1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the Fiscal Year Ended December 31, 1996 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from ____________ to ____________ Commission File No. 1-7259 SOUTHWEST AIRLINES CO. (Exact name of registrant as specified in its charter) TEXAS 74-1563240 (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification no.) P.O. BOX 36611 DALLAS, TEXAS 75235-1611 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (214) 792-4000 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NAME OF EACH EXCHANGE TITLE OF EACH CLASS ON WHICH REGISTERED ------------------- ------------------- Common Stock ($1.00 par value) New York Stock Exchange, Inc. Common Share Purchase Rights New York Stock Exchange, Inc. SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Aggregate market value of Common Stock held by nonaffiliates as of February 28, 1997: $3,350,000,000 Number of shares of Common Stock outstanding as of the close of business on February 28, 1997: 145,335,143 shares DOCUMENTS INCORPORATED BY REFERENCE Proxy Statement for Annual Meeting of Shareholders, May 15, 1997: PART III ================================================================================
2 PART I ITEM 1. BUSINESS DESCRIPTION OF BUSINESS Southwest Airlines Co. (Southwest) is a major domestic airline that provides 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 yearend 1996, Southwest operated 243 Boeing 737 aircraft and provided service to 50 airports in 49 cities in 24 states throughout the United States. Southwest commenced service to Jacksonville, Florida in January 1997, and has recently announced that it will commence service to Jackson, Mississippi in August 1997. On December 31, 1993, Southwest acquired Morris Air Corporation (Morris) in a stock-for-stock exchange, issuing approximately 3.6 million shares of Southwest Common Stock in exchange for all of the outstanding shares of Morris. During 1994, the operations of Morris were substantially integrated with those of Southwest, and Morris ceased service as a certificated air carrier in March 1995. Unless the context requires otherwise, references in this annual report to the "Company" include Southwest and Morris. 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). 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 per gallon for scheduled carrier service over the past five years was as follows: 1992 $.61 1993 $.59 1994 $.54 1995 $.55 1996 $.65 The Company is unable to predict the extent of future fuel cost changes. The Company has standard industry arrangements with major fuel suppliers. Standard industry fuel contracts do not provide material protection against price increases or for assured availability of supplies. The Company's principal hedging program utilizes the purchase of crude oil call options at a nominal premium and at volumes of up to 30% of its annual fuel requirements. Although market conditions can significantly impact the price of jet fuel, at present these conditions have not resulted in an inadequate supply of jet fuel. For more discussion of current jet fuel costs and the impact of these costs on the Company's operations, see Management's Discussion and Analysis of Financial Condition and Results of Operations. REGULATION Economic. The Dallas Love Field section of the International Air Transportation Competition Act of 1979 (Competition Act), 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 Arkansas, Louisiana, 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 1
3 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." Southwest does not interline or offer joint fares with any other air carrier at Love Field. The Competition Act does not restrict Southwest's intrastate Texas flights or its air service from points other than Love Field to points beyond Texas and the four contiguous states. 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 authorization, 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 Love Field section of the Competition Act, 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 any provisions of subchapter IV of the Federal Aviation Act of 1958, or any order, rule or regulation issued thereunder or any term, condition or limitation of such certificate; provided that, with respect to revocation, the certificate holder has first been advised of the alleged violation and has been given a reasonable time to effect compliance. 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. Several bills have been introduced in Congress with a goal of "reforming" the Federal Aviation Administration ("FAA") by, among other things, modifying the method of funding the FAA. For information regarding the impact of the lapse and reinstatement of the 10% federal excise tax on operating results, see Management's Discussion and Analysis of Financial Condition and Results of Operations. At the current time, Southwest is unable to predict how these issues will be resolved and what impact, if any, resolution of these uncertainties will have on future operating results or financial condition. Safety. The Company is subject to the jurisdiction of the 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. Environmental. The Airport Noise and Capacity Act of 1990 (ANCA) requires the phase out of Stage 2 airplanes (which meet less stringent noise emission standards than later model Stage 3 airplanes) in the contiguous 48 states by December 31, 1999. FAA rules establish a future interim compliance date for ANCA of December 31, 1998. An operator may comply by either implementing a reduction of the operator's base level, as defined in ANCA, of Stage 2 aircraft by at least 75 percent at December 31, 1998, or by operating a fleet that is at least 75 percent Stage 3 by December 31, 1998. Operation of Stage 2 aircraft after December 31, 1999 is prohibited, subject, however, to an extension of the final compliance date to December 31, 2003, if at least 85 percent of the aircraft used by the operator in the contiguous United States will comply with Stage 3 noise levels by July 1, 1999 and the operator successfully obtains a waiver from the FAA of the December 31, 1999 final phaseout date. Statutory requirements to obtain a waiver include a determination by the FAA that the waiver is in the public interest or would enhance competition or benefit service to small communities. There is no assurance that such a waiver is obtainable. The Company's fleet, as of December 31, 1996, consisted of 47 Stage 2 aircraft and 196 Stage 3 aircraft, yielding a Stage 3 percentage of over 80 percent. Accordingly, the Company exceeds the Stage 3 fleet percentage requirement for the December 31, 1998 interim compliance date. 2
4 As of December 31, 1996, of the 47 Stage 2 aircraft operated by the Company, 26 are leased from third parties and 21 are owned by the Company. Because the Company already complies with the December 31, 1998 interim compliance requirement of a 75 percent Stage 3 fleet, the Company could operate all 47 of its Stage 2 aircraft until December 31, 1999. Based upon the Company's current schedule for delivery of new Stage 3 aircraft, including options, and the Company's planned retirement schedule for Stage 2 aircraft, assuming no hushkitting, the Company will achieve 85 percent compliance by July 1, 1999; however, the Company currently intends to hushkit at least 20 aircraft. This would qualify the Company to apply for a waiver from the final compliance date, which, if obtained, could permit the Company to continue operation of the then remaining Stage 2 aircraft until, at the latest, December 31, 2003. ANCA also requires the FAA to establish parameters within which any new Stage 2 and Stage 3 noise or access restrictions at individual airports must be developed. The published rules generally provide that local noise restrictions on Stage 3 aircraft first effective after October 1990 require FAA approval, and establish a regulatory notice and review process for local restrictions on Stage 2 aircraft first proposed after October 1990. Certain airports, including Dallas Love Field, Los Angeles, San Diego, San Francisco, 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 are considering adopting similar noise regulations. 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 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 of materials into the environment. MARKETING AND COMPETITION Southwest focuses principally on point-to-point, rather than hub-and-spoke, service in shorthaul markets with frequent, conveniently timed flights, and low fares. For example, Southwest's average aircraft trip length in 1996 was 410 miles with an average duration of approximately one hour. At yearend, Southwest served approximately 400 one-way nonstop city pairs with an average weekday frequency of just over 5 roundtrips per city pair. Southwest's point-to-point route system, as compared to hub-and-spoke, provides for more direct nonstop routings for shorthaul customers and, therefore, minimizes connections, delays, and total trip time. Southwest focuses on nonstop, not connecting, traffic. As a result, approximately 80 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, Burbank, Oakland, San Jose, Providence and Ft. Lauderdale 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 is at the gate, approximately 20 minutes, thereby reducing the number of aircraft and gate facilities that would otherwise be required. Southwest does not interline with other domestic jet airlines, nor have any commuter feeder relationships. However, in late 1996 the Company entered into a marketing relationship with Icelandair, pursuant to which Icelandair may offer travel to Customers going between Cleveland and various foreign Icelandair destinations, 3
5 via Baltimore. Southwest provides the transportation between Cleveland and Baltimore on its regularly scheduled service. Southwest employs a very simple fare structure, featuring low, unrestricted, unlimited everyday coach fares. The Company operates only one aircraft type, the Boeing 737, which simplifies scheduling, maintenance, flight operations, and training activities. In May 1994, the computer reservations systems (CRSs) owned by United Airlines (Apollo) and Continental Airlines (System One) disabled automated ticketing for Southwest travel. Rather than pay the fees associated with CRS participation in Apollo and System One, Southwest took the following actions: Southwest introduced a Ticketless travel option, available system-wide in January 31, 1995, eliminating the need to print a paper ticket altogether; provided direct access to its own reservation system and ticketing for the 50 largest travel agencies (SWAT); instituted overnight delivery of Southwest-produced tickets for approximately 300 large travel agencies; and improved access to Ticket By Mail for direct Customers by reducing the time limit from seven days out from the date of travel to three days. Southwest also entered into a new arrangement with SABRE, the CRS 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's World Wide Web at http://www.iflyswa.com. By December 31, 1996, approximately 50% of Southwest's customers were choosing the ticketless travel option. The airline industry is highly competitive as to fares, frequent flyer benefits, routes, and service, and some carriers competing with the Company have greater financial resources, larger fleets, and wider name recognition. Several of the Company's larger competitors have initiated or are studying low-cost, shorthaul service in markets served by the Company, which represents a more direct threat in Southwest's market niche. Profit levels in the air transport industry are highly sensitive to changes in operating and capital costs and the extent to which competitors match an airline's fares and services. The profitability of a carrier in the airline industry is also impacted by general economic trends. For more discussion on the current competitive environment for Southwest, see Management's Discussion and Analysis of Financial Condition and Results of Operations. 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 which compete with surface transportation, price is a competitive factor, but frequency and convenience of scheduling, facilities, transportation safety, 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 in 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. FREQUENT FLYER AWARDS Southwest's frequent flyer program, Rapid Rewards (formerly The Company Club), is based on trips flown rather than mileage. Rapid Rewards offers one free roundtrip travel award to any Southwest destination after flying eight roundtrips (or 16 one-way trips) on Southwest within a consecutive twelve-month period. The trips flown as credit towards a free travel award certificate are valid for twelve months only; the free travel award is automatically generated when earned by the Customer rather than allowing the Customer to 4
