SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 1998 OR ____TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________ TO ________ Commission file No. 1-7259 SOUTHWEST AIRLINES CO. (Exact name of registrant as specified in its charter) TEXAS 74-1563240 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) P.O. Box 36611, Dallas, Texas 75235-1611 (Address of principal executive offices) (Zip Code) (214) 792-4000 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No . Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Number of shares of Common Stock outstanding as of the close of business on November 11, 1998: 336,360,194
SOUTHWEST AIRLINES CO. FORM 10-Q Part I - FINANCIAL INFORMATION Item 1. Financial Statements Southwest Airlines Co. CONDENSED CONSOLIDATED BALANCE SHEET (in thousands) (unaudited) <TABLE> <CAPTION> September 30, 1998 December 31, 1997 <S> ASSETS Current assets: <C> <C> Cash and cash equivalents $452,184 $623,343 Accounts receivable 109,811 76,530 Inventories of parts and supplies 48,814 52,376 Deferred income taxes 19,966 18,843 Prepaid expenses and other current assets 28,428 35,324 Total current assets 659,203 806,416 Property and equipment: Flight equipment 4,464,429 3,987,493 Ground property and equipment 697,982 601,957 Deposits on flight equipment purchase contracts 305,534 221,874 5,467,945 4,811,324 Less allowance for depreciation 1,544,809 1,375,631 3,923,136 3,435,693 Other assets 3,949 4,051 $4,586,288 $4,246,160 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $197,378 $160,891 Accrued liabilities 444,931 426,950 Air traffic liability 206,584 153,341 Income taxes payable 33,685 - Current maturities of long-term debt 10,708 121,324 Other current liabilities 2,923 6,007 Total current liabilities 896,209 868,513 Long-term debt less current maturities 622,000 628,106 Deferred income taxes 516,295 438,981 Deferred gains from sale and leaseback of aircraft 242,873 256,255 Other deferred liabilities 38,239 45,287 Stockholders' equity: Common stock 335,904 221,207 Capital in excess of par value 68,802 155,696 Retained earnings 1,958,087 1,632,115 Treasury stock at cost (92,121) - Total stockholders' equity 2,270,672 2,009,018 $4,586,288 $4,246,160 </TABLE> See accompanying notes.
Southwest Airlines Co. CONDENSED CONSOLIDATED STATEMENT OF INCOME (in thousands except per share amounts) (unaudited) <TABLE> <CAPTION> Three months ended Nine months ended September 30, September 30, 1998 1997 1998 1997 <S> Operating revenues: <C> <C> <C> <C> Passenger $1,042,813 $949,540 $2,967,840 $2,710,327 Freight 23,360 25,613 72,785 69,350 Other 28,657 22,088 75,699 61,551 Total operating revenues 1,094,830 997,241 3,116,324 2,841,228 Operating expenses: Salaries, wages, and benefits 335,654 293,032 954,425 841,463 Fuel and oil 96,619 119,062 294,138 370,698 Maintenance materials and repairs 77,373 72,430 224,073 185,688 Agency commissions 40,087 39,902 120,064 117,578 Aircraft rentals 51,547 50,402 152,711 151,250 Landing fees and other rentals 54,773 51,966 159,369 152,454 Depreciation 59,575 49,873 165,551 145,768 Other operating expenses 175,283 168,804 521,833 480,949 Total operating expenses 890,911 845,471 2,592,164 2,445,848 Operating income 203,919 151,770 524,160 395,380 Other expenses (income): Interest expense 13,459 16,428 42,731 47,872 Capitalized interest (6,093) (5,709) (18,810) (14,448) Interest income (8,533) (9,478) (24,821) (26,973) Nonoperating losses (gains), net (5,969) 142 (16,599) 1,318 Total other expenses (income) (7,136) 1,383 (17,499) 7,769 Income before income taxes 211,055 150,387 541,659 387,611 Provision for income taxes 81,410 57,876 208,613 150,394 Net income $129,645 $92,511 $333,046 $237,217 Net income per share Basic $.39 $.28 $1.00 $.72 Diluted $.37 $.27 $.94 $.70 Weighted average shares outstanding Basic 333,342 328,741 333,829 327,767 Diluted 353,561 342,457 353,521 338,808 </TABLE> See accompanying notes.
Southwest Airlines Co. CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (in thousands) (unaudited) <TABLE> <CAPTION> Nine months ended September 30, 1998 1997 <S> <C> <C> Net cash provided by operating activities $692,312 $440,884 Investing activities: Net purchases of property and equipment (672,992) (577,514) Financing activities: Issuance of long-term debt - 98,764 Payment of long-term debt and capital lease obligations (116,877) (10,182) Payment of cash dividends (9,284) (6,565) Proceeds from Employee stock plans 35,682 26,890 Repurchase of common stock (100,000) - Net cash provided by (used in) financing activities (190,479) 108,907 Net decrease in cash and cash equivalents (171,159) (27,723) Cash and cash equivalents at beginning of period 623,343 581,841 Cash and cash equivalents at end of period $452,184 $554,118 Cash payments for: Interest, net of amount capitalized $34,450 $42,446 Income taxes $91,151 $72,984 </TABLE> See accompanying notes.
