Fitch Ratings-Chicago-14 February 2019: Fitch Ratings has upgraded Southwest Airlines Co. (LUV) to 'A-'. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release.
The upgrade reflects the company's low fundamental level of credit risk as demonstrated by its track record of generating positive FCF, its solid financial flexibility, strong balance sheet and commitment to conservative financial policies. Fitch calculates LUV's total debt/EBITDAR at 2x as of year-end 2018 representing the lowest leverage metric among its North American peers.
Southwest also benefits from its market position as the largest domestic carrier in the U.S. and from the strength of its brand. The upgrade also reflects changes to the business that have occurred over the past decade that reduce risk, including significant revenue and market share growth, the development of a much broader route network and the growth in ancillary revenues (credit card, early boarding, etc.).
Fitch believes that Southwest has the flexibility and financial wherewithal to maintain a low level of credit risk through a potential downturn. The company's large base of unencumbered planes allows for capacity to be reduced if demand were to decline as well as providing an alternate source of secured funding if needed. Southwest's low cost base relative to the large network carriers also provides protection in a downturn, allowing flexibility to lower fares to stimulate demand while maintaining profitability.
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 affect the demand for air travel, pushing down average fares and potentially creating overcapacity in the industry. 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 ultra-low-cost carriers.
KEY RATING DRIVERS
Stable Credit Metrics: Southwest maintains some of 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 2x as of year-end 2018, the lowest total leverage among Fitch's rated airlines. On an unadjusted basis (excluding capitalized leases) Southwest is in a net cash position. Fitch expects adjusted leverage to remain around 2x over the next several years. LUV's balance sheet is also supported by a large base of unencumbered assets and by the absence of material pension obligations, which stands in contrast to the three large network carriers in the U.S.
FCF/total adjusted debt at Dec. 31, 2018 was 24.2%, which was the highest among Southwest's peers. This metric has remained above 10% since 2014 and Fitch expects it to remain in the high single digit to low double digit range over the next two years. FFO fixed-charge coverage at Dec. 31, 2018 was 4.5x, down from 4.7x at year-end 2017 primarily due to lower margins driven by higher fuel prices, but still healthy compared with peers.
Strong Market Position: The rating upgrade is supported by the company's position as the largest domestic air carrier in the U.S. and its reputation with 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.
Consolidated Airline Industry: The rating upgrade also reflects reduced credit risk that stems from a consolidated and more stable U.S. airline industry. The four largest carriers in the U.S. now carry nearly 80% of total traffic. Consolidation and better management have allowed the North American carriers to dramatically outpace global airline profitability every year since 2013. Fitch believes that the consolidated nature of the industry along with stronger airline balance sheets and large numbers of unencumbered planes will allow the U.S. carriers to better withstand downturns than they have historically.
Unit Costs are a Watch Item: Fitch expects unit revenue growth and the possibility of lower fuel prices to offset rising non-fuel costs and provide stable operating margins in 2019. Nevertheless, Southwest is projecting non-fuel unit cost growth of 3.0%-3.5% in 2019, which is above average projections provided by peers and is up from cost growth of around 1% in 2018 and approximately 5% in 2017. Investments in technology, infrastructure, rising maintenance costs and wage growth are the main drivers. Southwest also has several amendable contracts with its labor unions, which may lead to further wage increases.
Southwest's ex-fuel unit costs are more than 30% below its closest network carrier peer (adjusting for stage length). The cost gap is sizable, but has declined in recent years, and maintaining the advantage is key to its competitiveness. The company stands to benefit from its incoming 737-MAX8s, which are more fuel efficient than current generation aircraft and from its initiatives focusing on improved operating efficiencies. However, halting cost inflation could prove more difficult than in the past due to the increasing size and complexity of the airline and lower average capacity growth rates compared with when Southwest was expanding rapidly.
Solid FCF: Southwest's ability to consistently generate significant FCF is one of the factors that sets the company apart from its industry peers. FCF 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, though cash generation may be lower in 2021-2022 as 737 MAX deliveries ramp up. Fitch expects FCF generation in 2019 to be around $1.5 billion, down from 2.6 billion generated in 2018.
Southwest is rated one notch above Ryanair, the only airline that Fitch publicly rates at 'BBB+'. Southwest compares well with 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. Southwest has little foreign exchange exposure, while Europe-based RYA has FX exposure related to fuel, aircraft and other expenses such as maintenance. Ryanair faces additional risks due to its newly formed labor unions that have driven disruptions and will drive costs higher. Partially offsetting these advantages are Ryanair's very large liquidity balance (51% of LTM revenue at March 31, 2018 compared with 21% at Southwest) and its superior operating margins.
Southwest is rated three notches above its closest peers in North America (Fitch rates both Delta and Alaska at 'BBB-'). The higher rating reflects Southwest's superior leverage metrics and its consistent ability to generate positive FCF. Compared with Southwest, Delta benefits from a more diverse route network, but suffers from a sizable, 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. Alaska's ratings also reflect the integration risk and higher levels of debt that stem from its recent acquisition of Virgin America. Southwest also maintains an active hedging program, which limits its exposure to a near-term spike in fuel prices whereas many of its competitors are unhedged.
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;
- Brent crude oil prices averaging $70-$75/barrel through the forecast, a level that is conservative to the current forward curve;
- Limited unit revenue growth throughout the forecast period.
Developments That May, Individually or Collectively, Lead to Positive Rating Action
- The ratings for Southwest have limited upside potential due to the inherently risky nature of the airline industry.
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 3% on a sustained basis or FFO fixed-charge coverage falling below 4.5x on a sustained basis;
- A change in fuel hedging policies leading to significant exposure to volatile crude oil prices.
Healthy Liquidity: Fitch views Southwest's liquidity and financial flexibility as supportive of the rating. At year-end 2018 the company had a cash and short-term investments balance of $3.7 billion, plus full availability under its $1.0 billion revolver, bringing total liquidity to 21.3% of LTM revenue. Debt maturities, which range between $172 million and $821 million between 2019 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 $821 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 upgraded the following ratings:
Southwest Airlines Co.
--Long-Term Issuer Default Rating (IDR) to 'A-' from 'BBB+';
--Senior unsecured debt to 'A-' from 'BBB+';
--$1 billion unsecured revolving credit facility expiring 2022 to 'A-' from 'BBB+';
--Secured term loans due 2019 and 2020 to 'A' from 'A-'.
The Rating Outlook is Stable.