6 bank the trip credits indefinitely; and the free travel award is valid for one year with an automatic expiration date. Based on the issuance of free travel awards to qualified members, coupled with the foregoing program characteristics and the use of "black out" dates for the free travel awards during peak holiday periods, the financial impact of free travel awards used on the Company's consolidated financial statements has not been material. Free travel awards redeemed were approximately 459,000, 417,000, and 279,000 during 1996, 1995, and 1994, respectively. The amount of free travel award usage as a percentage of total Southwest revenue passengers carried was 1.9 percent in 1996, 1.9 percent in 1995, and 1.4 percent in 1994. The Company accounts for free travel awards using the incremental cost method, consistent with the other major airlines. This method recognizes an average incremental cost to provide roundtrip transportation to one additional passenger. The incremental cost to provide free transportation 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. The estimated incremental costs include passenger costs such as beverage and snack supplies, baggage claims, baggage handling, and liability insurance; operations costs such as security services, airport rentals, fuel, oil, and into-plane charges; and reservations costs, such as communications and system operations fees. The liability for free travel awards earned but not used at December 31, 1996 and 1995 was not material. The number of free travel awards for Southwest outstanding at December 31, 1996 and 1995 was approximately 404,000 and 295,000, respectively. These numbers do not include partially earned awards. The Company currently does not have a system to accurately estimate partially earned awards. However, these partially earned awards may equate to approximately 60-70 percent of the current outstanding awards. Since the inception of Rapid Rewards in 1987, approximately 15 percent of all award certificates have expired without being used. EMPLOYEES At December 31, 1996, Southwest had 22,944 active employees, consisting of 6,228 flight, 1,049 maintenance, 13,148 ground customer service and 2,519 management, accounting, marketing, and clerical personnel. Southwest has ten collective bargaining agreements covering approximately 84 percent of its employees. Southwest's Customer service and reservation employees are subject to an agreement with the International Association of Machinists and Aerospace Workers, AFL-CIO (IAM), which becomes amendable in November 1997. Flight attendants are subject to an agreement with the Transportation Workers Union of America, AFL-CIO (TWU), which became amendable May 31, 1996 and is currently in negotiations. Fleet service employees are subject to an agreement with the TWU which becomes amendable in December 1999. The pilots are subject to an agreement with the Southwest Airlines Pilots' Association (SWAPA), which becomes amendable in September 1999 (described below). Flight dispatchers are represented by the Southwest Airlines Employees Association, pursuant to an agreement which becomes amendable in November 1997. Aircraft cleaners and stock clerks; mechanics, flight simulator technicians and flight crew training instructors are represented by the International Brotherhood of Teamsters pursuant to separate agreements which become amendable in August 2000, August 2001, October 2000 and December 2000, respectively. The flight/ground school instructors are subject to an agreement with the Southwest Airlines Professional Instructors Association which becomes amendable in December 2000. In January 1995, Southwest's pilots ratified a ten-year labor contract that calls for no wage increases in the first five years and three percent annual wage increases in three of the last five years of the contract. Initially, the pilots received options to purchase approximately 14.5 million shares of Southwest common stock at $20 per share over the term of the contract; pilots hired subsequently receive additional grants at a five percent premium over then current fair market value, up to a total of 18,000,000 shares that can be issued under the stock option plan. Pilots are eligible for profitability bonuses of up to three percent of compensation in three of the first five years and profitability-based pay increases up to three percent in two of the second 5
7 five years of the contract. The pilot group may choose to reopen the contract after five years, in which event all unexercised options will terminate on December 1, 1999. ITEM 2. PROPERTIES AIRCRAFT Southwest operated a total of 243 Boeing 737 aircraft as of December 31, 1996, of which 106 and 13 were under operating and capital leases, respectively. The remaining 124 aircraft were owned. In January 1994, Southwest entered into an agreement with The Boeing Company, pursuant to which Southwest is the launch customer for the Boeing 737-700 aircraft, the newest generation of the Boeing 737 aircraft type. As the launch customer, Southwest has agreed to purchase sixty-three Boeing 737-700 aircraft from 1997 to 2001, with options for an additional sixty-seven 737-700 aircraft from 1998 to 2004. The first four 737-700 aircraft will be delivered to the Company in late 1997. In total, at December 31, 1996, the Company had 78 firm orders and 67 options as follows: <TABLE> <CAPTION> Type Seats 1996 1997 1998 1999 2000 2001 2002 2003 2004 ---- ----- ---- ---- ---- ---- ---- ---- ---- ---- ---- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> 737-200 122 47 -- -- -- -- -- -- -- -- 737-300 137 171 15 -- -- -- -- -- -- -- 737-500 122 25 -- -- -- -- -- -- -- -- 737-700 137 -- 4 21 25 21 18 18 18 5 </TABLE> The average age of the Company's fleet at December 31, 1996 was 7.9 years. For information regarding the Company's obligations under capital leases and noncancelable operating leases see Notes 4 and 5 to the Consolidated Financial Statements. For information concerning Southwest's aircraft purchase commitments, see Note 2 to the Consolidated Financial Statements. The Company has an agreement with CFM International, Inc. (a joint company of SNECMA (France) and General Electric Company) dated May 28, 1981, as amended, for the supply of spare engines for its Boeing 737-300, -500, and -700 aircraft. CFM also supplies the engines to The Boeing Company for original installation on such aircraft. CFM is the sole manufacturer of engines for use on the Boeing 737-300, -400, -500, and -700 aircraft. 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, and Phoenix Sky Harbor, its training center near Love Field which houses three 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, 1996, 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. 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 6
8 maintenance firms for major component overhauls and repairs for its airframes and engines, which comprise the majority of the annual maintenance costs. In recent years, many airports have increased or sought to increase the rates charged to airlines. The extent to which such charges are limited by statute and the ability of airlines to contest such charges has been subject to litigation and to administrative proceedings before the Department of Transportation. To the extent the limitations on such charges are relaxed or the ability of airlines to challenge such charges is restricted, the rates charged by airports to airlines may increase substantially. Management cannot predict the magnitude of any such increase. ITEM 3. LEGAL PROCEEDINGS Southwest has received examination reports from the Internal Revenue Service proposing certain adjustments to Southwest's income tax returns for 1987 through 1991. The adjustments relate to certain types of aircraft financings consummated by Southwest, as well as other members of the aviation industry, during that time period. Southwest intends to vigorously protest the adjustments made with which it does not agree. The industry's differences with the IRS involve complex issues of law and fact which are likely to take a substantial period of time to resolve. Management believes that final resolution of such protest will not have a materially adverse effect upon the results of operations of Southwest. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None to be reported. 7
9 EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of Southwest, their positions, and their respective ages (as of March 1, 1997) are as follows: <TABLE> <CAPTION> OFFICER CONTINUOUSLY NAME POSITION AGE SINCE ---- -------- --- ----- <S> <C> <C> <C> Herbert D. Kelleher Chairman of the Board, President, 65 1967 and Chief Executive Officer Colleen C. Barrett Executive Vice President-Customers 52 1978 and Corporate Secretary Gary A. Barron Executive Vice President, 52 1978 Chief Operations Officer John G. Denison Executive Vice President- 52 1986 Corporate Services Gary C. Kelly Vice President-Finance, 41 1986 Chief Financial Officer James F. Parker Vice President-General Counsel 50 1986 Ron Ricks Vice President-Governmental Affairs 47 1986 Joyce C. Rogge Vice President - Advertising and Promotions 39 1994 James C. Wimberly Vice President-Ground Operations 44 1985 </TABLE> 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 President pursuant to Board authorization. 8
10 PART II ITEM 5. 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: <TABLE> <CAPTION> PERIOD DIVIDEND HIGH LOW - - ------ -------- ---- --- <S> <C> <C> <C> <C> 1996 1st Quarter $.011 $33.00 $22.13 2nd Quarter .011 33.25 25.75 3rd Quarter .011 29.00 21.38 4th Quarter .011 26.00 20.63 1995 1st Quarter $.01 $20.00 $16.38 2nd Quarter .01 25.75 17.63 3rd Quarter .01 29.88 23.63 4th Quarter .01 26.13 19.75 </TABLE> As of March 4, 1997, there were 9,457 holders of record of the Company's common stock. RECENT SALES OF UNREGISTERED SECURITIES The Company re-employed Herbert D. Kelleher, effective as of January 1, 1996, as President and Chief Executive Officer under a five-year Employment Contract. Pursuant to this Contract, Mr. Kelleher was granted nonstatutory options to purchase, subject to his employment for four years, 144,395 shares of the Company's Common Stock at a purchase price of $1 per share and 500,000 shares at a purchase price of $23.50 per share, representing the composite tape closing sales price of the Common Stock on the New York Stock Exchange on January 2, 1996. One-fifth of the options are not subject to vesting and may be exercised at any time as to the underlying shares. Provided Mr. Kelleher remains in the continuous, full-time employ of the Company, the balance of the options will become exercisable in cumulative increments of one-fifth of the underlying shares each January 1 beginning January 1, 1997; provided that in the event of a change of control of the Company all of the options become immediately exercisable. Each of the options will expire ten years after it becomes exercisable. The options are not transferable by Mr. Kelleher other than by will or the laws of descent and distribution, and are exercisable during Mr. Kelleher's lifetime only by him. The options granted to Mr. Kelleher in 1996 are in addition to options granted to him pursuant to earlier employment agreements. During 1996, Mr. Kelleher exercised unregistered options to purchase Southwest Common Stock as follows: 9
11 <TABLE> <CAPTION> Number of Shares Purchased Exercise Price Date of Exercise - - -------------------------- -------------- ---------------- <S> <C> <C> 67,500 $1.00 07/30/96 33,750 4.889 07/30/96 22,500 4.889 01/09/96 45,000 1.00 01/09/96 </TABLE> The issuance 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 "Act"), by reason of the provision of Section 4(2) of the 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 Act and may not be transferred except pursuant to a registration statement which has become effective under the Act or to an exemption from such registration. The issuance of such shares was not underwritten. ITEM 6. SELECTED FINANCIAL DATA The following financial information for the five years ended December 31, 1996 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. 10