SOUTHWEST AIRLINES CO. Notes to Condensed Consolidated Financial Statements 1. Basis of presentation - The accompanying unaudited condensed consolidated financial statements of Southwest Airlines Co. (Company) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The condensed consolidated financial statements for the interim periods ended September 30, 1998 and 1997 include all adjustments (which include only normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. Operating results for the three and nine month periods ended September 30, 1998 are not necessarily indicative of the results that may be expected for the year ended December 31, 1998. For further information, refer to the consolidated financial statements and footnotes thereto included in the Southwest Airlines Co. Annual Report on Form 10-K for the year ended December 31, 1997. 2. Dividends - During the three month period ended September 30, 1998, dividends of $.0075 per share were declared on the 331,374,534 shares of common stock then outstanding. During the three month periods ended June 30, 1998 and March 31, 1998, dividends of $.0067 per share were declared on the 334,853,669 and 334,021,185 shares of common stock then outstanding, respectively. During the three month periods ended September 30, 1997, June 30, 1997, and March 31, 1997, dividends of $.0051 per share were declared on the 328,745,502, 327,698,634, and 327,004,073 shares of common stock then outstanding, respectively. 3. Long-term debt - During February 1998, the Company redeemed $100 million in senior unsecured 9 1/4% Notes due February 15, 1998, originally issued February 1991. The Notes were redeemed at par plus accrued interest. 4. Common stock - On September 25, 1997, the Company's Board of Directors declared a three-for-two stock split, distributing 73,577,983 shares on November 26, 1997. On July 22, 1998, the Company's Board of Directors declared a three-for-two stock split, distributing 111,894,315 shares on August 20, 1998. All share and per share data presented in the accompanying consolidated financial statements and notes thereto have been restated for these stock splits. As of July 22, 1998, the Board of Directors increased the Company's authorization to repurchase shares of its outstanding common stock to $100 million. Southwest completed this repurchase program during third quarter 1998, resulting in the repurchase of approximately 4.9 million shares. 5. Net income per share - The following table sets forth the computation of basic and diluted earnings per share (in thousands except per share amounts): <TABLE> <CAPTION> Three months ended Nine months ended September 30, September 30, 1998 1997 1998 1997 <S> <C> <C> <C> <C> NUMERATOR: Net income, available to common stockholders - numerator for basic and diluted earnings per share $129,645 $92,511 $333,046 237,217 DENOMINATOR: Weighted-average shares outstanding, basic 333,342 328,741 333,829 327,767 Dilutive effect of Employee stock options 20,219 13,716 19,692 11,041 Adjusted weighted-average shares outstanding, diluted 353,561 342,457 353,521 338,808 NET INCOME PER SHARE: Basic $.39 $.28 $1.00 $.72 Diluted $.37 $.27 $.94 $.70 </TABLE> 6. Recently issued accounting standards - In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130) and Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" (SFAS 131), both effective for years beginning after December 15, 1997. SFAS 130 establishes standards for reporting and display of comprehensive income and its components in a full set of financial statements and does not have any impact on the Company as the Company does not currently have any transactions which give rise to differences between net income and comprehensive income. SFAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. The Company is subject to the new requirements retroactively in 1998; however, SFAS 131 does not currently result in additional reported segment disclosures. Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition Comparative Consolidated Operating Statistics Relevant operating statistics for the three and nine month periods ended September 30, 1998 and 1997 are as follows: <TABLE> <CAPTION> Three months ended September 30, 1998 1997 Change <S> <C> <C> <C> Revenue passengers carried 13,680,772 13,019,325 5.1 % Revenue passenger miles (RPMs) (000s) 8,463,510 7,565,832 11.9 % Available seat miles (ASMs) (000s) 12,279,921 11,492,134 6.9 % Load factor 68.9% 65.8% 3.1 pts. Average length of passenger haul 619 581 6.5 % Trips flown 206,424 200,942 2.7 % Average passenger fare $76.22 $72.93 4.5 % Passenger revenue yield per RPM $.1232 $.1255 (1.8)% Operating revenue yield per ASM $.0892 $.0868 2.8 % Operating expenses per ASM $.0726 $.0736 (1.4)% Average fuel cost per gallon $.4418 $.5841 (24.4)% Number of employees at period-end 25,019 23,840 4.9 % Size of fleet at period-end 276 258 7.0 % </TABLE> <TABLE> <CAPTION> Nine months ended September 30, 1998 1997 Change <S> <C> <C> <C> Revenue passengers carried 39,295,796 37,787,869 4.0 % Revenue passenger miles (RPMs) (000s) 23,587,499 21,113,381 11.7 % Available seat miles (ASMs) (000s) 35,263,000 32,990,974 6.9 % Load factor 66.9% 64.0% 2.9 pts. Average length of passenger haul 600 559 7.3 % Trips flown 602,578 587,153 2.6 % Average passenger fare $75.53 $71.72 5.3 % Passenger revenue yield per RPM $.1258 $.1284 (2.0)% Operating revenue yield per ASM $.0884 $.0861 2.7 % Operating expenses per ASM $.0735 $.0741 (0.8)% Average fuel cost per gallon $.4643 $.6318 (26.5)% Number of employees at period-end 25,019 23,840 4.9 % Size of fleet at period-end 276 258 7.0 % </TABLE> Material Changes in Results of Operations Consolidated net income for third quarter 1998 was $129.6 million ($.37 per share, diluted) compared with $92.5 million ($.27 per share, diluted) earned in third quarter 1997. Consolidated net income for the nine months ended September 30, 1998 was $333.0 million ($.94 per share, diluted) compared with $237.2 million ($.70 per share, diluted) earned for the nine months ended September 30, 1997. Consolidated operating revenues increased 9.8 percent for the third quarter of 1998 and 9.7 percent for the nine months ended September 30, 1998, as compared to the corresponding periods of the prior year, primarily as a result of 9.8 percent and 9.5 percent increases, respectively, in consolidated passenger revenues. The increases in passenger revenues resulted from 11.9 percent and 11.7 percent increases in revenue passenger miles (RPMs) for the three and nine month periods ended September 30, 1998, respectively. The passenger revenue yield per RPM decreased 1.8 percent to $.1232 and 2.0 percent to $.1258 for the three and nine months ended September 30, 1998, primarily due to an increase in average length of passenger haul of 6.5 percent and 7.3 percent offset by 4.5 percent and 5.3 percent increases in average passenger fares, respectively. The increases in RPMs of 11.9 percent and 11.7 percent for the three and nine months ended September 30, 1998, respectively, exceeded the increases in available seat miles (ASMs) of 6.9 percent for these same periods resulting in a 3.1 point increase in load factor to 68.9 percent for third quarter 1998 and a 2.9 point increase to 66.9 percent for the nine months ended September 30, 1998. The increases in ASMs resulted primarily from the net addition of 18 aircraft since third quarter 1997. The load factor for October 1998 was 64.6 percent, up 1.5 points from October 1997's load factor of 63.1 percent. Thus far, bookings for November and December are also good. Fourth quarter passenger revenue yield per RPM is expected to continue to fall below year-ago levels due to higher load factors and longer passenger trip lengths. (The immediately preceding two sentences are forward-looking statements which involve uncertainties that could result in actual results differing materially from expected results. Such uncertainties include, but may not be limited to, competitive pressure such as fare sales and capacity changes by other carriers, general economic conditions, and variations in advance booking trends.) Consolidated freight revenues decreased 8.8 percent, despite increases in capacity, in the third quarter of 1998 primarily due to an 18.5 percent decrease in U.S. Mail revenue as the postal service shifts away from commercial