Southwest Airlines 2006 Annual Report Download - page 41

primarily related to higher fuel taxes as a result of the
substantial increase in fuel prices compared to 2004.
Other
“Other expenses (income)” included interest
expense, capitalized interest, interest income, and other
gains and losses. Interest expense increased by $34 mil-
lion, or 38.6 percent, primarily due to an increase in
floating interest rates. The majority of the Company’s
long-term debt is at floating rates. See Note 10 to the
Consolidated Financial Statements for more information.
Capitalized interest was flat compared to 2004 as lower
2005 progress payment balances for scheduled future
aircraft deliveries were offset by higher interest rates.
Interest income increased $26 million, or 123.8 percent,
primarily due to an increase in rates earned on cash and
investments. “Other (gains) losses, net” primarily
includes amounts recorded in accordance with SFAS 133.
See Note 10 to the Consolidated Financial Statements for
more information on the Company’s hedging activities.
During 2005, the Company recognized approximately
$35 million of expense related to amounts excluded from
the Company’s measurements of hedge effectiveness.
Also during 2005, the Company recognized approxi-
mately $110 million of additional income in “Other
(gains) losses, net,” related to the ineffectiveness of its
hedges and the loss of hedge accounting for certain
contracts. Of this additional income, approximately
$77 million was unrealized, mark-to-market changes
in the fair value of derivatives due to the discontinuation
of hedge accounting for certain contracts that will settle
in future periods, approximately $9 million was unreal-
ized ineffectiveness associated with hedges designated for
future periods, and $24 million was ineffectiveness and
mark-to-market gains related to contracts that settled
during 2005. For 2004, the Company recognized
approximately $24 million of expense related to amounts
excluded from the Company’s measurements of hedge
effectiveness and $13 million in expense related to the
ineffectiveness of its hedges and unrealized mark-to-mar-
ket changes in the fair value of certain derivative
contracts.
Income Taxes
The provision for income taxes, as a percentage of
income before taxes, increased to 37.9 percent in 2005
from 36.5 percent in 2004. The 2004 rate was favorably
impacted by an adjustment related to the ultimate reso-
lution of an airline industry-wide issue regarding the tax
treatment of certain aircraft engine maintenance costs,
and lower state income taxes.
Liquidity and Capital Resources
Net cash provided by operating activities was
$1.4 billion in 2006 compared to $2.1 billion in 2005.
For the Company, operating cash inflows primarily are
derived from providing air transportation for Customers.
The vast majority of tickets are purchased prior to the day
on which travel is provided and, in some cases, several
months before the anticipated travel date. Operating cash
outflows primarily are related to the recurring expenses of
operating the airline. The operating cash flows in both
years were significantly impacted by fluctuations in
counterparty deposits associated with the Company’s fuel
hedging program (counterparty deposits are reflected as
an increase to Cash and a corresponding increase to
Accrued liabilities.) There was a decrease in counterparty
deposits of $410 million for 2006, versus an increase of
$620 million during 2005. The decrease in these deposits
during 2006 was due to the decline in fair value of the
Company’s fuel derivative portfolio from December 31,
2005 to December 31, 2006, especially during the second
half of the year. The increase during 2005 was primarily
due to a large increase in the fair value of the Company’s
fuel derivative instruments, as a result of escalating energy
prices during 2005. Cash flows from operating activities
for 2006 were also driven by the $499 million in net
income, plus noncash depreciation and amortization
expense of $515 million. For further information on
the Company’s hedging program and counterparty
deposits, see Note 10 to the Consolidated Financial
Statements, and Item 7A. Qualitative and Quantitative
Disclosures about Market Risk, respectively. Cash gen-
erated in 2006 and in 2005 was used primarily to finance
aircraft-related capital expenditures and to provide work-
ing capital.
Net cash flows used in investing activities in 2006
totaled $1.5 billion compared to $1.1 billion in 2005.
Investing activities in both years primarily consisted of
payments for new 737-700 aircraft delivered to the
Company and progress payments for future aircraft deliv-
eries. The Company purchased 34 new 737-700 aircraft
and two previously owned 737-700 aircraft in 2006
versus the purchase of 33 new 737-700s in 2005. In
addition, progress payments for future deliveries were
higher in 2006 than 2005. See Note 4 to the Consoli-
dated Financial Statements. Investing activities for 2006
were also reduced by $117 million related to a change in
the balance of the Company’s short-term investments,
namely auction rate securities.
Net cash used in financing activities was $801 mil-
lion in 2006, primarily from the repurchase of $800 mil-
lion of common stock and the repayment of $607 million
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