Southwest Airlines Co.

February 20, 2015 Southwest Airlines Co. Current Recommendation Prior Recommendation Neutral Date of Last Change 05/18/2014 Current Price (02/19/15) $43.76 Target Price $53.00 OUTPERFORM SUMMARY (LUV-NYSE) Southwest Airlines posted strong fourth-quarter 2014 results wherein both the top and bottom line surpassed the Zacks Consensus Estimate. Several strategies like fleet restructuring, introduction of international services and capacity management are poised to drive Southwest Airlines top and bottom line higher. Moreover, the successful integration of AirTran Airways, lower fuel prices, high air travel demand, the winning of slots and expansion of operations at the Reagan and LaGuardia airports are likely to act as tailwinds going forward. Additionally, Southwest Airlines continues to boost shareholders return through dividends and share buybacks. Considering these favorable factors, we maintain our Outperform recommendation on the stock. SUMMARY DATA 52-Week High $47.17 52-Week Low $21.61 One-Year Return (%) 109.43 Beta 0.98 Average Daily Volume (sh) 8,994,878 Shares Outstanding (mil) 676 Market Capitalization ($mil) $29,581 Short Interest Ratio (days) 1.47 Institutional Ownership (%) 76 Insider Ownership (%) 0 Annual Cash Dividend $0.24 Dividend Yield (%) 0.55 5-Yr. Historical Growth Rates Sales (%) 12.3 Earnings Per Share (%) 33.6 Dividend (%) 97.3 using TTM EPS 21.7 using 2015 Estimate 12.8 using 2016 Estimate 12.2 Zacks Rank *: Short Term 1 3 months outlook 1 - Strong Buy * Definition / Disclosure on last page Risk Level * Average, Type of Stock Large-Growth Industry Trans-Airline Zacks Industry Rank * 10 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) 2013 4,084 A 4,643 A 4,545 A 4,428 A 17,700 A 2014 4,166 A 5,011 A 4,800 A 4,628 A 18,605 A 2015 4,407 E 5,305 E 5,083 E 4,927 E 19,722 E 2016 20,651 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) 2013 $0.07 A $0.38 A $0.34 A $0.33 A $1.12 A 2014 $0.18 A $0.70 A $0.55 A $0.59 A $2.02 A 2015 $0.61 E $1.14 E $0.90 E $0.76 E $3.41 E 2016 $3.59 E Projected EPS Growth - Next 5 Years % 12 2015 Zacks Investment Research, All Rights reserved. www.zacks.com 10 S. Riverside Plaza, Chicago IL 60606

OVERVIEW Based in Dallas, TX, Southwest Airlines Co. (LUV) is a passenger airline that provides scheduled air transportation in the United States. It primarily provides short-haul, high frequency, point-to-point and low-fare services. Southwest Airlines is a leisure-oriented point-to-point carrier largely in Las Vegas, Chicago (Midway) and Phoenix. The company s point-to-point route structure include services to and from many secondary or downtown airports such as Dallas Love Field, Houston Hobby, Chicago Midway, Baltimore-Washington International, Burbank, Manchester, Oakland, San Jose, Providence, Ft. Lauderdale/Hollywood, and Long Island Islip airports. Southwest Airlines is one of the world s most profitable low-cost airlines that consistently offers the lowest fares. The company sells frequent flyer credits and related services to companies participating in its Rapid Rewards frequent flyer program, including credit card companies, hotels, telecommunication companies and car rental agencies. In May 2011, Southwest Airlines completed the acquisition of AirTran Holdings, which now operates as a wholly owned subsidiary under the name AirTran Airways. REASONS TO BUY Successful execution of strategic initiatives has allowed Southwest Airlines to generate record profits for seven successive quarters with airline traffic increasing 4.3% year over year to 26.76 billion in the fourth quarter. Also, passenger revenue per available seat mile (PRASM) increased 2.6% year over year. The carrier expects first-quarter 2015 revenues to expand mainly on rising travel demand across the globe. Management also decided to retain 6% expansion of capacity in 2015, in order to meet rising demand. The successful integration of AirTran Airways has not only allowed Southwest Airlines to take over routes formerly operated by AirTran but also operate new flights to Punta Cana, Dominican Republic and Mexico City. The incorporation also aided Southwest Airlines in generating operating synergies of $500 million in 2014. The merger may also drive freight revenues by nearly 6% in the first quarter of 2015 in comparison with the last-year quarter. Southwest Airlines has also sought permission from the U.S. Department of Transportation for operating flights to six Latin American destinations from Houston s Hobby airport. In line with its expansion plans, Southwest Airlines stated that it intends to flag off daily nonstop flights to Belize City from Oct 2015 as it ramps up its international service. Furthermore, Southwest Airlines looks to offer daily non-stop services to four destinations in Mexico (Cancun, Mexico City, Puerto Vallarta, and San Jose del Cabo/Los Cabos) starting October 2015. The carrier also intends to initiate flights to the Costa Rican capital of San Jose from the same. Moreover, the recent agreement between the U.S. and China governments, to extend the validity of short-term visas for visitors between both nations for up to ten years followed with the extension of student exchange visas from one to five years, will considerably benefit airline companies going forward. Southwest Airlines has introduced a number of initiatives that will boost its performance level in 2015. The company has expanded its modern fleet size with new 33 Dash 800s from Boeing and Equity Research LUV Page 2