carriers. Freight revenues increased 5.0 percent for the nine months ended September 30, 1998 primarily due to increased capacity and retention of increased business in the first six months of 1998 resulting, in part, from the United Parcel Service labor strike in third quarter 1997. Other revenues increased 29.7 and 23.0 percent in the three and nine months ended September 30, 1998, primarily due to increased revenues from the sale of frequent flyer segment credits to participating partners in the Company's Rapid Rewards frequent flyer program. Operating expenses per ASM decreased 1.4 percent for third quarter 1998 and was essentially flat for the nine months ended September 30, 1998, primarily due to respective 24.4 percent and 26.5 percent decreases in average jet fuel prices from year-ago levels, offset by $10.9 million and $28.9 million increases in Profitsharing and Employee savings plan contributions. Operating expenses in the first half of 1998 experienced increases in maintenance costs primarily due to unusually low aircraft engine overhaul costs in the first half of 1997. Third quarter maintenance cost comparisons are flat. Southwest Airlines Co. Consolidated Operating Expenses per ASM (in cents except percent change) <TABLE> <CAPTION> Three months ended September 30, Increase Percent 1998 1997 (decrease) change <S> <C> <C> <C> <C> Salaries, wages, and benefits 2.34 2.23 .11 4.9 Profitsharing and Employee savings plans .39 .32 .07 21.9 Fuel and oil .78 1.04 (.26) (25.0) Maintenance materials and repairs .63 .63 - - Agency commissions .33 .35 (.02) (5.7) Aircraft rentals .42 .44 (.02) (4.5) Landing fees and other rentals .45 .45 - - Depreciation .49 .43 .06 14.0 Other operating expenses 1.43 1.47 (.04) (2.7) Total 7.26 7.36 (.10) (1.4) </TABLE> Southwest Airlines Co. Consolidated Operating Expenses per ASM (in cents except percent change) <TABLE> <CAPTION> Nine months ended September 30, Increase Percent 1998 1997 (decrease) change <S> <C> <C> <C> <C> Salaries, wages, and benefits 2.35 2.25 .10 4.4 Profitsharing and Employee savings plans .36 .30 .06 20.0 Fuel and oil .83 1.12 (.29) (25.9) Maintenance materials and repairs .64 .56 .08 14.3 Agency commissions .34 .36 (.02) (5.6) Aircraft rentals .43 .46 (.03) (6.5) Landing fees and other rentals .45 .46 (.01) (2.2) Depreciation .47 .44 .03 6.8 Other operating expenses 1.48 1.46 .02 1.4 Total 7.35 7.41 (.06) (0.8) </TABLE> Salaries, wages, and benefits per ASM increased 4.9 percent and 4.4 percent for the three and nine month periods ended September 30, 1998, respectively, as compared to the same periods of the prior year, primarily due to higher effective wage rates, increased health care and workers' compensation costs, and lower productivity caused by Boeing aircraft delivery delays. The Company's Customer Service and Reservations Sales Agents are subject to an agreement with the International Association of Machinists and Aerospace Workers, AFL-CIO (IAM), which became amendable in November 1997 and is currently under negotiation. Profitsharing and Employee savings plans expense per ASM increased 21.9 percent and 20.0 percent for the three and nine months ended September 30, 1998 as compared to year-ago periods due to higher earnings available for profitsharing in 1998. Fuel and oil expense per ASM decreased 25.0 percent and 25.9 percent in third quarter 1998 and the nine month period then ended due to corresponding decreases in the average jet fuel cost per gallon for the same periods. The average price paid for jet fuel in the three and nine month periods ended September 30, 1998 was $.4418 and $.4643 per gallon, respectively, compared to $.5841 and $.6318 for the corresponding periods in 1997. The average price paid for jet fuel in October 1998 was $.4670 per gallon. Maintenance materials and repairs per ASM remained flat in third quarter 1998 and increased 14.3 percent in the nine month period ended September 30, 1998 as compared to the same periods in 1997. The year-to-date increase was primarily due to higher engine overhaul costs in the first six months of 1998, when compared to the same period in 1997, as the Company had an unusually low number of aircraft engine overhauls in the first six months of 1997. Agency commissions per ASM decreased 5.7 percent and 5.6 percent for the three and nine months ended September 30, 1998 as compared to the same periods of 1997, primarily due