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
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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