New York, November 14, 2017 -- Moody's Investors Service ("Moody's") assigned an A3 rating to the two tranches of new senior unsecured notes that Southwest Airlines Co. ("Southwest") offered earlier today. The company plans to issue five-year and ten-year notes due in 2022 and 2027. The proceeds will be used for general corporate purposes. The rating outlook is stable.
The A3 rating reflects Moody's expectation that Southwest will continue to conservatively manage its capital structure, allowing it to sustain credit metrics supportive of the single A rating category. Southwest is a leader in the US domestic passenger air travel market and has been profitable in each of the last 44 years. "Bags Fly Free", "No Change Fees" and "Transfarency" are unique attributes that help enhance the brand and distinguish Southwest among its competitors.
Moody's believes that Southwest remains well positioned to manage periods of higher fuel prices or a cyclical downturn in demand because of its strong liquidity, manageable funded debt, typically competitive fares and expanding network. The power of the brand, combined with a strengthening network should lead to relatively favorable traffic performance for Southwest compared to most US airlines. The company mentioned in its Q3 earnings call its plans to sooner than later add Hawaii to its network.
Southwest reduced funded debt by $308 million during the first nine months of 2017 to $3.079 billion while operating profit declined by about $173 million to $2.742 billion. Debt to EBITDA has remained steady at about 1.4x this year. Moody's expects this metric to remain close to 1.5x through 2018, considering today's debt offering and modest pressure on operating profits from higher fuel expense, more measured annual increases in contractual labor rates and a continuing competitive fare environment offset by lower profit-sharing accruals.
Southwest's leading share of the US domestic market in terms of passengers boarded, the efficiencies of its point-to-point network and its proficiency in airline operations contribute to its competitive operating margins and support the A3 rating. Operating margin for the first nine months was 17% versus almost 19% for the same period in 2016. This pullback is in line with the industry trend, but remains leading among the larger rated airlines. Moody's anticipates that Southwest will hold about $3 billion of cash on hand and that funded debt will remain below $3.75 billion. The rating considers that the majority of free cash flow, which Moody's estimates at about $1 billion in 2017 and potentially $1.5 billion in 2018 on lower capital expenditures will be used to repurchase shares. However, share repurchases will not regularly exceed free cash flow except from the deployment of excess cash on hand.
The stable outlook reflects Moody's expectation of 1) steady demand for US domestic air travel, 2) Moody's forecast for an average price of Brent of below $60 per barrel through 2018 and 3) the cushion in current credit metrics that would absorb the effects of a weaker than expected operating environment.
The ratings could be downgraded if Southwest was to adopt less conservative financial policies, such as sustaining Debt to EBITDA above the low 2x level, using debt to repurchase shares or holding less than $2.5 billion of cash or $3.5 billion of liquidity. EBIT to Interest sustained below 6x or Retained Cash Flow to Net Debt sustained below 40% could also pressure the ratings. The prospects for further upgrades are limited.
Southwest Airlines Co., based in Dallas, Texas, is a leading low-cost airline in the United States. Southwest operates more than 4,000 flights a day during peak travel seasons, serving 100 destinations across the United States and 10 additional countries. Based on the U.S. Department of Transportation's most recent data, Southwest remains the nation's largest carrier in terms of domestic originating passengers boarded. The company reported revenue of $20.973 billion for the last 12 months through September 2017.
The principal methodology used in these ratings was Global Passenger Airlines published in May 2012. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.
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