12 <TABLE> <CAPTION> YEARS ENDED DECEMBER 31, ------------------------------------------------------------------------- 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- <S> <C> <C> <C> <C> <C> FINANCIAL DATA: (in thousands except per share amounts) Operating revenues ............................ $ 3,406,170 $ 2,872,751 $ 2,591,933 $ 2,296,673 $ 1,802,979 Operating expenses ............................ 3,055,335 2,559,220 2,275,224 2,004,700 1,609,175 ----------- ----------- ----------- ----------- ----------- Operating income .............................. 350,835 313,531 316,709 291,973 193,804 Other expenses, net ........................... 9,473 8,391 17,186 32,336 36,361 ----------- ----------- ----------- ----------- ----------- Income before income taxes and cumula- tive effect of accounting changes .......... 341,362 305,140 299,523 259,637 157,443 Provision for income taxes (1) ................ 134,025 122,514 120,192 105,353 60,058 ----------- ----------- ----------- ----------- ----------- Income before cumulative effect of accounting changes (1) ..................... 207,337 182,626 179,331 154,284 97,385 Cumulative effect of accounting changes ....... -- -- -- 15,259(2) 12,538(3) ----------- ----------- ----------- ----------- ----------- Net income (1) ................................ $ 207,337 $ 182,626 $ 179,331 $ 169,543 $ 109,923 =========== =========== =========== =========== =========== Net income per common and common equivalent share before cumulative effect of accounting changes (1) ........... $ 1.37 $ 1.23 $ 1.22 $ 1.05 $ 0.68 Cash dividends per common share ............... $ .04400 $ .04000 $ .04000 $ .03867 $ .03533 Total assets at period-end .................... $ 3,723,479 $ 3,256,122 $ 2,823,071 $ 2,576,037 $ 2,368,856 Long-term obligations at period-end ........... $ 650,226 $ 661,010 $ 583,071 $ 639,136 $ 735,754 Stockholders' equity at period-end ............ $ 1,648,312 $ 1,427,318 $ 1,238,706 $ 1,054,019 $ 879,536 OPERATING DATA: Revenue passengers carried .................... 49,621,504 44,785,573 42,742,602(5) 36,955,221(5) 27,839,284 Revenue passenger miles (RPMs) (000s) ......... 27,083,483 23,327,804 21,611,266 18,827,228 13,787,005 Available seat miles (ASMs) (000s) ............ 40,727,495 36,180,001 32,123,974 27,511,000 21,366,642 Load factor ................................... 66.5% 64.5% 67.3% 68.4% 64.5% Average length of passenger haul (miles) ...... 546 521 506 509 495 Trips flown ................................... 748,634 685,524 624,476 546,297 438,184 Average passenger fare ........................ $ 65.88 $ 61.64 $ 58.44 $ 59.97 $ 58.33 Passenger revenue yield per RPM ............... 12.07c. 11.83c. 11.56c. 11.77c. 11.78c. Operating revenue yield per ASM ............... 8.36c. 7.94c. 8.07c. 8.35c. 7.89c. Operating expenses per ASM .................... 7.50c. 7.07c. 7.08c. 7.25c.(6) 7.03c. Fuel cost per gallon (average) ................ 65.47c. 55.22c. 53.92c. 59.15c. 60.82c. Number of employees at period-end ............. 22,944 19,933 16,818 15,175 11,397 Size of fleet at period-end (4) ............... 243 224 199 178 141 </TABLE> - - ------------------ (1) Proforma prior to 1993, assuming Morris, an S-Corporation prior to 1993, was taxed at statutory rates. (2) Includes the net cumulative effect of adopting Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." (3) Includes one-time adjustment for the cumulative effect of a change in the method of accounting for scheduled airframe overhaul costs from the direct expense method to that of capitalizing and amortizing the costs over the periods benefited. (4) Includes leased aircraft. (5) Includes certain estimates for Morris. (6) Excludes merger expenses of $10.8 million. 11
13 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS YEAR IN REVIEW Southwest and the airline industry continued to post record profits in 1996. Southwest's net income for the first half of 1996 benefitted from the lapse in the ten percent federal ticket tax on December 31, 1995. Net income for the second half of 1996 fell below year ago levels primarily due to significant increases in jet fuel prices. Southwest continued to maintain our advantage as the low cost leader in the industry. Despite this advantage, we continue pursuing numerous cost reduction efforts, which have proven to be beneficial. We added 22 new Boeing 737-300 aircraft to our fleet in 1996 and retired three - - -200s. Our fleet remains one of the youngest fleets in the industry with an average age of 7.9 years. In October 1997, we will be the launch customer for the new Boeing 737-700 aircraft. In total for 1997, we will accept delivery of 15 -300s and four -700s. We currently plan to retire four -200s in fourth quarter 1997. Our expansion into Florida in 1996 has been successful with strong load factors. We added Jacksonville, Florida service beginning January 15, 1997. Service to Providence, Rhode Island, which began October 27, 1996, also looks promising. Our current plans for capacity growth in 1997 will be primarily directed to cities we presently serve, either with increased frequencies or new routes. We may begin service to one more new city later in 1997. Proposed FAA "funding reform" continues to present uncertainty as to how or if any changes would impact Southwest. While Congress reinstated the ten percent ticket tax in August 1996, the tax lapsed again as of December 31, 1996. At the current time, Southwest is unable to predict how this FAA funding issue will be resolved and what impact, if any, resolution of this uncertainty will have on future operating results. RESULTS OF OPERATIONS 1996 COMPARED WITH 1995 The Company's consolidated net income for 1996 was $207.3 million ($1.37 per share), as compared to the corresponding 1995 amount of $182.6 million ($1.23 per share), an increase of 13.5 percent. OPERATING REVENUES Consolidated operating revenues increased by 18.6 percent in 1996 to $3,406.2 million, compared to $2,872.8 12
14 million for 1995. This increase in 1996 operating revenues was derived primarily from an 18.4 percent increase in passenger revenues. Revenue passenger miles (RPMs) increased 16.1 percent in 1996, compared to a 12.6 percent increase in available seat miles (ASMs), resulting in an increase in load factor from 64.5 percent in 1995 to 66.5 percent in 1996. The 1996 ASM growth resulted from the net addition of 19 aircraft during the year: 22 additions and three retirements. In December 1995, because of the impasse in the federal budget, Congress allowed the ten percent federal ticket tax to lapse. This benefitted Southwest's revenues until late August when Congress reimposed the tax through December 31, 1996. The reimposition of the ticket tax negatively impacted revenues in third and fourth quarters 1996 as compared to revenue trends in the first half of 1996. In celebration of the Company's 25th Anniversary, Southwest launched a fare sale in July for travel between August 19 and October 31, 1996. The sale was extremely popular and resulted in record advance bookings, with more than four and a half million seats sold. Although July and early August load factors and revenues were negatively impacted by the telephone line congestion experienced during the sale, revenues for September and October 1996 were positively impacted with very heavy passenger volumes. Freight revenues in 1996 were $80.0 million, compared to $65.8 million in 1995. The 21.5 percent increase in freight revenues exceeded the 12.6 percent increase in ASMs for the same period primarily due to increased air freight volumes and United States mail services primarily resulting from the development of new markets added in 1995 and early 1996. Other revenues increased by 23.3 percent in 1996 to $56.9 million, compared to $46.2 million in 1995. This increase is primarily due to increased charter revenue. OPERATING EXPENSES Consolidated operating expenses for 1996 were $3,055.3 million, compared to $2,559.2 million in 1995, an increase of 19.4 percent, compared to the 12.6 percent increase in capacity. Operating expenses per ASM increased 6.1 percent in 1996 compared to 1995, primarily due to significantly higher jet fuel prices along with the 4.3 cent per gallon federal jet fuel tax implemented October 1, 1995. Excluding jet fuel costs and related taxes, operating expenses per ASM were up 3.1 percent in 1996 compared to 1995. Unit costs are expected to increase in first quarter 1997 versus first quarter 1996, due to higher jet fuel prices. (The 13
15 immediately preceding sentence is a forward-looking statement which involves uncertainties that could result in actual results differing materially from expected results. Such uncertainties include, but may not be limited to, the largely unpredictable levels of fuel prices.) Operating expenses per ASM for 1996 and 1995 were as follows: OPERATING EXPENSES PER ASM <TABLE> <CAPTION> - - -------------------------------------------------------------------------------- PERCENT 1996 1995 INCREASE CHANGE - - -------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Salaries, wages, and benefits ... 2.22(cents) 2.17(cents) .05(cents) 2.3% Employee profitsharing and savings plans .. .23 .23 -- -- Fuel and oil ............ 1.19 1.01 .18 17.8 Maintenance materials and repairs ........ .62 .60 .02 3.3 Agency commissions ...... .35 .34 .01 2.9 Aircraft rentals ........ .47 .47 -- -- Landing fees and other rentals .. .46 .44 .02 4.5 Depreciation ............ .45 .43 .02 4.7 Other ................... 1.51 1.38 .13 9.4 - - -------------------------------------------------------------------------------- TOTAL ................... 7.50(cents) 7.07(cents) .43(cents) 6.1% - - -------------------------------------------------------------------------------- </TABLE> Salaries, wages, and benefits per ASM increased 2.3 percent in 1996. This increase resulted primarily from a 16.2 percent increase in 1996 average headcount, which outpaced the 1996 capacity (ASM) increase of 12.6 percent, and offset a 0.8 percent decrease in average salary and benefits cost per Employee. The 16.2 percent increase in average headcount was primarily the result of a 24.3 percent increase in Reservations Sales Agents in 1996. Excluding Reservations Sales Agents, total average headcount increased 13.1 percent, in line with capacity. Southwest's mechanics are subject to an agreement with the International Brotherhood of Teamsters, Chauffeurs, Warehousemen and Helpers of America (the Teamsters), which became amendable August 16, 1995. The Company reached an agreement with the Teamsters which was ratified by its membership in March 1996. The Company's flight attendants are subject to an agreement with the Transport Workers Union of America, AFL-CIO (TWU), which became amendable May 31, 1996. Southwest is currently in negotiations with TWU to amend the contract. 14
16 Fuel and oil expenses per ASM increased 17.8 percent in 1996, primarily due to an 18.6 percent increase in the average jet fuel cost per gallon from 1995. The average price paid for jet fuel in 1996 was $.6547 compared to $.5522 in 1995. During fourth quarter 1996, the average cost per gallon increased 25.0 percent to $.7323 compared to $.5859 in fourth quarter 1995. In January 1997, fuel prices have averaged approximately $.76 per gallon. Maintenance materials and repairs per ASM increased 3.3 percent in 1996 compared to 1995 primarily as a result of increased scheduled airframe inspections during 1996. Agency commissions per ASM increased 2.9 percent in 1996 compared to 1995, which was slightly slower than the 5.2 percent increase in passenger revenues per ASM. Landing fees and other rentals per ASM increased 4.5 percent in 1996 compared to 1995, which included an airport credit of $4.9 million. Depreciation expense per ASM increased 4.7 percent in 1996 compared to 1995 due to an increase in the percentage of owned aircraft. Other operating expenses per ASM increased 9.4 percent in 1996 compared to 1995. This increase was primarily due to increased advertising costs resulting from the expansion into Florida and Providence, Rhode Island, as well as a new advertising campaign; the 4.3 cents per gallon tax on commercial aviation jet fuel purchased for use in domestic operations, which became effective October 1, 1995; and increased airport security costs. The additional fuel tax increased 1996 and 1995 "other operating expenses" by $32.7 million and $7.4 million, respectively. OTHER "Other expenses (income)" included interest expense, capitalized interest, interest income, and nonoperating gains and losses. Capitalized interest decreased $9.1 million in 1996 as a result of certain amendments to aircraft purchase contracts during third quarter 1995 that affected the timing of payments. Interest income for 1996 increased $5.7 million primarily due to higher invested cash balances. INCOME TAXES The provision for income taxes, as a percentage of income before taxes decreased in 1996 to 39.3 percent from 40.2 percent in 1995. The decrease was primarily the result of lower effective state tax rates. 1995 COMPARED WITH 1994 The Company's consolidated net income for 1995 was $182.6 million ($1.23 per share), as compared to the 15
