 92,986 37,117
Income before income taxes 196,502 287,451 245,870 97,836
Net income 121,045 175,633 150,964 63,505
Net income per share, basic .16 .23 .20 .08
Net income per share, .15 .22 .19 .08
diluted
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
See "Election of Directors" incorporated herein by reference from the
definitive Proxy Statement for Southwest's Annual Meeting of Shareholders to be
held May 14, 2003. See "Executive Officers of the Registrant" in Part I
following Item 4 for information relating to executive officers.
A-51
EXECUTIVE COMPENSATION
See "Compensation of Executive Officers," incorporated herein by
reference from the definitive Proxy Statement for Southwest's Annual Meeting of
Shareholders to be held May 14, 2003.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS
See "Voting Securities and Principal Shareholders," incorporated herein
by reference from the definitive Proxy Statement for Southwest's Annual Meeting
of Shareholders to be held May 14, 2003.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
See "Election of Directors" incorporated herein by reference from the
definitive Proxy Statement for Southwest's Annual Meeting of Shareholders to be
held May 14, 2003.
CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
The Company maintains controls and procedures designed to ensure that
it is able to collect the information it is required to disclose in the reports
it files with the SEC, and to process, summarize and disclose this information
within the time periods specified in the rules of the SEC. The Company's Chief
Executive and Chief Financial Officers are responsible for establishing and
maintaining these procedures, and, as required by the rules of the SEC, evaluate
their effectiveness. Based on their evaluation of the Company's disclosure
controls and procedures which took place as of a date within 90 days of the
filing date of this report, the Chief Executive and Chief Financial Officers
believe that these procedures are effective to ensure that the Company is able
to collect, process and disclose the information it is required to disclose in
the reports it files with the SEC within the required time periods.
INTERNAL CONTROLS
The Company maintains a system of internal controls designed to provide
reasonable assurance that: transactions are executed in accordance with
management's general or specific authorization; transactions are recorded as
necessary (1) to permit preparation of financial statements in conformity with
generally accepted accounting principles, and (2) to maintain accountability for
assets; access to assets is permitted only in accordance with management's
general or specific authorization; and the recorded accountability for assets is
compared with the existing assets at reasonable intervals and appropriate action
is taken with respect to any differences.
Since the date of the most recent evaluation of the Company's internal
controls by the Chief Executive and Chief Financial Officers, there have been no
significant changes in such controls or in other factors that could have
significantly affected those controls, including any corrective actions with
regard to significant deficiencies and material weaknesses.
A-52
DIRECTIONS TO THE ANNUAL MEETING
Southwest Airlines Co. corporate headquarters is located at 2702 Love
Field Drive, Dallas, Texas. From Dallas Love Field, take Cedar Springs Road
south to the airport exit. Turn right onto West Mockingbird Lane. Turn right
onto Denton Drive and travel approximately two miles to Seelcco Street. Turn
right at Seelcco Street. Go past the security booth and the headquarters
building will be to your left. Please park near the main entrance to the
building.
PROXY
SOLICITED BY THE BOARD OF DIRECTORS OF SOUTHWEST AIRLINES CO.
The undersigned hereby appoints Colleen C. Barrett, James F. Parker, and Gary C.
Kelly proxies (to act by majority decision if more than one shall act), and each
of them with full power of substitution, to vote all shares of Common Stock of
Southwest Airlines Co. that the undersigned is entitled to vote at the annual
meeting of shareholders thereof to be held on May 14, 2003, or at any
adjournments thereof, as follows:
THE BOARD OF DIRECTORS RECOMMENDS A VOTE "FOR ALL NOMINEES."
(1) ELECTION OF DIRECTORS
[ ] FOR all nominees listed [ ] WITHHOLD AUTHORITY to
below (except those vote for all nominees
indicated to the contrary listed below
below, see instructions)
Herbert D. Kelleher, Rollin W. King, June M. Morris, William H.
Cunningham, Louis E. Caldera, and Nancy B. Loeffler
INSTRUCTION: TO WITHHOLD AUTHORITY TO VOTE FOR ANY INDIVIDUAL NOMINEE, WRITE
THAT NOMINEE'S NAME IN THE SPACE PROVIDED HERE.
--------------------------------------------------------------------------------
THE BOARD OF DIRECTORS RECOMMENDS A VOTE "DISAPPROVE" THE FOLLOWING SHAREHOLDER
PROPOSAL:
(2) [ ] APPROVE or [ ] DISAPPROVE or [ ] ABSTAIN shareholder proposal
(Item 2) on page 17 of the Proxy Statement.
(Please Date and Sign on Reverse Side)
Please complete, sign and promptly mail this proxy in the enclosed envelope.
ALL SHARES WILL BE VOTED AS DIRECTED HEREIN AND, UNLESS OTHERWISE DIRECTED,
WILL BE VOTED "FOR ALL NOMINEES" IN ITEM 1 AND AGAINST THE SHAREHOLDER PROPOSAL
SET FORTH IN ITEM 2 AND IN ACCORDANCE WITH THE DISCRETION OF THE PERSON VOTING
THE PROXY WITH RESPECT TO ANY OTHER BUSINESS PROPERLY BEFORE THE MEETING.
YOU MAY REVOKE THIS PROXY AT ANY TIME PRIOR TO A VOTE THEREON.
Dated: , 2003
---------------------------
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Please sign exactly as name appears on this
card. Joint owners should each sign.
Executors, administrators, trustees, etc.,
should give their full titles.