to a decrease in the percentage of commissionable sales. Aircraft rentals per ASM decreased 4.5 percent and 6.5 percent for the quarter and nine months ended September 30, 1998, compared to the corresponding periods of 1997 primarily due to a lower percentage of the aircraft fleet being leased. Landing fees and other rentals per ASM remained flat in third quarter 1998 and decreased 2.2 percent for the nine month period ended September 30, 1998 when compared to the corresponding year-ago periods. The year-to-date decrease is primarily due to a 4.0 percent increase in average aircraft stage length in the nine months ended September 30, 1998, offset by increases in other rentals in third quarter 1998. Depreciation expense per ASM increased 14.0 percent for third quarter 1998 and 6.8 percent for the nine months ended September 30, 1998 as compared to the same periods of 1997 primarily due to a higher percentage of the aircraft fleet being owned. Other operating expenses per ASM decreased 2.7 percent in third quarter 1998 and increased 1.4 percent for the nine month periods ended September 30, 1998, respectively. The third quarter decrease was primarily due to lower advertising spending in third quarter 1998 and lower insurance and property tax costs, offset by increased revenue related costs. The increase for the nine months ended September 30, 1998 was primarily due to increased costs resulting from the Year 2000 remediation program and increased revenue related costs such as credit card processing and communications, offset by lower insurance and property tax costs. During third quarter 1998, Boeing continued to experience production delays related to the 737 production line. However, the delays have shortened in that all aircraft contracted to be delivered in third quarter were received during their contract month. Boeing will continue to compensate Southwest for delivery delays, however, management expects this compensation to decrease in fourth quarter 1998 due to Boeing's improving delivery schedule. Other expenses (income) for the three months and nine months ended September 30, 1998 included interest expense, capitalized interest, interest income, and nonoperating gains and losses. Interest expense decreased for the three and nine months ended September 30, 1998 as compared to same periods in 1997 due to the February 1998 redemption of $100 million of senior unsecured 9 1/4% Notes originally issued in February 1991. Capitalized interest increased for the three and six month periods ended September 30, 1998 as a result of higher 1998 progress payment balances caused by Boeing 737-700 aircraft delivery delays. Interest income decreased for the three and nine months ended September 30, 1998 due to lower invested cash balances. Nonoperating gains in the third quarter and the first nine months of 1998 primarily included contractual penalties due from Boeing as a result of the aircraft delivery delays. Material Changes in Financial Condition Net cash provided by operating activities was $183.9 million for the three months ended September 30, 1998 and $862.0 million for the twelve months ended September 30, 1998. This cash was primarily used to finance aircraft-related expenditures, provide working capital, and repurchase approximately 4.9 million shares of the Company's outstanding common stock. For the twelve months ended September 30, 1998, net capital expenditures were $784.4 million, which were primarily for the purchase of seventeen new 737-700 aircraft and three used 737-300 aircraft and progress payments for future aircraft deliveries. As of July 22, 1998, the Board of Directors increased the Company's authorization to repurchase shares of its outstanding common stock to $100 million. Southwest completed this repurchase program during third quarter 1998, resulting in the repurchase of approximately 4.9 million shares. The Company's contractual commitments consist primarily of scheduled aircraft acquisitions. As of September 30, 1998, six 737-700s are scheduled for delivery in the remainder of 1998, 29 in 1999, 24 in 2000, 21 in 2001, 21 in 2002, six in 2003, and five in 2004. In addition, the Company has options to purchase up to sixty-two 737-700s during 2003-2006. The Company has the option, which must be exercised two years prior to the contractual delivery date, to substitute 737-600s or 737-800s for the 737-700s delivered subsequent to 