17 corresponding 1994 amount of $179.3 million ($1.22 per share), an increase of 1.8 percent. Operating Revenues Consolidated operating revenues increased by 10.8 percent in 1995 to $2,872.8 million, compared to $2,591.9 million for 1994. This increase in 1995 operating revenues was derived from a 10.5 percent increase in passenger revenues. RPMs increased 7.9 percent in 1995, compared to a 12.6 percent increase in ASMs, resulting in a decrease in load factor from 67.3 percent in 1994 to 64.5 percent in 1995. The 1995 ASM growth resulted from the addition of 25 aircraft during the year. Freight revenues in 1995 were $65.8 million, compared to $54.4 million in 1994. The 21.0 percent increase in freight revenues exceeded the 12.6 percent increase in ASMs for the same period primarily due to increased air freight volumes and United States mail services primarily resulting from the development of new markets added throughout 1994 and 1995. Operating Expenses Consolidated operating expenses for 1995 were $2,559.2 million, compared to $2,275.2 million in 1994, an increase of 12.5 percent, compared to the 12.6 percent increase in ASMs. For the second consecutive year, operating expenses on a per-ASM basis decreased year-over-year, down .1 percent in 1995. Salaries, wages, and benefits per ASM increased 1.9 percent in 1995. This increase resulted primarily from a 17.8 percent increase in 1995 average headcount, which outpaced the 1995 capacity (ASM) increase of 12.6 percent, and offset a 2.6 percent decrease in average salary and benefits cost per Employee. The 17.8 percent increase in average headcount was primarily the result of a 44.6 percent increase in Reservations Sales Agents in 1995. Excluding Reservations Sales Agents, total average headcount increased only 11.4 percent. The Reservations Sales Agent increase coincided with increased demand for reservations capacity following 1994 enhancements to Southwest's ticket delivery systems for direct Customers. Employee profitsharing and savings plans expense per ASM increased 4.5 percent in 1995. The increase is primarily the result of increased matching contributions to Employee savings plans resulting from increased Employee participation and higher matching rates in 1995 for non-contract Employees and certain Employee groups covered by collective bargaining agreements. Fuel and oil expenses per ASM increased 1.0 percent in 1995, primarily due to a 2.4 percent increase in the average jet fuel cost per gallon from 1994. Jet fuel prices remained relatively stable throughout most of 1995, with quarterly averages through 16
18 the first three quarters ranging from $.53 to $.55 per gallon. During fourth quarter 1995, the average cost per gallon increased to $.59 and, in January 1996, averaged approximately $.62 per gallon. Maintenance materials and repairs per ASM increased 1.7 percent in 1995 compared to 1994 primarily as a result of performing more engine overhauls during 1995. Agency commissions per ASM decreased 17.1 percent in 1995 compared to 1994, due to a lower mix of travel agency sales in 1995. The lower travel agency sales mix resulted from 1994 enhancements to Southwest's ticket delivery systems for direct Customers, as described below. In response to actions taken by our competitor-owned reservations systems in 1994, we reduced our operating costs and enhanced our ticket delivery systems by developing our own Southwest Airlines Air Travel ("SWAT") system allowing high-volume travel agents direct access to reservations; introduced overnight ticket delivery for travel agents; reduced to three the number of advance days reservations required for overnight delivery of tickets to consumers (Ticket By Mail); developed our own Ticketless system, which was rolled out system-wide on January 31, 1995; and effective March 30, 1995 subscribed to a new level of service with SABRE that automates the booking process for SABRE travel agencies. Aircraft rentals per ASM increased 11.9 percent in 1995. The increase primarily resulted from second and third quarter 1995 sale/leaseback transactions involving ten new 737-300 aircraft and a higher percentage of the fleet consisting of leased aircraft. Other operating expenses per ASM decreased 2.8 percent in 1995 compared to 1994. This decrease was primarily due to operating efficiencies resulting from the transition of Morris operating functions to Southwest commencing first quarter 1994, and lower communications costs. Communications costs decreased approximately 15 percent per ASM primarily due to lower negotiated rates, increased reservations operations efficiencies, and enhancements to the Company's ticket delivery system. In August 1993, the Revenue Reconciliation Act of 1993 was enacted, which, among other things, included an assessment of a 4.3 cents per gallon tax on commercial aviation jet fuel purchased for use in domestic operations, which became effective September 30, 1995. This additional fuel tax increased 1995 "other operating expenses" by $7.4 million. 17
19 Other "Other expenses (income)" included interest expense, capitalized interest, interest income, and nonoperating gains and losses. Interest expense increased $5.4 million in 1995 due to the March 1995 issuance of $100 million senior unsecured 8% Notes due 2005. Capitalized interest increased $5.0 million in 1995 as a result of higher levels of progress payments on aircraft compared to 1994. Interest income for 1995 increased $10.9 million primarily due to higher invested cash balances and higher short-term interest rates. Income Taxes The provision for income taxes as a percentage of income before taxes was relatively unchanged year over year. LIQUIDITY AND CAPITAL RESOURCES Cash provided from operations was $615.2 million in 1996, compared to $456.4 million in 1995. During 1996, additional funds of $330.0 million were generated from the sale and leaseback of ten new 737-300 aircraft subject to long-term operating leases (increasing total commitments for operating leases by $588.8 million). During 1996, capital expenditures of $677.4 million primarily were for the purchase of 22 new 737-300 aircraft, one used 737-200 aircraft previously leased by the Company, and progress payments for future aircraft deliveries. At December 31, 1996, capital commitments of the Company consisted primarily of scheduled aircraft acquisitions. The Company recently announced its intention to order 20 hushkits for our 737-200 fleet, with an option for 14 more, for delivery in 1997-1999. These hushkits, with an approximate cost of $1.0 million per aircraft, will make the Stage 2 -200 aircraft compliant with Stage 3 noise requirements. As of January 1997, Southwest had 78 new 737s on firm order, including 19 to be delivered in 1997, with options to purchase another 67. Aggregate funding required for firm commitments approximated $1,960.1 million through the year 2001 of which $515.1 million related to 1997. See Note 2 to the Consolidated Financial Statements for further information. In September 1996, the Company's Board of Directors reaffirmed a 1990 authorization for the Company to purchase shares of its common stock from time-to-time on the open market. The authorization reaffirmed the purchase of up to 2,500,000 shares. As of February 21, 1997, no shares have been purchased pursuant to this authority since 1990. The Company has various options available to meet its capital and operating commitments, including cash on hand at December 31, 1996 18
20 of $581.8 million, internally generated funds, and a revolving credit line with a group of banks of up to $460 million (none of which had been drawn at December 31, 1996). In addition, the Company will also consider various borrowing or leasing options to maximize earnings and supplement cash requirements. The Company currently has outstanding shelf registrations for the issuance of $114.4 million of public debt securities which it currently intends to utilize for aircraft financings in 1997. Cash provided from operations was $456.4 million in 1995 as compared to $412.7 million in 1994. During 1995, additional funds of $321.7 million were generated from the sale and leaseback of ten new 737-300 aircraft subject to long-term operating leases (increasing total commitments for operating leases by $607.9 million). In addition, $98.8 million was generated from the March 1995 issuance of $100 million in senior unsecured 8% Notes due 2005. These proceeds were primarily used to finance aircraft-related capital expenditures and to provide working capital. 19
21 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF ERNST & YOUNG LLP 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, 1996 and 1995, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. 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 generally accepted auditing standards. 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, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. ERNST & YOUNG LLP /s/ ERNST & YOUNG LLP Dallas, Texas January 23, 1997 20
22 SOUTHWEST AIRLINES CO. CONSOLIDATED BALANCE SHEET (IN THOUSANDS EXCEPT SHARE AND PER SHARE AMOUNTS) <TABLE> <CAPTION> December 31, 1996 1995 - - -------------------------------------------------------------------------- <S> <C> <C> ASSETS Current assets: Cash and cash equivalents .................... $ 581,841 $ 317,363 Accounts receivable .......................... 73,440 79,781 Inventories of parts and supplies, at cost .................................... 51,094 41,032 Deferred income taxes (Note 9) ............... 11,560 10,476 Prepaid expenses and other current assets ..................................... 33,055 24,484 ---------- ---------- Total current assets ..................... 750,990 473,136 Property and equipment, at cost (Notes 2 and 5): Flight equipment ............................. 3,435,304 3,024,702 Ground property and equipment ................ 523,958 435,822 Deposits on flight equipment purchase contracts ......................... 198,366 323,864 ---------- ---------- 4,157,628 3,784,388 Less allowance for depreciation .............. 1,188,405 1,005,081 ---------- ---------- 2,969,223 2,779,307 Other assets ................................... 3,266 3,679 ---------- ---------- $3,723,479 $3,256,122 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ............................. $ 214,232 $ 116,530 Accrued liabilities (Note 3) ................. 380,747 349,419 Air traffic liability ........................ 158,098 131,156 Current maturities of long-term debt ....................................... 12,327 13,516 ---------- ---------- Total current liabilities ................ 765,404 610,621 Long-term debt less current maturities (Note 4) .......................... 650,226 661,010 Deferred income taxes (Note 9) ................. 349,987 281,650 Deferred gains from sale and leaseback of aircraft ........................ 274,891 245,154 Other deferred liabilities ..................... 34,659 30,369 Commitments and contingencies (Notes 2, 5, and 9) Stockholders' equity (Notes 6 and 7): Common stock, $1.00 par value: 680,000,000 shares authorized; 145,112,090 and 144,033,273 shares issued and outstanding in 1996 and 1995, respectively ......................... 145,112 144,033 Capital in excess of par value ............... 181,650 162,704 Retained earnings ............................ 1,321,550 1,120,581 ---------- ---------- Total stockholders' equity ................ 1,648,312 1,427,318 ---------- ---------- $3,723,479 $3,256,122 ========== ========== </TABLE> SEE ACCOMPANYING NOTES. 21
