Fitch Ratings-Chicago-16 January 2018: Fitch Ratings has affirmed the ratings on Southwest Airlines Co. (LUV) at 'BBB+'. The Rating Outlook has been revised to Positive from Stable. A full list of rating actions follows at the end of this release.
The Outlook revision is supported by Southwest's solid financial flexibility, strong balance sheet, commitment to conservative financial policies, history of generating positive free cash flows, and reduced operating risks. The revision is also aided by the overall improvement in the health of the North American airline industry. Fitch calculates LUV's total debt/EBITDAR at 1.9x as of Sept. 30, 2017 representing the lowest leverage metric 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, the absence of material pension obligations, and minimal foreign exchange exposure.
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
Reduced Operational Risks: The revision of Southwest's Outlook to Positive is due in part to a lower level of operational risk at the company now that it has successfully navigated through several major undertakings. The purchase of Airtran in 2011, the company's expansion into international markets, the switch-over of its reservation systems, and the retirement of its fleet of 737 Classic fleet all represented material hurdles that are now in the past. Southwest managed to avoid major pitfalls through its transition period while maintaining solid financial performance and a sound balance sheet, which reflects well on the company's management team, and is supportive of the Outlook.
Stable Credit Metrics: Southwest maintains some the strongest credit metrics among Fitch's rated airline peer group, and Fitch anticipates that metrics will remain fairly stable over the intermediate term. Total adjusted leverage stood at 1.9x as of Sept. 30, 2017, the lowest total leverage among Fitch's rated airlines. On an unadjusted basis (excluding capitalized leases) Southwest's net debt position is close to zero. Fitch expects adjusted leverage to remain below 2x throughout our 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 pension obligations.
Strong Market Position: The Positive Outlook and the potential for Southwest to move into the 'A' category are also supported by company's position as the largest domestic air carrier in the U.S. and its positive reputation with its customers. Southwest carries nearly a quarter of the total domestic traffic within the U.S. and maintains a commanding position in many of its key markets. Fitch believes that the utility of LUV's route network and its market share support the long-term sustainability of the company's creditworthiness. LUV's customer-friendly policies (free checked bags, no change fees) also drive positive comparisons with competitors, creating a valuable degree of customer loyalty.
Shareholder Returns are Manageable: Fitch views the pace at which Southwest is returning cash to shareholders as manageable. Share repurchases ramped up beginning in 2014 and totalled more than $5.1 billion between 2014 and September 2017. Repurchases and dividends did not come at the expense of a healthy balance sheet nor did they impede necessary capital expenditures. Fitch expects that share repurchases would act as the first lever for the company to pull if it needed to conserve cash in a downturn. Although not anticipated at this time a more aggressive policy towards shareholder returns would be viewed as a credit negative.
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. 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 particularly as capital spending is expected to come down from the relatively high levels seen in 2016 and 2017. Fitch expects capital expenditures to be below $2 billion in each of the next several years, down from $2 billion in 2016 and $2.3 billion in the LTM period ended 9/30/2017. Cash flow will also be aided by the recent tax legislation. Southwest is one of the few airlines in North America that pays a material amount of cash taxes, and the lower statutory tax rate along with immediate expensing of capital expenditures will provide a significant cash benefit going forward. Fitch expects FCF generation in 2018 to be between $1.5-2 billion.
Manageable Operating Costs: Fitch expects cost per available seat mile (CASM) growth at Southwest to flatten out over the next couple of years after higher wages put pressure on unit costs in 2017. Southwest will move beyond the worst of its labor pressures in 2018, which along with an increasingly efficient fleet and the benefits of its new reservation system, should allow the company to keep its unit costs relatively flat. Southwest retired the last of its 737 classics (the least efficient aircraft in its fleet) in 2017 and started taking delivery of its first 737 MAXs. The significant improvement in fuel efficiency of the MAX over the 737 classic, along with a higher average seat count will provide a material cost tailwind over the next few years.
Southwest is one of two airlines in Fitch's rated universe rated 'BBB+'; the other is Ryanair. Southwest compares well to Ryanair in that it has a lower level of gross leverage, longer track record of profitability, and larger base of unencumbered assets. Southwest also benefits from its customer-friendly reputation. Partially offsetting these advantages are Ryanair's very large liquidity balance (62% of LTM revenue at 3/31/2017 compared to 19% at Southwest) and its superior operating margins.
Southwest is rated two notches above its closest peers in North America (Delta and Alaska, both rated 'BBB-'). The higher rating reflects Southwest's superior leverage metrics and its consistent ability to generate positive FCF. Compared to Southwest, Delta benefits from a more diverse route network but suffers from a sizeable, though shrinking, pension deficit and lower operating margins. Alaska has a much more concentrated route network than Southwest due to its heavy reliance on its home market of Seattle. ALK's ratings also reflect the integration risk and higher levels of debt that stem from its recent acquisition of Virgin America.
Fitch's Key Assumptions Within Our Rating Case for the Issuer
--Capacity growth in the mid-single digits over the forecast period.
--Continued moderate economic growth for the U.S. over the near-term, translating to stable demand for air travel.
--Jet fuel prices slowly increasing to around $65/barrel by 2020.
--Limited unit revenue growth throughout our forecast period.
Developments That May, Individually or Collectively, Lead to Positive Rating Action
--FCF margins remaining in the mid-to-high single digits.
--EBIT margins remaining in the mid-to-high teens or higher.
--Sustained commitment to conservative financial policies.
--Adjusted debt/EBITDAR sustained below 2x (1.9x as of Sept. 30, 2017).
--Net on-balance sheet debt sustained at minimal levels.
Developments That May, Individually or Collectively, Lead to Negative Rating Action
--An exogenous shock that causes demand for air travel to drop significantly or a fuel shock that is not adequately offset by rising fares.
--Change in management strategy that favors shareholder returns at the expense of a healthy balance sheet.
--Sustained adjusted debt/EBITDAR above 2.5x.
--FCF margins declining to below 1-2% on a sustained basis or FFO fixed charge coverage falling below 4x on a sustained basis.
Fitch views Southwest's liquidity and financial flexibility as supportive of the rating. At Sept. 30, 2017 the company had a cash and short-term investments balance of $3 billion, plus full availability under its $1 billion revolver, bringing total liquidity to 19% of LTM revenue. Debt maturities, which range between $323 million and $797 million between 2018 and 2022, are manageable in light of the company's cash balance, capacity to generate cash flow, and demonstrated access to capital markets. Maturities peak at just under $800 million in 2020 when LUV's 2.65% notes mature. Financial flexibility is also supported by a large balance of unencumbered assets.
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 at 'BBB+';
--$1 billion unsecured revolving credit facility expiring 2022 at 'BBB+';
--Secured term loans due 2019 and 2020 at 'A-'.
Fitch has revised the Outlook to Positive from Stable.