1999. Aggregate funding needed for these commitments was approximately $2,809.4 million at September 30 due as follows: $162.2 million in 1998; $651.7 million in 1999; $599.5 million in 2000; $502.5 million in 2001; $515.8 million in 2002, $288.6 million in 2003, and $89.1 million in 2004. The Company has various options available to meet its capital and operating commitments, including cash on hand at September 30, 1998 of $452.2 million, internally generated funds, and revolving credit line with a group of banks of up to $425 million, none of which had been drawn at September 30, 1998. (In August 1998, the Company opted to reduce the bank credit line to $425 million from $475 million based on its strong operating performance, financial condition, and overall liquidity.) In addition, the Company will also consider various borrowing or leasing options to maximize earnings and supplement cash requirements. The Company currently has outstanding shelf registrations for the issuance of $318.8 million of public debt securities which it may utilize for aircraft financings during the remainder of 1998, 1999, and 2000. Impact of the Year 2000 The Company is in the process of converting its computer systems to be Year 2000 ready. This project encompasses information technology systems as well as embedded technology assets. The project also includes an assessment of material third-party relationships and associated risks. The project as it relates to internal systems and equipment consists of four phases: identification, assessment, remediation, and testing. This project is expected to be substantially completed by June 30, 1999. Flight Safety Systems The Company has completed all phases of its Year 2000 project as it relates to its aircraft fleet and onboard support systems. The Company has determined that there are no safety issues with these systems. The Company also utilizes ground computer systems and equipment essential for the maintenance of aircraft and the management of flight operations. The identification, assessment, and remediation phases of the project with respect to these systems and equipment are nearing completion. The Company expects to complete testing by mid-1999. Internal Systems The Company's critical internal systems include computer hardware, software, and related equipment for customer reservations, ticketing, flight and crew scheduling, revenue management, accounting functions, and payroll, as well as airport activities including aircraft ground handling, bag handling, and security. The computing hardware and telecommunications in the Company's central data center are essentially Year 2000 ready at this time. Many of the Company's software systems are either in testing or have already been made Year 2000 ready. While some systems are currently in the testing phase with a small number in the remediation phase, the Company expects all systems to be Year 2000 ready by mid-1999. Third-Parties The Company has categorized its third party vendors with respect to their potential impact on Company operations in the event any such third party vendor has Year 2000 issues which are not dealt with on a timely basis. The Company expects to complete initial contacts with all of its material third party vendors by the end of November this year and is in the process of evaluating their statements of Year 2000 compliance. In addition, the Company is working with other members of the Air Transport Association, the airline industry trade group, to share information and resources regarding vendors which are common to the entire industry. In management's experience, it is not always possible to obtain written certification of Year 2000 compliance from third party vendors. Accordingly, in such cases, the Company is basing its assessment on its own testing, other materials made available by such vendors and other publicly available information. Upon the conclusion of such assessment, the Company will evaluate the need for contingency plans which may be needed in the event any such vendor cannot demonstrate to the Company, on a timely basis, its Year 2000 compliance. The Company currently intends to substantially complete assessment and contingency planning of sole providers and other vital and critical vendors by the end of 1998. Year 2000 Costs The Company has expensed $7.9 million ($1.3 million in third quarter 1998) of costs incurred to date related to the