Fitch Ratings has affirmed Southwest Airlines' Long-Term Issuer Default Rating (IDR) at 'BBB+'.
The Rating Outlook is Stable. Southwest's 'BBB+' IDR continues to be supported by the company's conservative financial policies. While Southwest's gross EBITDAR leverage of 3.4x at YE 2023 remains high for the rating, the company remains in a net cash position and maintains more than $12 billion in total liquidity and a has a high degree of financial flexibility.
The ratings also reflect Southwest's leading market position in the U.S. domestic market, supported by its broad route network and strong customer base.
Ratings concerns include Fitch's expectations for operating margins to remain well below historical levels at least through 2024 and for FCF to remain negative. Fitch expects profitability to improve modestly over the forecast period, driving leverage lower. However, evidence of prolonged margin weakness, potentially driven by persistent cost pressures or a tougher competitive environment, may lead to a Negative Rating Outlook.
Key Rating Drivers
Strong Balance Sheet: Southwest's total debt and operating lease liabilities stood at $9.2 billion as of YE 2023, down from a peak of $13.3 billion during the pandemic. Total debt remains below Southwest's total cash and short-term investments of $11.5 billion. Fitch expects debt balances to remain fairly stable over the forecast period. This is a revision from the prior forecast, in which Fitch anticipated debt to decline.
Fitch's current forecast includes operating margins that increase from current low levels but remain below prior expectations primarily driven by cost pressures. This is expected to lead to weaker cash flows and potential borrowing to either refinance pending maturities or fund aircraft deliveries. Nevertheless, Fitch expects gross leverage to trend from 3.4x at YE 2023 towards 2x over the next one to two years as margins rebound from levels generated in 2023. Net leverage is expected to remain near zero, supporting Southwest's current rating.
Financial Flexibility Supports the Rating: In addition to manageable debt balances and solid liquidity, Southwest maintains a sizeable base of unencumbered assets that could be leveraged in a downturn. At YE 2023, the company reported unencumbered assets with a book value of more than $17 billion, including $14.5 billion of aircraft.
Debt maturities in 2024 are minimal before stepping up in 2025 when the company's $1.3 billion 5.25% notes and $1.6 billion 1.25% converts come due. Southwest has a large aircraft orderbook, though the timing of its capital expenditures will depend on Boeing's ability to deliver aircraft. Though capital spending will be significant through the rest of the decade, capex largely consists of highly financeable aircraft that can be debt funded if Southwest needed to maintain cash.
Demand and Revenue Initiatives Support Top Line: Fitch expects the demand environment to be supportive in 2024, based on general macroeconomic trends and the potential for restored balance between domestic and international flying. Fitch also believes that the maturing of recently entered routes and Southwest's expanding share of managed business travel present upsides. Other initiatives include increasing day of week variability to pull capacity out of weaker demand periods, a strategy being pursued by multiple domestic carriers. Various initiatives along with supportive demand drive low to mid-single digit positive unit revenues in 2024 in Fitch's forecast.
Margin Underperformance: Southwest's operating margins underperformed network carrier peers in 2023. Fitch expects to see modest margin expansion over the forecast period, but anticipates that profitability will remain well below pre-pandemic levels in the near term. Relative performance in 2023 was driven in part by Southwest's domestic focus, as network carriers benefited from strong international demand.
Going forward, Southwest's efforts to improve profitability face continued headwinds from cost pressures. Southwest previously guided to a unit cost increase of 5.5%-7% for 2024; however, that number could rise based on an inability to grow capacity driven by delays in new aircraft deliveries. Fitch expects higher costs to be offset by improved unit revenues supported by Southwest's various network initiatives along with industry-wide pressures to increase revenues to offset inflation.
Southwest reported an EBITDAR margin of 10% for 2023, which remains several hundred basis points below several competitors and roughly 10 percentage points below where it was in 2019. Fitch expects margins to expand into the low to mid-teens over the forecast period as cost pressures ease beyond 2024. Southwest has emphasized its focus on margin expansion in recent public commentary, with a long-term goal of generating ROIC well in excess of its cost of capital.
Weak FCF Driven by Fleet Spending: Fitch expects Southwest's FCF to remain weak for the rating over the next several years as it works through its fleet renewal program. Weak FCF is offset by Southwest's strong balance sheet along with the efficiency and gauge benefits to be gained by retiring older aircraft. Southwest has firm orders for 495 Boeing Max 7s and Max 8s with options for another 199 to be delivered through 2031. Fitch expects Southwest to pay for most aircraft with cash, but the company maintains the option of financing its deliveries if needed.
The timing of aircraft deliveries will largely dictate Southwest's capital spending. The company recently revised its expected aircraft deliveries for 2024 to 46 aircraft from 79 due to manufacturing delays. The revision presents some headwinds in terms of network planning, inefficiencies and potential for prolonged operation of less efficient aircraft but provides near-term capex relief.
Fitch anticipates that capex will come in below $3 billion for 2024, below Southwest's prior projection of $3.5 billion-$4 billion, due to delivery delays. Fitch's base case incorporates annual capex of $4 billion thereafter as a placeholder, though the delivery stream from Boeing remains uncertain, particularly for 2025. Expectations for modest profitability combined with material capital spending drive FCF margins to be negative in the low to mid-single digits through the forecast.
Derivation Summary
Southwest's 'BBB+' rating is in line with Ryanair and is several notches above most North American competitors. Southwest's rating is supported by its strong balance sheet, large balance of unencumbered assets and low-cost structure. It remains in a net cash position as of Dec. 31, 2023 despite raising a material amount of debt during the downturn to bolster liquidity. The company also has a strong position in domestic and leisure markets. Southwest's hedging policies also provide some insulation from jet fuel price shocks.
Key Assumptions
Mid-single digit traffic growth in 2024 followed by low-to-mid single digit growth thereafter;
Fitch expects Southwest's load factors to increase to the 82%-83% range over the forecast;
Yields are generally supportive, reflecting solid demand levels and limited seat supply in the market;
Jet fuel prices averaging around $2.80 through the forecast;
Capex is in line with company forecasts.
RATING SENSITIVITIES
Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade:
Southwest progresses through its fleet modernization plan in a credit-conscious manner, adding to unencumbered assets;
Gross debt balances trending toward pre-pandemic levels, leading total adjusted debt/EBITDAR to 2.0x or below;
Achievement of revenue and productivity goals, network restoration targets and cost strategy, leading to FCF margins sustained in the mid-single digits or higher;
Effective management of nonfuel unit costs, allowing Southwest to maintain a cost advantage compared with peers.
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade:
Sustained adjusted debt/EBITDAR above 2.5x or EBITDAR/gross interest plus rent falling below 4.0x on a sustained basis;
Structurally lower operating margins suggesting an erosion of Southwest's competitive position or cost advantage, leading to FCF margins sustained below the low-single digits;
Deviation in capital allocation and financial policies leading to a reduction in financial flexibility, including lower balances of unencumbered assets.
Liquidity and Debt Structure
Robust Liquidity Position: As of Dec. 31, 2023, Southwest had approximately $12.5 billion in liquidity, which consisted of $9.3 billion in cash, $2.2 billion in marketable securities and full availability under its $1 billion revolving credit facility. Liquidity compares with roughly $5 billion that the company held pre-pandemic due to the airline's effort to shore up liquidity by issuing debt during the downturn.
Issuer Profile
Southwest is the largest domestic air carrier in the U.S., and serves 121 airports across 11 countries.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG Considerations
The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.
SOUTHWEST AIRLINES CO. 