23 SOUTHWEST AIRLINES CO. CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) <TABLE> <CAPTION> Years ended December 31, 1996 1995 1994 - - -------------------------------------------------------------------------- <S> <C> <C> <C> OPERATING REVENUES: Passenger .................. $ 3,269,238 $ 2,760,756 $ 2,497,765 Freight .................... 80,005 65,825 54,419 Other ...................... 56,927 46,170 39,749 ----------- ----------- ----------- Total operating revenues 3,406,170 2,872,751 2,591,933 OPERATING EXPENSES: Salaries, wages, and benefits (Note 8) ........ 999,719 867,984 756,023 Fuel and oil ............... 484,673 365,670 319,552 Maintenance materials and repairs .................. 253,521 217,259 190,308 Agency commissions ......... 140,940 123,380 133,081 Aircraft rentals ........... 190,663 169,461 132,992 Landing fees and other rentals .................. 187,600 160,322 148,107 Depreciation ............... 183,470 156,771 139,045 Other operating expenses ... 614,749 498,373 456,116 ----------- ----------- ----------- Total operating expenses 3,055,335 2,559,220 2,275,224 ----------- ----------- ----------- OPERATING INCOME ............. 350,835 313,531 316,709 OTHER EXPENSES (INCOME): Interest expense ........... 59,269 58,810 53,368 Capitalized interest ....... (22,267) (31,371) (26,323) Interest income ............ (25,797) (20,095) (9,166) Nonoperating (gains) losses, net ....................... (1,732) 1,047 (693) ----------- ----------- ----------- Total other expenses .... 9,473 8,391 17,186 ----------- ----------- ----------- INCOME BEFORE INCOME TAXES ... 341,362 305,140 299,523 PROVISION FOR INCOME TAXES (NOTE 9) ................... 134,025 122,514 120,192 ----------- ----------- ----------- NET INCOME ................... $ 207,337 $ 182,626 $ 179,331 =========== =========== =========== NET INCOME PER SHARE (NOTES 6, 7, AND 10) ....... $ 1.37 $ 1.23 $ 1.22 =========== =========== =========== </TABLE> SEE ACCOMPANYING NOTES. 22
24 SOUTHWEST AIRLINES CO. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994 (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) <TABLE> <CAPTION> Capital in excess Common of Retained stock par value earnings Total - - -------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Balance at December 31, 1993 .......................................... $ 142,756 $ 141,168 $ 770,095 $ 1,054,019 Issuance of common stock upon exercise of executive stock options and pursuant to Employee stock option and purchase plans (Note 7) .......................................................... 500 8,243 -- 8,743 Tax benefit of options exercised .................................... -- 2,335 -- 2,335 Cash dividends, $.04 per share ...................................... -- -- (5,722) (5,722) Net income - 1994 ................................................... -- -- 179,331 179,331 ----------- ----------- ----------- ----------- Balance at December 31, 1994 .......................................... 143,256 151,746 943,704 1,238,706 Issuance of common stock upon exercise of executive stock options and pursuant to Employee stock option and purchase plans (Note 7) .......................................................... 777 9,907 -- 10,684 Tax benefit of options exercised .................................... -- 1,051 -- 1,051 Cash dividends, $.04 per share ...................................... -- -- (5,749) (5,749) Net income - 1995 ................................................... -- -- 182,626 182,626 ----------- ----------- ----------- ----------- Balance at December 31, 1995 .......................................... $ 144,033 $ 162,704 $ 1,120,581 $ 1,427,318 Issuance of common stock upon exercise of executive stock options and pursuant to Employee stock option and purchase plans (Note 7) .......................................................... 1,079 14,513 -- 15,592 Tax benefit of options exercised .................................... -- 4,433 -- 4,433 Cash dividends, $.044 per share ..................................... -- -- (6,368) (6,368) Net income - 1996 ................................................... -- -- 207,337 207,337 ----------- ----------- ----------- ----------- Balance at December 31, 1996 .......................................... $ 145,112 $ 181,650 $ 1,321,550 $ 1,648,312 =========== =========== =========== =========== </TABLE> SEE ACCOMPANYING NOTES. 23
25 SOUTHWEST AIRLINES CO. CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) <TABLE> <CAPTION> Years ended December 31, 1996 1995 1994 - - --------------------------------------------------------------------------------------- <S> <C> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income ............................ $ 207,337 $ 182,626 $ 179,331 Adjustments to reconcile net income to cash provided by operating activities: Depreciation ...................... 183,470 156,771 139,045 Deferred income taxes ............. 67,253 48,147 49,887 Amortization of deferred gains on sale and leaseback of aircraft ..................... (18,263) (24,286) (30,341) Amortization of scheduled airframe overhauls ............... 20,539 17,337 14,216 Changes in certain assets and liabilities: Accounts receivable .......... 6,341 (4,089) (5,208) Other current assets ......... (19,534) (11,857) 648 Accounts payable and accrued liabilities....... 132,096 61,937 52,679 Air traffic liability ........ 26,942 25,017 9,993 Other current liabilities .... 5,334 1,050 (4,690) Other ............................. 3,713 3,789 7,106 --------- --------- --------- Net cash provided by operating activities .... 615,228 456,442 412,666 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment ... (677,431) (728,643) (788,649) --------- --------- --------- Net cash used in investing activities .............. (677,431) (728,643) (788,649) CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of long-term debt ............ -- 98,811 -- Proceeds from aircraft sale and leaseback transactions ............ 330,000 321,650 315,000 Payment of long-term debt and capital lease obligations ................. (12,695) (10,379) (63,071) Payment of cash dividends ............. (6,216) (5,749) (5,722) Proceeds from Employee stock plans .... 15,592 10,693 8,743 --------- --------- --------- Net cash provided by financing activities ... 326,681 415,026 254,950 --------- --------- --------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ........................... 264,478 142,825 (121,033) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD ............................. 317,363 174,538 295,571 --------- --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD ................................ $ 581,841 $ 317,363 $ 174,538 ========= ========= ========= CASH PAYMENTS FOR: Interest, net of amount capitalized ........ $ 36,640 $ 25,277 $ 26,598 Income taxes ............................... 66,447 73,928 80,461 </TABLE> SEE ACCOMPANYING NOTES. 24
26 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Southwest Airlines Co. (Southwest) is a major domestic airline that provides 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 generally accepted accounting principles 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. Certain prior year amounts have been reclassified for comparison purposes. CASH AND CASH EQUIVALENTS Cash equivalents consist of certificates of deposit and investment grade commercial paper issued by major corporations and financial institutions that are highly liquid and have original maturity dates 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 charged to expense when issued for use. PROPERTY AND EQUIPMENT Depreciation is provided by the straight-line method to residual values over periods ranging from 12 to 20 years for flight equipment and 3 to 30 years for ground property and equipment. 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 accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", the Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows to be generated by those assets are less than the carrying amounts of those assets. AIRCRAFT AND ENGINE MAINTENANCE The cost of engine overhauls and routine maintenance costs for aircraft and engine maintenance 25
27 are charged to maintenance expense as incurred. Scheduled airframe overhaul costs are capitalized and amortized over the estimated period benefited, presently 8 years. Modifications that significantly enhance the operating performance or extend the useful lives of aircraft or engines are capitalized and amortized over the remaining life of the asset. REVENUE RECOGNITION Passenger revenue is recognized when transportation is provided. Tickets sold but not yet used are included in "Air traffic liability", which includes estimates that are evaluated and adjusted periodically. Any adjustments resulting therefrom are included in results of operations for the periods in which the evaluations are completed. FREQUENT FLYER AWARDS The Company accrues the estimated incremental cost of providing free travel awards earned under its Rapid Rewards frequent flyer program. ADVERTISING The Company expenses the production costs of advertising as incurred. Advertising expense for the years ended December 31, 1996, 1995, and 1994 was $109,136,000, $92,087,000, and $79,475,000, respectively. STOCK-BASED EMPLOYEE COMPENSATION Pursuant to Statement of Financial Accounting Standards No. 123 (SFAS 123) "Accounting for Stock-Based Compensation", the Company accounts for stock-based compensation plans utilizing the provisions of Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees" and related Interpretations because, as discussed in Note 7, the alternative fair value accounting provided for under SFAS 123 requires use of option valuation models that were not developed for use in valuing employee stock options. 2. COMMITMENTS The Company's contractual purchase commitments consist primarily of scheduled aircraft acquisitions. Timing of payments pursuant to contractual commitments was affected favorably by third quarter 1995 amendments to certain aircraft purchase contracts, which modified future progress payment schedules. Fifteen 737-300 and four 737-700 aircraft are scheduled for delivery in 1997. Sixteen - - -700s are scheduled for delivery in 1998, 16 in 1999, 15 in 2000, and 12 in 2001. In addition, the Company has options to purchase up to sixty-seven -700s during 1998-2004. 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 -700s delivered subsequent to 1999. Aggregate funding needed for these commitments is approximately $1,960.1 million, subject to adjustments for inflation, due as follows: $515.1 million in 1997, 26
28 $420.0 million in 1998, $502.2 million in 1999, $318.3 million in 2000, and $204.5 million in 2001. The Company has historically used jet fuel and heating oil fixed price swap arrangements to hedge its exposure to price fluctuations on an insignificant percent of its annual fuel requirements. As of December 31, 1996, the Company had no open swap agreements, although the hedging program has not been discontinued. As of December 31, 1995, the Company had a heating oil swap agreement with a broker-dealer to exchange monthly payments on a notional quantity of 1,050,000 gallons during May 1996. Under the swap agreement, the Company paid or received the difference between the daily average heating oil price and a fixed price of $.46 per gallon. The Company's principal hedging program utilizes the purchase of crude oil call options at a nominal premium and at volumes of up to 30 percent of its annual fuel requirements. Gains and losses on hedging transactions are recorded as adjustments to fuel expense and have been insignificant. Any such future agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements. The Company does not anticipate such nonperformance. 3. ACCRUED LIABILITIES (in thousands) <TABLE> <CAPTION> 1996 1995 - - ------------------------------------------------------------------------------- <S> <C> <C> Aircraft rentals ___________________ $121,384 $105,534 Employee profitsharing and savings plans (Note 8)_______ 61,286 55,253 Vacation pay _______________________ 44,763 38,777 Aircraft maintenance costs__________ 25,942 31,463 Taxes, other than income ___________ 25,574 22,478 Interest ___________________________ 21,853 22,326 Other ______________________________ 79,945 73,588 ---------------------------- $380,747 $349,419 ============================ </TABLE> 27
29 4. LONG-TERM DEBT (in thousands) <TABLE> <CAPTION> 1996 1995 - - ------------------------------------------------------------------------------- <S> <C> <C> 9 1/4% Notes due 1998 ____________________ $100,000 $100,000 9.4% Notes due 2001 ______________________ 100,000 100,000 8 3/4% Notes due 2003 ____________________ 100,000 100,000 7 7/8% Notes due 2007 ____________________ 100,000 100,000 8% Notes due 2005 ________________________ 100,000 100,000 Capital leases (Note 5) 165,610 177,696 Other ____________________________________ 10 430 --------------------------- 665,620 678,126 Less current maturities _________________ 12,327 13,516 Less debt discount _______________________ 3,067 3,600 --------------------------- $650,226 $661,010 =========================== </TABLE> On March 7, 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. On September 9, 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 9 1/4% Notes, $100 million of senior unsecured 9.4% Notes, and $100 million of senior unsecured 8 3/4% Notes due February 15, 1998, July 1, 2001, and October 15, 2003, respectively. Interest on the Notes is payable semi-annually. The Notes are not redeemable prior to maturity. The fair values, based on quoted market prices, of these Notes at December 31, 1996, were as follows (in thousands): <TABLE> <S> <C> 9 1/4% Notes due 1998 _____________________ $103,520 9.4% Notes due 2001 ______________________ 110,670 8 3/4% Notes due 2003 _____________________ 109,820 7 7/8% Notes due 2007 _____________________ 104,800 8% Notes due 2005 _________________________ 106,190 </TABLE> 28