has also sidelined most of the AirTran 717s from the operation. Earlier, it has acquired 12 pairs of slots at New York s LaGuardia (LGA) international airport and in the process has secured permanency for its previously owned 10 slots. The company has also won bids for 27 additional pairs of slots at Washington s Reagan airport (DCA), subject to approval from the U.S. Department of Justice. However, the company is returning a pair of slots at DCA as it did not fit its flight schedule. Southwest has decided to extend daily departures from DCA to 44 from the current 17, thus increasing its operations from the airport more than 2.5 times. Apart from expanding Southwest Airlines reach to 14 destinations, the new low-fare, non-stop services from DCA will strengthen its operations in the capital city. The new flights from Love Field, DCA and LGA coupled with upgradation of fleet will boost the carrier s capacity in 2015 by 2-3%. The company also started offering Beats Music service to flyers on Wi-Fi which we believe will further enrich the in-flight entertainment quotient. Southwest Airlines exited the fourth quarter of 2014 with nearly $3 billion in cash and short-term investments and $1 billion remaining in revolving credit facilities. The company expects to slash debt by $182 million and maintain capital expenditure in between $1.6 billion and $1.7 billion in 2015. In the reported quarter, S&P raised its previous rating on Southwest Airlines to BBB. Meanwhile, the carrier maintained $2.7 billion cash flow despite incurring $1.3 billion capital expenditure in the reported quarter. Southwest generated 17.1% pre-tax return on invested capital in the last one year and expects a 15% return (before tax) on its invested capital for the full year. Further, Southwest Airlines is the first low-cost carrier to pay dividend to its shareholders. The company has been paying uninterrupted dividends for the last 153 quarters. Earlier, the airline s board of directors approved a $1 billion share buyback program and also raised its $0.04 quarterly dividend by 50% to $0.06 per share. In the fourth quarter of 2014, the company bought back $200 million worth of shares. Both the actions strongly reflect the company s commitment to enhance shareholder value. RISKS RECENT NEWS Recently, Southwest Airlines signed a four-year employee-friendly deal with its customer service agents and customer representatives. The new agreement is aimed at improving employee welfare by including provisions for pay raise and performance-related bonus payments. In the reported quarter, salaries and wages which form an important component of operating expenses increased 8.3% year over year. Hence, signing of such deals in the future will further drive operating expenses. The airline industry is both capital intensive and labor intensive. Most of the employees at Southwest Airlines are unionized, depending on various U.S. labor organizations. The relation between airlines and labor unions are governed by the Railway Labor Act, which states that a collective bargaining agreement between an airline and a labor union does not expire; instead it becomes amendable as of a stated date. Failure to amend terms and conditions suitably may lead to work stoppages or strikes, and thereby hamper operations. This will lead us to revisit our recommendation on the stock. Southwest Outperforms in Q4 Jan 22, 2015 Southwest Airlines reported earnings of $0.59 a share, surpassing the Zacks Consensus Estimate of $0.54. This also marks the carrier s sixth consecutive quarter of record profits, achieved on the back of successful execution of its strategic initiatives. Quarterly revenues moved up 4.5% year over year to $4,628 million, ahead of the Zacks Consensus Estimate of $4,590 million. On a year-over-year basis, Passenger and Freight revenues increased 5.1% and 12.2%, respectively, while Other revenues fell 8.9%. Equity Research LUV Page 3

