Fitch Affirms Southwest Airlines at 'BBB+'; Outlook Stable

CHICAGO--()--Fitch Ratings has affirmed the ratings on Southwest Airlines Co. (LUV) at 'BBB+'. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release.

The rating is supported by Southwest's solid financial flexibility, strong balance sheet, history of generating positive free cash flows and its position as one of the largest air carriers in the U.S. Southwest's credit metrics continue to be supportive of the 'BBB+' rating. Fitch calculates LUV's total debt/EBITDAR at 1.8x as of Sept. 30, 2016 representing one of the lowest leverage metrics among its North American peers. Fitch expects leverage to remain below 2x throughout the forecast period. In addition to low leverage, LUV's balance sheet is supported by a large base of unencumbered assets and by the absence of material pension obligations.

Although Southwest's financial results through the first part of the year have been slightly weaker than Fitch's prior forecast, the company has still exhibited solid performance by many measures. Southwest continues to generate healthy financial results though margins have slipped in 2016 both on an absolute basis and compared to peers. Like most carriers, LUV's unit revenues have been soft since the second quarter of 2015. However, Southwest's unit revenues have outperformed the industry average fairly consistently dating back to the last recession, which Fitch views as a positive result considering that the company has grown its capacity significantly over that time period. In addition, Southwest continues to generate healthy operating margins, despite paying significantly higher all-in costs for jet fuel than most of its peers due to on-going hedge losses. Through the first nine months of 2016 Southwest has paid an average of $1.87/gallon of jet fuel compared to around $1.35 to $1.45 for most other carriers.

Fitch expects LUV to continue to perform well financially for the foreseeable future, though margins are likely to contract further in the near-term due to the confluence of rising labor costs, higher jet fuel prices, and soft unit revenues. Despite the various headwinds Fitch expects Southwest's profitability throughout our forecast period to remain above levels seen prior to 2014.

Primary rating concerns include industry risks that are typical for any airline, including cyclicality, high levels of operating leverage, exposure to exogenous events, fluctuating fuel prices, and macroeconomic concerns. The industry remains highly leveraged to the overall macroeconomic environment. A future downturn could significantly impact the demand for air travel resulting in lower yields and load factors and higher unit costs. Shareholder focused cash utilization could present a concern if it were pursued at the expense of the company's balance sheet. Concerns also include increased competition both from LUV's large network rivals that are now financially healthier than they have been in the past, and from rapidly growing low cost carriers.

KEY RATING DRIVERS

Slowing Capacity Growth

Southwest's capacity growth has been well above industry average over the past two years, but is expected to moderate in 2017. LUV has stated that its 2017 year-over-year capacity growth will be around 3.5% compared to 5% to 6% that it expects to add in 2016. Two percentage points of growth in 2017 is expected to come from domestic markets. Fitch views Southwest's slowing capacity as prudent given the current macroeconomic environment and on-going unit revenue pressures. Moderating growth plans both at Southwest and among US competitors should lead to improved unit revenue trends over the near-to-intermediate term.

Increased Shareholder Friendly Cash Deployment

Fitch does not view LUV's increase in shareholder returns to be a material concern at this time particularly given the strength of Southwest's balance sheet and its track record of producing free cash flow. Shareholder returns would be more concerning if management pursued and repurchases and dividends at the expense of the company's balance sheet.

Southwest announced in May that it would increase its dividend by 33% to $0.10/share from $0.075/share, equivalent to an annual payout of roughly $250 million. This is up from around $180 million that the company paid in dividends in 2015. Share repurchases have also accelerated in recent years. LUV announced a new $2 billion repurchase plan in May of this year. The company has spent a total of $4.5 billion on share repurchases since 2011, including nearly $1.5 billion in the LTM period ended Sept. 30, 2016.