30 In addition to the credit facilities described above, Southwest has an unsecured Bank Credit Agreement with a group of banks that permits Southwest to borrow through December 14, 1999 on a revolving credit basis up to $460 million. Interest rates on borrowings under the Credit Agreement can be, at the option of Southwest, the agent bank's prime rate, 0.275% over LIBOR, or 0.50% over domestic certificate of deposit rates. The commitment fee is 0.125% per annum. There were no outstanding borrowings under this agreement at December 31, 1996 or 1995. 29
31 5. LEASES Total rental expense for operating leases charged to operations in 1996, 1995, and 1994 was $280,389,000, $247,033,000, and $198,987,000, respectively. The majority of the Company's terminal operations space, as well as 106 aircraft, were under operating leases at December 31, 1996. The amounts applicable to capital leases included in property and equipment were (in thousands): 1996 1995 - - ------------------------------------------------------------------------------- [S] Flight equipment __________________ $226,677 $223,844 Less accumulated amortization _____ 111,815 101,641 --------------------------- $114,862 $122,203 =========================== Future minimum lease payments under capital leases and noncancelable operating leases with initial or remaining terms in excess of one year at December 31, 1996 were (in thousands): <TABLE> <CAPTION> CAPITAL OPERATING LEASES LEASES - - --------------------------------------------------------------------------------- <S> <C> <C> 1997 _______________________ $ 25,858 $ 243,253 1998 _______________________ 32,026 223,479 1999 _______________________ 20,245 215,553 2000 _______________________ 16,871 213,798 2001 _______________________ 17,391 208,460 After 2001 _______________________ 155,360 2,342,794 ----------------------------- Total minimum lease payments _____ 267,751 $3,447,337 ========== Less amount representing interest ______________________ 102,141 ---------- Present value of minimum lease payment _________________ 165,610 Less current portion _____________ 12,317 ---------- Long-term portion ________________ $ 153,293 ========== </TABLE> The aircraft leases can generally 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, but generally not to exceed a stated percentage of the lessor's defined cost of the aircraft. 30
32 6. COMMON STOCK At December 31, 1996, the Company had common stock reserved for issuance pursuant to Employee stock benefit plans (35,257,962 shares) and upon exercise of rights (180,370,052 shares) pursuant to the Common Stock Rights Agreement, as amended (Agreement). Effective July 18, 1996, the Company amended and restated the Agreement. The principal purpose of the amendment and restatement was to extend the Agreement by 10 years. Pursuant to the Agreement, each outstanding share of the Company's common stock is accompanied by one common share purchase right (Right). Each Right entitles its holder to purchase one share of common stock at an exercise price of $16.67 and is exercisable only in the event of a proposed takeover, as defined by the Agreement. The Company may redeem the Rights at $.0111 per Right prior to the time that 15 percent of the common stock has been acquired by a person or group. If the Company is acquired, as defined in the Agreement, each Right will entitle its holder to purchase for $16.67 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, 2006. 7. STOCK PLANS At December 31, 1996, the Company had six stock-based compensation plans and other stock options outstanding, which are described below. The Company applies APB 25 and related Interpretations in accounting for its stock-based compensation. Accordingly, no compensation cost is recognized for its fixed option plans because the exercise prices of the Company's Employee stock options equal the market prices of the underlying stock on the date of the grants. Compensation cost charged against income for other options outstanding was $649,778, $564,251, and $451,400 for 1996, 1995, and 1994, respectively. The Company has five fixed option plans. Under the 1991 Incentive Stock Option Plan, the Company may grant options to key Employees for up to 9,000,000 shares of common stock. Under the 1991 Non-Qualified Stock Option Plan, the Company may grant options to key Employees and non-employee directors for up to 750,000 shares of common stock. All options granted under these plans have ten-year maximum terms and vest and become fully exercisable at the end of three, five, or ten years of continued employment, depending upon the grant type. Under the 1995 Southwest Airlines Pilots' Association Non-Qualified Stock Option Plan (SWAPA Plan), the Company may grant 31
33 options to Pilots for up to 18,000,000 shares of common stock. An initial grant of approximately 14,500,000 shares was made on January 12, 1995 at an option price of $20.00 per share, which exceeded the market price of the Company's stock on that date. Options granted under the initial grant vest in ten annual increments of ten percent. On September 1 of each year of the agreement, beginning September 1, 1996, additional options will be granted to Pilots that become eligible during that year. Additional options granted on September 1, 1996 vest in eight annual increments of 12.5 percent. Options under both grants must be exercised prior to January 31, 2007, or within a specified time upon retirement or termination. In the event that the Southwest Airlines Pilots' Association exercises its option to make the collective bargaining agreement amendable on September 1, 1999, any unexercised options will be canceled on December 1, 1999. Under the 1996 Incentive Stock Option Plan, the Company may grant options to key Employees for up to 6,000,000 shares of common stock. Under the 1996 Non-Qualified Stock Option Plan, the Company may grant options to key Employees and non-employee directors for up to 575,000 shares of common stock. All options granted under these plans have ten-year terms and vest and become fully exercisable at the end of three, five, or ten years of continued employment, depending upon the grant type. Under all fixed option plans, except the SWAPA Plan, the exercise price of each option equals the market price of the Company's stock on the date of grant. Under the SWAPA Plan, for additional options granted each September 1, eligible Pilots will be required to pay a purchase price equal to 105 percent of the fair value of such stock on the date of the grant. 32
34 A summary of the status of the Company's five fixed option plans as of December 31, 1996, 1995, and 1994, and changes during the years ending on those dates is presented below: <TABLE> <CAPTION> INCENTIVE PLANS NON-QUALIFIED PLANS --------------- ------------------- AVERAGE AVERAGE EXERCISE EXERCISE OPTIONS * PRICE OPTIONS ** PRICE --------- ----- ---------- ----- <S> <C> <C> <C> <C> Outstanding December 31, 1993 .. 4,312,287 $ 8.83 301,277 $ 8.92 Granted - Incentive Plans ... 794,714 29.02 -- -- Granted - SWAPA Plan ........ -- -- -- -- Granted - Other Non-Qualified Plans ................... -- -- 63,918 34.85 Exercised ................... (190,159) 8.23 (9,940) 7.85 Surrendered ................. (104,880) 14.22 -- -- --------- ---------- Outstanding December 31, 1994 .. 4,811,962 12.07 355,255 13.61 Granted - Incentive Plans .... 983,214 18.80 -- -- Granted - SWAPA Plan ......... -- -- 14,527,050 20.00 Granted - Other Non-Qualified Plans .................... -- -- 93,315 18.77 Exercised ................... (275,058) 8.50 (60,510) 15.12 Surrendered ................. (308,239) 12.71 (61,041) 19.61 --------- ---------- Outstanding December 31, 1995 .. 5,211,879 13.47 14,854,069 19.86 Granted - Incentive Plans ... 1,670,344 25.18 -- -- Granted - SWAPA Plan ......... -- -- 466,200 23.82 Granted - Other Non-Qualified Plans .................... -- -- 69,122 25.17 Exercised ................... (395,848) 10.27 (290,385) 17.89 Surrendered ................. (250,446) 20.16 (94,985) 20.00 --------- ---------- Outstanding December 31, 1996 .. 6,235,929 $ 16.54 15,004,021 $ 20.04 ========= ========== Exercisable December 31, 1996 .. 1,237,517 4,250,643 Available for granting in future periods ............. 7,352,821 3,854,504 </TABLE> 33
35 *Includes 1991 Incentive Stock Option Plan. No options have been granted under the 1996 Incentive Stock Option Plan. **Includes 1991 Non-Qualified Stock Option Plan and SWAPA Plan. No options have been granted under the 1996 Non-Qualified Stock Option Plan. The following table summarizes information about fixed stock options outstanding under the fixed option plans at December 31, 1996: <TABLE> <CAPTION> Options Outstanding Options Exercisable ------------------------------------------------------------------------------------------ Weighted- Average Weighted- Weighted- Number Remaining Average Number Average Range of Outstanding at Contractual Exercise Exercisable at Exercise Exercise Prices 12/31/96 Life Price 12/31/96 Price - - ---------------- ------------------ ---- ----- ------------------ ----- <S> <C> <C> <C> <C> <C> $6.02 to $7.81 2,487,991 4.05 yrs. $ 6.12 682,231 $ 6.39 $11.33 to $16.87 326,591 5.09 12.02 71,291 12.07 $18.81 to $27.19 18,248,078 8.09 20.71 4,572,348 20.33 $35.69 to $37.44 177,290 7.02 37.29 162,290 37.40 ------------------ ------------------ $6.02 to $37.44 21,239,950 7.56 yrs. $19.01 5,488,160 $18.99 ================== ================== </TABLE> The Company has granted options to purchase the Company's common stock related to employment contracts with the Company's president and chief executive officer. These options have terms of ten years from the date of grant or ten years from the date exercisable, depending upon the grant. The options vest and become fully exercisable over three or four years. In 1996, the Company granted 144,395 options with an exercise price of $1.00 per share and 500,000 options with an exercise price of $23.50 per share related to the 1996 employment agreement. None of the 1996 options granted were exercised in 1996, however, 128,879 were exercisable as of December 31, 1996. At December 31, 1996, 1995, and 1994, 1,897,898, 1,422,253, and 1,489,753 total options were outstanding. Exercise prices range from $1.00 to $23.50 per share. Options for 168,750, 67,500, and 15,000 shares were exercised in 1996, 1995, and 1994, respectively. Under the 1991 Employee Stock Purchase Plan (ESPP), the Company is authorized to issue up to a balance of 1,183,236 shares of common stock to Employees of the Company 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 309,446 shares in 1996, 388,339 shares in 1995, and 290,054 shares in 1994 at average prices of $23.05, $19.18, and $24.98, respectively. 34
36 Pro forma information regarding net income and net income per share is required by SFAS 123, and 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 that SFAS. 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 in 1996 and 1995, respectively: dividend yield of .16% and .21%; expected volatility of 35.4% and 36.9%; risk-free interest rate of 5.9% and 7.8%; and expected lives of 5.0 years for both periods. Assumptions for the stock options granted in 1996 to the Company's president and chief executive officer were the same as for the fixed option plans except for the weighted average expected lives of 8.0 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the 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. 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. The Company's pro forma net income and net income per share is as follows (in thousands except per share amounts): <TABLE> <CAPTION> 1996 1995 ---- ---- <S> <C> <C> Net income As reported $207,337 $182,626 Pro forma $196,478 $167,907 Net income per share As reported $1.37 $1.23 Pro forma $1.33 $1.14 </TABLE> The effects of applying SFAS 123 for providing pro forma disclosures during the initial phase-in period may not be representative of the effects on reported net income for future years. The weighted-average fair value of options granted under the five fixed option plans during 1996 and 1995 was $10.17 and $8.42, respectively, for the incentive plans, $9.24 and $7.97, respectively, for the SWAPA Plan, and $10.17 and $8.42, 35