Year 2000 issue. The total remaining cost of the Year 2000 project is presently estimated at approximately $13.2 million, which will be expensed as incurred. Risk of Year 2000 Issues The Company believes that its project to convert its computer systems to be Year 2000 ready will be completed in a timely manner and that Year 2000 issues will not have a material adverse effect on operations. However, it is possible that the Company's or third parties' systems and equipment could fail and result in the reduction or suspension of the Company's operations. The Company is currently in the process of developing contingency plans related to internal business critical systems and for those critical relationships with third parties. There can be no guarantee, however, that the Company's systems and equipment or third parties' systems and equipment on which Southwest relies will be Year 2000 ready in a timely manner or that contingency plans will mitigate the impact of any failure to complete plans in a timely manner. The costs of the project, the dates on which the Company believes it will complete the Year 2000 modifications and assessments, and the Company's analysis of its risk in this area, are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources. There can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area and the ability to locate and correct all relevant computer code, as well as the cooperation needed from third party vendors and others upon whom the Company must rely. Item 3. Quantitative and Qualitative Disclosures About Market Risk There have been no material changes in information required to be provided under this Item during third quarter 1998. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk in the Company's Annual Report on Form 10-K for the year ended December 31, 1997. PART II. OTHER INFORMATION Item 1. Legal Proceedings The Company received a statutory notice of deficiency from the Internal Revenue Service (the "IRS") in July 1995 in which the IRS proposed to disallow deductions claimed by the Company on its federal income tax returns for the taxable years 1989 through 1991 for the costs of certain aircraft inspection and maintenance procedures. The IRS has proposed similar adjustments to the tax returns of numerous other members of the airline industry. In response to the statutory notice of deficiency, the Company filed a petition in the United States Tax court on October 30, 1997, seeking a determination that the IRS erred in disallowing the deductions claimed by the Company and that there is no deficiency in the Company's tax liability for the taxable years in issue. It is expected that the Tax Court's decision will not be entered for several years. Management believes that the final resolution of this controversy will not have a materially adverse effect upon the results of operations of the Company. This forward-looking statement is based on management's current understanding of the relevant law and facts; it is subject to various contingencies including the views of legal counsel, changes in the IRS' position, the potential cost and risk associated with litigation and the actions of the IRS, judges and juries. Item 2. Changes in Securities and Use of Proceeds None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information In September 1998, Southwest's pilots voted to keep their ten-year contract which originally became effective in 1994. The ten-year agreement, which froze the pilots' pay for the first five years of the contract in exchange for stock options, contained a unilateral provision which allowed pilots to reopen contract negotiations at the midpoint of the agreement in 1999. The agreement now becomes amendable September 1, 2004. In October 1998, Southwest's dispatch Employees signed a twelve-year contract which will be effective through November 30, 2009. The contract provides for the issuance of up to 1,050,000 shares of stock options distributed to dispatch Employees over the term of the agreement. Item 6. Exhibits and Reports on Form 8-K a) Exhibits (27) Financial Data Schedule b) Reports on Form 8-K None SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SOUTHWEST AIRLINES CO. November 12, 1998 /s/ Gary Kelly Date Gary C. Kelly Vice President - Finance and Chief Financial Officer (Principal Financial and Accounting Officer) INDEX TO EXHIBITS Exhibit Number Exhibit (27) Financial Data Schedule