Fitch Affirms Southwest Airlines at 'BBB'; Outlook Stable

Fitch Ratings has affirmed the ratings for Southwest Airlines (LUV) at ‘BBB’. The Rating Outlook is Stable. A full rating list is shown below.

LUV’s investment grade ratings are supported by the company’s strong competitive position in the U.S. domestic market, solid free cash flow, declining leverage, substantial financial flexibility, and large base of unencumbered assets. The ratings are also supported by the company’s consistent profitability and management’s focus on ROIC.

Rating concerns: Primary rating concerns include industry risks that are typical for any airline, including fuel prices, event risk, 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. Other concerns include total adjusted leverage that is high for the ‘BBB’ rating. Fitch calculates adjusted leverage (lease adjusted debt/EBITDAR) at 3.9x as of June 30, 2013. Potential operational risks concerning the ongoing integration of Airtran also remain a concern.

Key Ratings Drivers

Generally Positive Demand Trends: Despite lackluster macroeconomic growth, demand trends in the North American airline industry are generally positive. Weak results in March and April notwithstanding, the industry as a whole has posted fairly consistent, positive PRASM growth over much of the last two years. Expectations for sustained GDP growth, although modest, combined with the capacity discipline that has come to define much of the industry, should continue to promote healthy traffic performance for U.S. Carriers in the near term.

Southwest has underperformed the industry in terms of unit revenue growth for much of the past year, partially due to the addition of seats as a result of upgauging to the 737-800 and adding seats to existing 737-700s by retrofitting those planes with LUV’s Evolve interior. Southwest also utilized aggressive fare sales in the first half of the year to keep load factors high. Through the first six months of the year, PRASM growth for the industry averaged roughly 0.9%, whereas PRASM at Southwest was down by 0.3%. Nevertheless, the company managed to post record second quarter earnings ex-special items, and PRASM trends in July and August were strong, pointing to positive results in the second half.

Solid Free Cash flows: Southwest’s ability to consistently generate significant free cash flow is one of the factors that sets the company apart from its industry peers. In the last 12 months ended June 30, 2013, LUV generated $873 million in free cash flow, despite relatively heavy capital spending. Free cash flow has been consistently positive since 2008 when the industry was going through the worst of the recession. Over the next several years, Fitch expects FCF to be pressured by heavy capital spending as the company continues to renew its fleet, by increased dividend payments announced in May, and by the remaining share buybacks under the company’s $1.5 billion repurchase authorization. However, free cash flow is expected to remain steadily positive through the near to intermediate term.

Southwest announced in May 2013 that it would quadruple its quarterly dividend from $.01/share to $.04/share, which is roughly equivalent to $110 million/year. The company is approximately two thirds of the way through its current $1.5 billion share repurchase authorization. Through the first half of 2013, common share repurchases have totaled $351 million. Fitch views the increase in shareholder-friendly cash outflows cautiously. While sizeable future increases in dividends or buybacks would present a concern, Fitch does not expect the company to increase payouts to the detriment of the ratings.

Improving Balance Sheet: Through the first six months of the year Southwest paid down $220 million in balance sheet debt and plans to pay down roughly another $100 million by year end. In addition, the company is in the process of offloading the fleet of 717s that it inherited through the Airtran merger. LUV’s aircraft operating lease expense is expected to decline materially over the next few years as it transfers those aircraft to Delta, reducing the company’s total adjusted debt balance, which incorporates lease expenses. As of June 30, 2013 the 78 717s under operating leases comprised roughly 42% of the 186 active leased aircraft in Southwest’s fleet.

Fitch calculates LUV’s total adjusted leverage (gross adjusted debt/EBITDAR) as of June 30, 2013 at 3.9x, which is somewhat high for the ‘BBB’ rating. However adjusted debt is down from 4.1x at 6/30/2012. Fitch expects leverage to continue to improve over the intermediate term as EBITDAR grows. Margin trends have been largely positive over the past two years, with EBITDAR as a percentage of revenue increasing to 15.6% in the LTM ended June 30, 2013 from 15.4% at year-end 2012 and 15.1% at year-end 2011. Leverage is also expected to improve as LUV to pays down on balance sheet debt and reduces rental expenses over the next several years.

Healthy Financial Flexibility: Southwest’s investment grade ratings are supported by the company’s sizeable financial flexibility. As of the end of the second quarter, LUV maintained a cash balance of $3.4 billion, augmented by a recently upsized $1 billion revolver. Total liquidity, including revolver capacity, totaled 25.5% of LTM revenue, which is among the highest in the industry.

Unlike most other North American carriers, Southwest also maintains a significant pool of unencumbered assets which should support its access to the capital markets even in a future recession. Unencumbered assets at the end of 2012 totaled $6.8 billion. 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.

As opposed to some other North American airlines, Southwest’s financial flexibility also benefits from its lack of a defined benefit pension plan.

Airtran Integration on Track: LUV has made steady progress in integrating the operations of Airtran since receiving a single operating certificate in March of 2012. Significant hurdles still remain, including the implementation of Southwest’s new reservations system and the full integration of the Airtran and Southwest labor unions. Later this year Southwest will also complete the process of ‘de-hubbing’ its operations in Atlanta, Airtran’s largest former hub. Fitch notes that the integration continues to represent an operational risk in the near term, with the full integration expected to be complete by year end 2014. Meanwhile, the acquisition is beginning to prove beneficial, with Southwest reporting $95 million in acquisition related synergies in the second quarter.

Rating Sensitivities: A positive rating action is unlikely in the intermediate term given the inherent cyclicality of the airline industry, and due to remaining risks involved with the integration of Airtran and the introduction of international flying. A positive rating action is also made less likely by the recent increase in dividends and share repurchases.

A revision of the Outlook to Negative or a downgrade to ‘BBB-’ could be driven by a decrease in cash flows to levels below Fitch’s base case expectations. An air travel demand shock that materially impacts LUV’s unit revenues could lead to a negative action. Ratings could also be pressured by additional shareholder focused cash deployment that comes at the expense of Southwest’s balance sheet.

Fitch affirms LUV’s ratings as follows:

—Issuer Default Rating (IDR) at ‘BBB’;

—Senior unsecured debt at ‘BBB’;

—$1 billion unsecured revolving credit facility expiring 2018 at ‘BBB’;

—Secured term loans due 2019 and 2020 at ‘BBB+’.

Additional information is available at ‘www.fitchratings.com’

Applicable Criteria and Related Research:

—‘Corporate Rating Methodology’ (Aug. 5, 2013);

—‘Recovery Ratings and Notching Criteria for Nonfinancial Corporate Issuers’ (Nov. 13, 2012).

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=693773

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=803154