37 respectively, for other non-qualified plans. The weighted average fair value of options granted in 1996 to the Company's president and chief executive officer (no options were granted in 1995) was $13.98. The weighted-average fair value of each purchase right under the ESPP granted in 1996 and 1995, which is equal to the ten percent discount from the market value of the common stock at the end of each purchase period, was $2.56 and $2.15, respectively. 36
38 8. EMPLOYEE PROFITSHARING AND SAVINGS PLANS Substantially all of Southwest's Employees are members of the Southwest Airlines Co. Profitsharing Plan (the Plan). Total profitsharing expense charged to operations in 1996, 1995, and 1994, was $59,927,000, $54,033,000, and $52,782,000, respectively. The Company sponsors Employee savings plans under Section 401(k) of the Internal Revenue Code. The plans cover substantially all full-time Employees. The amount of matching contributions varies by Employee group. Company contributions generally vest over five years with credit for prior years' service granted. Company matching contributions expensed in 1996, 1995 and 1994 were $35,125,000, $28,954,000, and $19,817,000, respectively. 9. 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, 1996 and 1995 are as follows (in thousands): <TABLE> <CAPTION> 1996 1995 - - ------------------------------------------------------------------------------- <S> <C> <C> Deferred tax liabilities: Accelerated depreciation _____________ $467,372 $400,321 Scheduled airframe overhauls _________ 30,984 27,129 Other ________________________________ 78,195 68,458 --------------------------- Total deferred tax liabilities 576,551 495,908 Deferred tax assets: Deferred gains from sale and leaseback of aircraft ___________ 114,514 106,119 Capital and operating leases _______ 58,252 54,472 Alternative minimum tax credit carryforward ___________________ 6,019 11,333 Other ______________________________ 59,339 52,810 --------------------------- Total deferred tax assets _______ 238,124 224,734 --------------------------- Net deferred tax liability ______ $338,427 $271,174 =========================== </TABLE> 37
39 The provision for income taxes is comprised of the following (in thousands): <TABLE> <CAPTION> 1996 1995 1994 - - ------------------------------------------------------------------------------- <S> <C> <C> <C> Current: Federal ___________ $ 59,101 $ 64,420 $ 59,603 State _____________ 7,671 9,947 10,702 -------- -------- -------- Total Current 66,772 74,367 70,305 Deferred: Federal ___________ 60,967 44,580 46,470 State _____________ 6,286 3,567 3,417 -------- -------- -------- Total deferred 67,253 48,147 49,887 -------- -------- -------- $134,025 $122,514 $120,192 ======== ======== ======== </TABLE> Southwest has received examination reports from the Internal Revenue Service proposing certain adjustments to Southwest's income tax returns for 1987 through 1991. The adjustments relate to certain types of aircraft financings consummated by Southwest, as well as other members of the aviation industry during that time period. Southwest intends to vigorously protest the adjustments proposed with which it does not agree. The industry's difference with the IRS involves complex issues of law and fact that are likely to take a substantial period of time to resolve. Management believes that final resolution of such protest will not have a materially adverse effect upon the results of operations of Southwest. The effective tax rate on income before income taxes differed from the federal income tax statutory rate for the following reasons (in thousands): 1996 1995 1994 - - ------------------------------------------------------------------------------- Tax at statutory U.S. tax rates ___ $119,477 $106,799 $104,833 Nondeductible items 5,168 4,488 3,689 State income taxes, net of federal benefit __________ 9,072 8,784 9,177 Other, net _________ 308 2,443 2,493 ________ ________ ________ Total income tax $134,025 $122,514 $120,192 provision __________ ======== ======== ======== 38
40 10. NET INCOME PER COMMON AND COMMON EQUIVALENT SHARE Net income per common and common equivalent share is computed based on the weighted-average number of common and common equivalent shares outstanding (151,793,477 in 1996, 148,850,512 in 1995 and 147,305,374 in 1994). Fully diluted earnings per share have not been presented as the fully dilutive effect of shares issuable upon the exercise of options under the Company's Stock Option Plans is not material. 39
41 QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) <TABLE> <CAPTION> THREE MONTHS ENDED -------------------------------------- 1996 MARCH 31 JUNE 30 SEPT. 30 DEC. 31 - - ---- -------- ------- -------- ------- <S> <C> <C> <C> <C> Operating revenues $772,529 $910,308 $891,492 $831,841 Operating income 57,393 142,206 102,934 48,302 Income before income taxes 54,771 139,989 100,243 46,359 Net income 33,000 85,316 60,858 28,163 Net income per common and .22 .56 .40 .19 common equivalent share <CAPTION> THREE MONTHS ENDED -------------------------------------- 1996 MARCH 31 JUNE 30 SEPT. 30 DEC. 31 - - ---- -------- ------- -------- ------- <S> <C> <C> <C> <C> Operating revenues $620,999 $738,205 $764,975 $748,572 Operating income 23,409 103,425 114,098 72,599 Income before income taxes 20,034 100,801 114,215 70,090 Net income 11,826 59,724 67,717 43,359 Net income per common and .08 .41 .45 .29 common equivalent share </TABLE> ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None to be reported. 40
42 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See "Election of Directors" incorporated herein by reference, from pages 1-4 of the definitive Proxy Statement for Southwest's Annual Meeting of Shareholders to be held May 15, 1997. See "Executive Officers of the Registrant" in Part I following Item 4 for information relating to executive officers. ITEM 11. EXECUTIVE COMPENSATION See "Compensation of Executive Officers," incorporated herein by reference, from pages 6-9 of the definitive Proxy Statement for Southwest's Annual Meeting of Shareholders to be held May 15, 1997. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Voting Securities and Principal Shareholders," incorporated herein by reference, from pages 4-5 of the definitive Proxy Statement for Southwest's Annual Meeting of Shareholders to be held May 15, 1997. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Election of Directors" incorporated herein by reference, from pages 1-4 of the definitive Proxy Statement for Southwest's Annual Meeting of Shareholders to be held May 15, 1997. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: The financial statements included in Item 8 above are filed as part of this annual report. 2. Financial Statement Schedules: There are no financial statement schedules filed as part of this annual report, since the required information is included in the consolidated financial statements, including the notes thereto, or the circumstances requiring inclusion of such schedules are not present. 3. Exhibits: 3.1 Restated Articles of Incorporation of Southwest (incorporated by reference to Exhibit 4.1 to Southwest's Registration Statement on Form S-3 (File No. 33-52155)); Amendment to Restated Article of Incorporation of Southwest (incorporated by reference to Exhibit 4.1 to Southwest's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (File No. 1-7259). 41
43 3.2 Bylaws of Southwest, as amended through February 1994 (incorporated by reference to Exhibit 3.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)). 4.1 Credit Agreement dated December 15, 1990, between Southwest and Texas Commerce Bank - Dallas, N.A., as agent for itself and four other banks named therein, and such banks (incorporated by reference to Exhibit 4.1 on Southwest's Current Report on Form 8-K dated February 14, 1991 (File No. 1-7259)); First Amendment to Credit Agreement, dated April 4, 1991 and Second Amendment to Credit Agreement, dated December 14, 1991 (incorporated by reference to Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)); Third Amendment to Credit Agreement, dated December 14, 1992 (incorporated by reference in Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)); Fourth Amendment to Credit Agreement, dated December 14, 1993 (incorporated by reference to Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 1-7259)); Fifth and Sixth Amendments to Credit Agreement, dated March 10, 1995 and May 18, 1995, respectively (incorporated by reference to Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 1-7259). 4.2 Specimen certificate representing Common Stock of Southwest (incorporated by reference to Exhibit 4.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 1-7259)). 4.3 Indenture dated as of December 1, 1985 between Southwest and MBank Dallas, N.A., Trustee, relating to an unlimited amount of Debt Securities (incorporated by reference to Exhibit 4.1 of Southwest's Current Report on Form 8-K dated February 26, 1986 (File No. 1-7259)) and First Supplemental Indenture dated as of January 21, 1988, substituting MTrust Corp, National Association, as Trustee, thereunder (incorporated by reference to Exhibit 4.3 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1987 (File 1-7259)). 4.4 Amended and Restated Rights Agreement dated July 18, 1996 between Southwest and Continental Stock Transfer & Trust Company, as Rights Agent (incorporated by reference to Exhibit 1, Southwest's Registration Statement on Form 8-A/A dated August 12, 1996 (File No. 1-7259)). 4.5 Indenture dated as of June 20, 1991 between Southwest Airlines Co. and Bank of New York, successor to NationsBank of Texas, N.A. (formerly NCNB Texas National Bank), Trustee (incorporated by reference to Exhibit 4.1 to Southwest's Current Report on Form 8-K dated June 24, 1991 (File No. 1-7259)). 4.6 Form of 9.4 percent Note due 2001 (incorporated by reference to Exhibit 4.2 to Southwest's Current Report on Form 8-K dated June 24, 1991 (File No. 1-7259)). 4.7 Form of 8-3/4 percent Note due 2003 (incorporated by reference to Exhibit 4.2 to Southwest's Current Report on Form 8-K dated October 4, 1991 (File No. 1-7259)). 4.9 Form of 9-1/4 percent Note due 1998 (incorporated by reference to Exhibit 4.9 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 42
44 4.10 Form of 7-7/8 percent Note due 2007 (incorporated by reference to Exhibit 4.10 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)). 4.11 Form of Global Security representing all 8% Notes due 2005 (incorporated by reference to Exhibit 4 to Southwest's Current Report on Form 8-K dated March 6, 1995 (File No. 1- 7259)). 4.12 Indenture dated as of February 25, 1997 between the Company and U.S. Trust Company of Texas, N.A. 4.13 Form of Global Security representing all 7 3/8% Debentures due 2027 (incorporated by reference to Exhibit 4.1 to Southwest's Current Report on Form 8-K dated February 25, 1997 (File No. 1-7259)). 10.1 General Terms Agreement between CFM International, Inc. and Southwest (with all amendments through March 29, 1990) dated May 28, 1981 (incorporated by reference to Exhibit 10.2 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-7259)); Amendments from November 6, 1989 through March 29, 1993 (incorporated by reference to Exhibit 10.2 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)); Amendments from March 29, 1993 through March 29, 1994 (incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)); Amendment No. 7 and Letter Agreement No. 11, each dated as of January 19, 1994 (incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)). 10.2 Purchase Agreement No. 1405, dated July 23, 1987 between The Boeing Company and Southwest (with all amendments through March 29, 1990) (incorporated by reference to Exhibit 10.3 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-7259)); Amendments from April 1, 1990 through March 29, 1993 (incorporated by reference to Exhibit 10.3 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)); Amendments from March 29, 1993 through March 29, 1994 (incorporated by reference to Exhibit 10.3 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)); Amendments from March 30, 1994 through March 29, 1995 (incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)); Amendments from March 30, 1995 through March 29, 1996(incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 1-7529)). *10.3 Purchase Agreement No. 1810, dated January 19, 1994 between The Boeing Company and Southwest (incorporated by reference to Exhibit 10.4 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)); Supplemental Agreement No. 1. The following exhibits filed under paragraph 10 of Item 601 are the Company's compensation plans and arrangements. 10.4 Form of Executive Employment Agreement between Southwest and certain key employees pursuant to Executive Service Recognition Plan (incorporated by reference to Exhibit 28 to Southwest Quarterly Report on Form 10-Q for the quarter ended June 30, 1987 (File No. 1- 7259)). 43
