Fitch Upgrades Southwest Airlines to 'BBB+'; Outlook Stable

CHICAGO--()--Fitch Ratings has upgraded Southwest Airlines Co. (LUV) to 'BBB+' from 'BBB'. The Rating Outlook is revised to Stable from Positive. A full rating list is shown below.

The upgrade reflects steady improvements to Southwest's credit profile over the past several years as it worked through the integration of Airtran, paid down debt, and returned credit metrics to pre-recession levels. Going forward, Fitch expects Southwest to continue to generate solid free cash flow (FCF), exhibit stable or modestly declining leverage, and maintain its substantial financial flexibility. Southwest's investment-grade credit ratings are also supported by its competitive position in the U.S. domestic market, its strong brand, and its sizeable base of high-quality unencumbered assets.

KEY RATING DRIVERS

Solid Financial Results:

Southwest has exhibited solid performance by many measures through the first part of 2015 and over the last several years in general. Fitch expects LUV to continue to perform well financially for the foreseeable future, with operating margins remaining well above levels generated in recent years, continued low leverage, and solid FCF generation.

Like most North American airlines, LUV's unit revenues softened through the first part of the year. However, revenue per available seat mile (RASM) declined by less than the industry average through the first nine months, which Fitch views as a positive result considering that the company grew its capacity by 6.9% over the same time period and had a significant number of new routes that were still ramping up to full potential. As new routes continue to mature they should contribute to higher yields and operating margins. Southwest's results in the first half compare favorably against larger rivals United and American. We expect unit revenues to turn mildly positive in 2016 as the market absorbs recent capacity growth. Southwest is also well positioned relative to its peers to take advantage of the stability of the U.S. economy, compared to the mainline carriers who are experiencing weakness in various international economies and dealing with currency headwinds.

Southwest has also been successful in keeping costs in check, with unit costs excluding fuel, special items and profit sharing, being held relatively flat over the last year. Fitch's forecast anticipates that LUV will be able to hold non-fuel unit costs flat or lower them slightly in the coming years based on new aircraft coming into the fleet and continued upgauging. Open labor contracts create some risk that unit costs could increase if the company strikes new deals with its unions. However, those cost pressures are likely to be largely offset by other items such as the company's ongoing fleet modernization program.

Current Rate of Growth Not a Near-term Concern:

Fitch views Southwest's current growth plans to be prudent, given where and how the company is increasing capacity. Above-industry-average capacity growth could be seen as a negative over the longer term if it is not supported by demand or if it were detrimental to unit revenues. LUV plans to grow 2015 available seat miles (ASMs) by around 7% followed by another 5%-6% in 2016.

The company's recent growth has been driven primarily by attractive opportunities presented by the repeal of the Wright Amendment in Dallas, the acquisition of slots at DCA and LaGuardia, and expansion into international markets. A majority of 2016's expected growth is simply carry-over from new flying that was put into place in mid-to-late 2015. 'Stage and gauge', i.e. flying larger, denser aircraft over longer distances will be another major growth driver. Growth of this type tends to come at low incremental costs and can often be accretive to margins even if it has a negative impact on unit revenues.

Increased Shareholder-Friendly Cash Deployment: Fitch does not view Southwest's increased 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 FCF. LUV also views its share repurchase program as discretionary, and could scale back repurchases if it was needed to preserve cash. Shareholder returns would be more concerning if management's strategy were to change, and repurchases/dividends were pursued at the expense of the company's balance sheet.

Southwest announced in May that it would increase its dividend by 25% to $0.075/share, equivalent to an annual payout of roughly $200 million. This is up from around $22 million that the company paid in dividends in 2012. Share repurchases have also accelerated in recent years. LUV announced a new $1.5 billion repurchase plan in May of this year. On its third-quarter earnings call, the company stated that it had used $800 million of that capacity in the five months since the program was announced. Year-to-date Southwest has spent $1.18 billion on share repurchases compared to $955 million for the full year 2014.

Solid FCF:

Southwest's ability to consistently generate significant FCFis one of the factors that sets the company apart from its industry peers. Fitch expects Southwest to continue to generate steadily positive FCF for the intermediate term despite relatively high capital expenditures, particularly in 2016-2017 when aircraft deliveries will be heavy, and despite Fitch's expectations that dividends will likely continue to increase. Fitch expects FCF generation in 2015 to reach $1.1 billion-$1.4 billion, compared to $1.02 billion in 2014. Fitch's base forecast anticipates that Southwest will continue to generate FCF margins in the low- to mid-single digits through the forecast period despite relatively heavy capital spending. FCF has been positive each year since 2008 when the industry was going through the worst of the recession.

Materially Improved Debt and Leverage: Fitch calculates Southwest's total adjusted debt/EBITDAR at 1.8x as of Sept. 30, 2015, which is down by more than two full turns from year-end 2012. Total on-balance-sheet debt of $2.7 billion as of Sept. 30, 2015 is lower than where it was at year-end 2008. Over that same time period, revenue (excluding special items) has grown by 75% and margins have improved materially. Fitch expects that leverage could continue to decline moderately over the next several years, primarily based on top-line growth as opposed to lower debt levels, which may remain relatively flat over the near term.

Rating concerns: 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. Southwest faces some technological risk in the intermediate term as it transitions away from its current domestic reservations system over the next few years. Poor implementation of technological changes has created severe operational disruptions for airlines in the past. 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 ASSUMPTIONS

Fitch's key assumptions within the rating case for Southwest include:

--Mid-single-digit capacity growth through the forecast period;

--Continued stable/slow growth in demand for U.S. domestic travel;

--Low-single-digit RASM decline in 2015 followed by flat unit revenues thereafter;

--Conservative fuel price assumption which includes crude oil approaching $80/barrel in 2016 and rising incrementally thereafter.

RATING SENSITIVITIES

Fitch views the rating as having near term 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%-2% on a sustained basis, or if FFO fixed charge coverage were to fall below 4x on a sustained basis.

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 $3.1 billion, augmented by a $1 billion revolver. Total liquidity, including revolver capacity, totalled 21% of LTM revenue, which is above average for the industry. Southwest also maintains a sizeable pool of unencumbered assets which should support its access to the capital markets even in a future recession. Fitch expects Southwest to generate sufficient cash flow over the next several years to continue to fund its aircraft deliveries without accessing the debt markets, adding to its existing pool of high-quality, unencumbered assets.

FULL LIST OF RATING ACTIONS

Fitch has upgraded the ratings for Southwest as follows:

--Issuer Default Rating (IDR) to 'BBB+' from 'BBB';

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

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

--Secured term loans due 2019 and 2020 to 'A-' from 'BBB+'.

Additional information is available on www.fitchratings.com

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=993219

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Contacts

Fitch Ratings
Primary Analyst
Joe Rohlena, CFA
Director
+1-312-368-3112
Fitch Ratings, Inc.
70 W. Madison St.
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser
Managing Director
+1-212-908-0310
or
Committee Chairperson
Michael Zbinovec
Senior Director
+1-312-368-3164
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Joe Rohlena, CFA
Director
+1-312-368-3112
Fitch Ratings, Inc.
70 W. Madison St.
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser
Managing Director
+1-212-908-0310
or
Committee Chairperson
Michael Zbinovec
Senior Director
+1-312-368-3164
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com