Fitch Lifts Outlook on Southwest Airlines (LUV) to Positive; Affirms 'BBB' Rating

Fitch Ratings has affirmed the ratings for Southwest Airlines (NYSE: LUV) at 'BBB'. The Rating Outlook is revised to Positive from Stable. A full rating list is shown below.

Southwest's investment grade ratings are supported by the company's strong competitive position in the U.S. domestic market, solid free cash flow (FCF), declining leverage, and substantial financial flexibility. While credit metrics in recent years were weak for the 'BBB' rating due to negative impacts from the financial crisis and the AirTran acquisition, improvements over the past year now put Southwest's credit metrics solidly in line with the 'BBB' rating.

The Positive Outlook reflects Fitch's view that a positive rating action could be warranted over the intermediate term should the company continue to strengthen operating margins, control unit cost inflation, generate solid FCF, and exhibit stable or declining leverage. Fitch also notes that operating risks relating to the integration of AirTran are now largely in the past as Southwest expects to effectively complete the integration process by year-end 2014.

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 affect demand for air travel, resulting in lower yields and load factors. Southwest may also face continued pressure from rising labor costs. Most of Southwest's major union contracts are open for amendment, and the ultimate cost impact from those negotiations is uncertain at this time. Concerns also include increased competition both from Southwest'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

Solid Domestic Operating Environment: Despite moderate macroeconomic growth, demand trends in the North American airline industry remain positive. Fitch expects continued capacity discipline from the large domestic carriers combined with a stable economic environment to continue to foster high load factors and growing yields. Southwest's route structure has proven to be a significant advantage relative to its peers in 2013 and 2014 due to its domestic focus, as the U.S. domestic market has proven to be one of the strongest aviation markets in the world over that time frame.

Improving Financial Performance: Southwest has shown solid unit revenue performance through the first half of 2014 with PRASM increasing by 6.4%, outpacing all of its larger network rivals. Unit costs are increasing modestly, primarily due to higher salaries and wages, but costs are rising slower than unit revenues, leading to higher operating margins. Fitch calculates Southwest's EBITDAR margin for the LTM period ended June 30, 2014 at 20.7%, up from 18.2% for fiscal 2013. Further margin expansion is expected going forward following the completed integration of AirTran, the continued retirement of Southwest's 737 classics, and the growing portion of the fleet represented by the larger 737-800.

Unit costs were largely held in check through the first part of the year, with higher wages being offset by lower fuel and maintenance. Southwest continues to face pressure from rising labor costs, an issue that has been present for the past several years. Most of Southwest's major union contracts are currently open for amendment and the company is actively negotiating with its labor groups. Southwest's relationships with its unions have generally been healthy, but the possibility exists that any new contracts that the unions ratify could further pressure wages. While total salaries/wages were up by 8% in the first six months of the year, roughly half of that increase was due to higher profit sharing.

Improving financial performance can be seen in Southwest's pre-tax return on invested capital (ROIC) metric. The company has a long-standing goal of hitting a minimum pre-tax ROIC of 15% (excluding special items), which they had fallen short of for the past few years. In the LTM period ended June 30, 2014 pre-tax ROIC reached 17.1%. The company expects full-year 2014 ROIC to exceed 15%, which Fitch considers achievable.

AirTran Integration Largely Complete: Southwest expects the integration of AirTran to be effectively complete by the end of 2014. Fitch previously considered the operational risks involved with a complex integration process as well as inefficiencies inherent in operating with two different brands and a subfleet of 717s to be rating concerns. With the integration process now largely complete those concerns are in the past. The AirTran integration is living up to expectations previously communicated by Southwest, with expected synergies expected to reach $400 million in 2014. Cumulative merger and integration costs will total approximately $550 million, of which $466 million has been incurred through the first half of 2014.

Solid Free Cash Flows: 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 despite relatively high capital expenditures, particularly in 2014 and 2016-2017 when aircraft deliveries will be heavy, and despite Fitch's expectation that dividend payments will continue increase. Fitch expects FCF generation in 2014 to be consistent with 2013 at $900 million to $1 billion. FCF is also expected to be solid in 2015 owing to Southwest's strong operating margins and lower expected aircraft deliveries.

Increased Shareholder-Friendly Cash Deployment: Southwest announced in May that it would increase its dividend from $0.04/share to $0.06/share, equivalent to an annual payout of roughly $168 million. This increase follows last year's announced increase from $0.01/share to $0.04/share. Share repurchases have also accelerated in recent years. Following the completion of its $1.5 billion share buyback program, Southwest announced a new $1 billion program, including two accelerated share repurchase programs of $200 million each. Fitch expects that Southwest could fulfil the $1 billion program by the end of 2015.

Increased cash outflows could be a concern particularly in light of the relatively heavy capital spending that will be required in the coming years. However, Fitch expects Southwest to manage its dividends and buybacks prudently, prioritizing a healthy balance sheet over increased returns to shareholders. Concerns are also mitigated by the company's history of producing strong FCF.

Compelling Growth Opportunities: Fitch expects the impending repeal of the Wright Amendment, recently acquired slots at Washington Reagan and New York LaGuardia, and new opportunities to expand internationally to provide solid opportunities for Southwest to grow in the coming years. Washington D.C., New York, and Dallas each represent attractive aviation markets, and Southwest's increased flying out of those markets is likely to be accretive to operating margins.

Improving Balance Sheet: Fitch calculates Southwest's total adjusted debt/EBITDAR at 2.8x as of June 30, 2014, which is down by a full turn from a year ago. Aircraft adjusted debt (i.e. debt adjusted only for aircraft rent rather than total rent) is lower at roughly 1.7x, while funds from operations (FFO) adjusted leverage stands at 3.4x. Fitch expects leverage to continue to decline incrementally over the next several years, as the completion of the Airtran integration and the delivery of new fuel efficient aircraft present opportunities for margin growth, and because of the potential for incremental debt reduction. Leverage has improved over the past year partly due to lower debt; Southwest has paid down $175 million in debt since June 30, 2013, and intends to pay down more in the second half of 2014, and partly due to Southwest's rising operating margins.

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, Southwest maintained a cash balance of $4 billion, augmented by a $1 billion revolver. Total liquidity, including revolver capacity, totalled 27.5% 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.

RATING SENSITIVITIES

A positive rating could be triggered by sustained EBITDAR margins above 20%, solid FCF generation particularly in light of heavy expected future capital expenditures, and total adjusted debt/EBITDAR approaching 2.5x on a sustained basis. Fitch would also look for clarification around Southwest's currently open labor contracts in respect to their longer-term cost implications.

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 affirms Southwest'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+'.

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