Recent Fleet Actions Support Intermediate-term FCF

LUV will retire its remaining 737-300s ahead of its first 737 MAX's being put into service in the fourth quarter of 2017. As of Sept. 30, 2016 Southwest's fleet still included 95 737-300s. In order to address the capacity that will be leaving the fleet as the company retires the Classic fleet, LUV restructured its order book in June 2016, accelerating six 737-800 deliveries from 2018 into 2017 and purchasing or leasing 737-700s in the used aircraft market. The company trimmed its fleet additions and capital spending plans in the 2018-2022 timeframe by deferring a significant number of 737 MAX deliveries. These fleet actions will allow LUV to continue to modestly grow capacity, but will also defer nearly $2 billion of capital spending from the latter part of this decade to beyond 2020. Capital spending is likely to peak in 2017 as the company takes a large number of aircraft deliveries, but should moderate thereafter, supporting FCF generation in subsequent years.

Solid Free Cash Flows

Southwest's ability to consistently generate significant free cash flow sets the company apart from its industry peers. Free cash flow has been positive each year since 2008 when the industry was going through the worst of the recession. Fitch expects Southwest to continue to generate steadily positive FCF for the intermediate term despite relatively high capital expenditures, particularly 2017, when aircraft deliveries and spending on facilities projects will be at their heaviest, and despite Fitch's expectations that dividends may continue to increase. Fitch expects FCF generation in 2017 to be around $500 million to $1 billion. Fitch's base forecast anticipates that FCF will increase thereafter and remain in the mid-single digits as a percentage of revenue.

Liquidity

Southwest's investment grade ratings are supported by the company's substantial financial flexibility. As of the end of the third quarter, LUV maintained a cash balance of $3.4 billion, augmented by a $1.0 billion revolver. Total liquidity, including revolver capacity, totalled 22% of LTM revenue, which is above average for the industry. Upcoming debt maturities are manageable given the company's cash on hand and expected FCF generation.

KEY ASSUMPTIONS

Key assumptions in Fitch's rating case include:

--Capacity growth in the low single digits through the forecast period;

--Continued moderate economic growth in the U.S. over the near-term, translating into stable demand for air travel;

--Jet Fuel prices equating to roughly $55/barrel on average for 2017, increasing to around $65/barrel by the end of the forecast period;

--High single digit RASM decline in 2016 followed by low growth thereafter.

RATING SENSITIVITIES

Fitch views the rating as having limited upside potential due to the inherent cyclicality and volatility in the airline industry.

Fitch does not expect to take a negative rating action in the near-term. However a negative action could be driven by an exogenous shock that causes demand for air travel to drop significantly or a fuel shock that is not offset by rising yields. A negative action could also be driven by a change in management strategy favoring shareholder returns at the expense of a healthy balance sheet. Fitch could consider a downgrade if adjusted debt/EBITDAR were to rise and be sustained above 2.5x, if free cash flow margins were to decline below 1% to 2% on a sustained basis, or if FFO fixed charge coverage were to fall below 4x on a sustained basis.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:

Southwest Airlines Co.

--Long-Term Issuer Default Rating (IDR) at 'BBB+';

--Senior unsecured debt to at 'BBB+';

--$1 billion unsecured revolving credit facility expiring 2018 at 'BBB+';

--Secured term loans due 2019 and 2020 at 'A-'.

Additional information is available on www.fitchratings.com

Summary of Financial Statement Adjustments

Fitch sets aside a certain amount of cash and revolver availability as 'not readily available' to reflect a minimum amount of cash that may be necessary for the company to carry on day-to-day operations and is thus not immediately available for things like debt payments or capital expenditures. Fitch estimates this amount at roughly 10% of LTM revenue.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 21 Nov 2016)

https://www.fitchratings.com/site/re/890199

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1015231

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1015231

Endorsement Policy

https://www.fitchratings.com/regulatory

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Contacts

Fitch Ratings
Primary Analyst
Joe Rohlena, CFA, +1-312-368-3112
Director
Fitch Ratings, Inc.
70 West Madison Street
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser, +1-212-908-0310
Managing Director
or
Committee Chairperson
Shalini Mahajan, +1-212-908-0351
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Joe Rohlena, CFA, +1-312-368-3112
Director
Fitch Ratings, Inc.
70 West Madison Street
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser, +1-212-908-0310
Managing Director
or
Committee Chairperson
Shalini Mahajan, +1-212-908-0351
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com