Operating Statistics Airline traffic, measured in billions of revenue passenger miles, rose 4.3% year over year to 26.76 billion in the fourth quarter. Capacity or available seat miles decreased 2.4% to 33.79 billion, while load factor (percentage of seats filled with passengers) stood at 82% against 80.4% in the year-ago quarter. Meanwhile, passenger revenue per available seat mile (PRASM) increased 2.6% year over year to $0.135. Operating Expenses & Operating Income In the fourth quarter, adjusted operating income scaled up to $621 million from $386 million a year ago, reflecting an operating margin of 13.4%. Total adjusted operating expenses fell 0.9% year over year to $4,007 million. Fuel price (economic) stood at $2.62 per gallon, down from $3.05 a year ago. Consolidated unit cost or cost per available seat mile (CASM), excluding fuel and special items, increased 2.3% year over year to $0.852. Liquidity At the end of the fourth quarter, Southwest Airlines had $2,988 million in cash and short-term investments against $3,152 million in the year-ago quarter. The company had long-term debt (including current portion) of $2,434 million against $2,191 million in the last-year quarter. Southwest Airlines generated operating cash flow of $203 million in the quarter while capital expenditures totaled $467 million. VALUATION Southwest Airlines is currently trading at 12.8x our 2015 earnings estimate. This is at a discount to both the industry average and the S&P 500. With respect to our 2016 earnings estimate, the sock is trading at 12.2x, which is at a premium to the industry average but at a discount to the S&P 500. We believe that Southwest Airlines is committed to sustain its brand and operational excellence based on its strategic initiatives, expected launch of international services, increased ancillary product offering and an improving domestic economy. Further, slot pair wins, leverage from Rapid Rewards program and healthy shareholders return bode well for Southwest Airlines. Hence, we maintain our Outperform rating on the company with a target price of $53.The price target is based on 15.5x our earnings estimate for 2015. Equity Research LUV Page 4

Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low SOUTHWEST AIR (LUV) 12.8 12.2 12.0 12.7 21.7 69.9 14.4 Industry Average 20.3 10.1 18.8 8.2 27.1 235.1 9.5 S&P 500 16.7 15.6 10.7 15.3 19.3 19.4 12.0 INTL CONS AIRLN (ICAGY) 10.3 8.6 8.2 19.0 25.0 11.6 AIR FRANCE-ADR (AFLYY) 95.3 4.8 12.8 1.4 38.8 9.7 CHINA SOUTH-ADR (ZNH) 5.9 6.5 2.6 8.6 14.2 4.3 ANA HOLDINGS (ALNPY) 28.5 21.7 5.9 31.9 50.0 9.4 TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow P/B Last Qtr. P/B 5-Yr High P/B 5-Yr Low ROE D/E Last Qtr. Div Yield Last Qtr. EV/EBITDA SOUTHWEST AIR (LUV) 4.5 4.5 0.9 19.3 0.4 0.5 10.3 Industry Average 2.9 2.9 2.9 15.0 0.3 0.7 9.6 S&P 500 5.3 9.8 3.2 25.5 2.1 Equity Research LUV Page 5

Earnings Surprise and Estimate Revision History Equity Research LUV Page 6

DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of LUV. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1126 companies covered: Outperform - 15.7%, Neutral - 75.9%, Underperform 7.5%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Equity Research LUV Page 7