45 10.5 1992 stock option agreements between Southwest and Herbert D. Kelleher (incorporated by reference to Exhibit 10.8 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 10.6 1987 stock option agreement between Southwest and Herbert D. Kelleher (incorporated by reference to Exhibit 10.11 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1987 (File No. 1-7259)). 10.7 1996 employment contract between Southwest and Herbert D. Kelleher and related stock option agreements (incorporated by reference to Exhibit 10.8 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 1-7259)). 10.8 1991 Incentive Stock Option Plan (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-8 (File No. 33-40652)). 10.9 1991 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 4.2 to Registration Statement on Form S-8 (File No. 33-40652)). 10.10 1991 Employee Stock Purchase Plan as amended May 20, 1992 (incorporated by reference to Exhibit 10.13 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)). 10.11 Southwest Airlines Co. Profit Sharing Plan (incorporated by reference to Exhibit 10.13 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 10.12 Southwest Airlines Co. 401(k) Plan (incorporated by reference to Exhibit 10.14 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 10.13 Southwest Airlines Co. 1995 SWAPA Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.14 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 1-7259)). 10.14 1996 Incentive Stock Option Plan (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-8 (File No. 333-20275)). 10.15 1996 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 4.2 to Registration Statement on Form S-8 (File No. 333-20275)). 11 Computation of earnings per share. 22 Subsidiaries of Southwest. 23 Consent of Ernst & Young LLP, Independent Auditors. 27 Financial Data Schedule. - - ------------------------- * Pursuant to 17 CFR 240.24b-2, confidential information has been omitted and has been filed separately with the Securities and Exchange Commission. 44
46 Southwest will furnish to the Commission supplementally upon request a copy of each other instrument with respect to the long-term debt of the Company. A copy of each exhibit may be obtained at a price of 15 cents per page, $10.00 minimum order, by writing to: Director of Investor Relations, Southwest Airlines Co., P.O. Box 36611, Dallas, Texas 75235- 1611. (b) There were no Form 8-K's filed during the fourth quarter of 1996. 45
47 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SOUTHWEST AIRLINES CO. March 21, 1997 By /s/ Gary C. Kelly ------------------------- Gary C. Kelly Vice President-Finance, Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on March 21, 1997 on behalf of the registrant and in the capacities indicated. Signature Capacity --------- -------- /s/ Herbert D. Kelleher Chairman of the Board of Directors, - - ---------------------------- President and Chief Executive Officer Herbert D. Kelleher /s/ Gary C. Kelly Vice President-Finance - - ---------------------------- (Chief Financial and Accounting Officer) Gary C. Kelly /s/ Samuel E. Barshop Director - - ---------------------------- Samuel E. Barshop /s/ Gene H. Bishop Director - - ---------------------------- Gene H. Bishop /s/ C. Webb Crockett Director - - ---------------------------- C. Webb Crockett /s/ William P. Hobby, Jr. Director - - ---------------------------- William P. Hobby, Jr. /s/ Travis C. Johnson Director - - ---------------------------- Travis C. Johnson /s/ R.W. King Director - - ---------------------------- R. W. King /s/ Walter M. Mischer, Sr. Director - - ---------------------------- Walter M. Mischer, Sr. /s/ June M. Morris Director - - ---------------------------- June M. Morris E-1
48 INDEX TO EXHIBITS 3.1 Restated Articles of Incorporation of Southwest (incorporated by reference to Exhibit 4.1 to Southwest's Registration Statement on Form S-3 (File No. 33-52155)); Amendment to Restated Article of Incorporation of Southwest (incorporated by reference to Exhibit 4.1 to Southwest's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (File No. 1-7259). 3.2 Bylaws of Southwest, as amended through February 1994 (incorporated by reference to Exhibit 3.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)). 4.1 Credit Agreement dated December 15, 1990, between Southwest and Texas Commerce Bank - Dallas, N.A., as agent for itself and four other banks named therein, and such banks (incorporated by reference to Exhibit 4.1 on Southwest's Current Report on Form 8-K dated February 14, 1991 (File No. 1-7259)); First Amendment to Credit Agreement, dated April 4, 1991 and Second Amendment to Credit Agreement, dated December 14, 1991 (incorporated by reference to Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)); Third Amendment to Credit Agreement, dated December 14, 1992 (incorporated by reference in Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)); Fourth Amendment to Credit Agreement, dated December 14, 1993 (incorporated by reference to Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 1-7259)); Fifth and Sixth Amendments to Credit Agreement, dated March 10, 1995 and May 18, 1995, respectively (incorporated by reference to Exhibit 4.1 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 1-7259). 4.2 Specimen certificate representing Common Stock of Southwest (incorporated by reference to Exhibit 4.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 1-7259)). 4.3 Indenture dated as of December 1, 1985 between Southwest and MBank Dallas, N.A., Trustee, relating to an unlimited amount of Debt Securities (incorporated by reference to Exhibit 4.1 of Southwest's Current Report on Form 8-K dated February 26, 1986 (File No. 1-7259)) and First Supplemental Indenture dated as of January 21, 1988, substituting MTrust Corp, National Association, as Trustee, thereunder (incorporated by reference to Exhibit 4.3 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1987 (File 1-7259)). 4.4 Amended and Restated Rights Agreement dated July 18, 1996 between Southwest and Continental Stock Transfer & Trust Company, as Rights Agent (incorporated by reference to Exhibit 1, Southwest's Registration Statement on Form 8-A/A dated August 12, 1996 (File No. 1-7259)). 4.5 Indenture dated as of June 20, 1991 between Southwest Airlines Co. and Bank of New York, successor to NationsBank of Texas, N.A. (formerly NCNB Texas National Bank), Trustee (incorporated by reference to Exhibit 4.1 to Southwest's Current Report on Form 8-K dated June 24, 1991 (File No. 1-7259)). E-1
49 4.6 Form of 9.4 percent Note due 2001 (incorporated by reference to Exhibit 4.2 to Southwest's Current Report on Form 8-K dated June 24, 1991 (File No. 1-7259)). 4.7 Form of 8-3/4 percent Note due 2003 (incorporated by reference to Exhibit 4.2 to Southwest's Current Report on Form 8-K dated October 4, 1991 (File No. 1-7259)). 4.9 Form of 9-1/4 percent Note due 1998 (incorporated by reference to Exhibit 4.9 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 4.10 Form of 7-7/8 percent Note due 2007 (incorporated by reference to Exhibit 4.10 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)). 4.11 Form of Global Security representing all 8% Notes due 2005 (incorporated by reference to Exhibit 4 to Southwest's Current Report on Form 8-K dated March 6, 1995 (File No. 1- 7259)). 4.12 Indenture dated as of February 25, 1997 between the Company and U.S. Trust Company of Texas, N.A. 4.13 Form of Global Security representing all 7 3/8% Debentures due 2027 (incorporated by A reference to Exhibit 4.1 to Southwest's Current Report on Form 8-K dated February 25, 1997 (File No. 1-7259)). 10.1 General Terms Agreement between CFM International, Inc. and Southwest (with all amendments through March 29, 1990) dated May 28, 1981 (incorporated by reference to Exhibit 10.2 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-7259)); Amendments from November 6, 1989 through March 29, 1993 (incorporated by reference to Exhibit 10.2 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)); Amendments from March 29, 1993 through March 29, 1994 (incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)); Amendment No. 7 and Letter Agreement No. 11, each dated as of January 19, 1994 (incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)). 10.2 Purchase Agreement No. 1405, dated July 23, 1987 between The Boeing Company and Southwest (with all amendments through March 29, 1990) (incorporated by reference to Exhibit 10.3 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-7259)); Amendments from April 1, 1990 through March 29, 1993 (incorporated by reference to Exhibit 10.3 on Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)); Amendments from March 29, 1993 through March 29, 1994 (incorporated by reference to Exhibit 10.3 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)); Amendments from March 30, 1994 through March 29, 1995 (incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-7259)); Amendments from March 30, 1995 through March 29, 1996(incorporated by reference to Exhibit 10.2 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 1-7529)). *10.3 Purchase Agreement No. 1810, dated January 19, 1994 between The Boeing Company and Southwest (incorporated by reference to Exhibit 10.4 to Southwest's Annual Report on Form E-2
50 10-K for the year ended December 31, 1993 (File No. 1-7259)); Supplemental Agreement No. 1. The following exhibits filed under paragraph 10 of Item 601 are the Company's compensation plans and arrangements. 10.4 Form of Executive Employment Agreement between Southwest and certain key employees pursuant to Executive Service Recognition Plan (incorporated by reference to Exhibit 28 to Southwest Quarterly Report on Form 10-Q for the quarter ended June 30, 1987 (File No. 1- 7259)). 10.5 1992 stock option agreements between Southwest and Herbert D. Kelleher (incorporated by reference to Exhibit 10.8 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 10.6 1987 stock option agreement between Southwest and Herbert D. Kelleher (incorporated by reference to Exhibit 10.11 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1987 (File No. 1-7259)). 10.7 1996 employment contract between Southwest and Herbert D. Kelleher and related stock option agreements (incorporated by reference to Exhibit 10.8 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 1-7259)). 10.8 1991 Incentive Stock Option Plan (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-8 (File No. 33-40652)). 10.9 1991 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 4.2 to Registration Statement on Form S-8 (File No. 33-40652)). 10.10 1991 Employee Stock Purchase Plan as amended May 20, 1992 (incorporated by reference to Exhibit 10.13 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-7259)). 10.11 Southwest Airlines Co. Profit Sharing Plan (incorporated by reference to Exhibit 10.13 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 10.12 Southwest Airlines Co. 401(k) Plan (incorporated by reference to Exhibit 10.14 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-7259)). 10.13 Southwest Airlines Co. 1995 SWAPA Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.14 to Southwest's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 1-7259)). 10.14 1996 Incentive Stock Option Plan (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-8 (File No. 333-20275)). 10.15 1996 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 4.2 to Registration Statement on Form S-8 (File No. 333-20275)). 11 Computation of earnings per share. 22 Subsidiaries of Southwest. E-3
51 23 Consent of Ernst & Young LLP, Independent Auditors. 27 Financial Data Schedule. - - ------------------------- * Pursuant to 17 CFR 240.24b-2, confidential information has been omitted and has been filed separately with the Securities and Exchange Commission. E-4