Southwest Airlines outlook revised to negative by Fitch, maintains BBB+ rating

Investing.com -- Fitch Ratings has updated its perspective on Southwest Airlines (NYSE:LUV) Co (Southwest), affirming its Long-Term Issuer Default Rating (IDR) at ’BBB+’ but changing the Rating Outlook from Stable to Negative on April 3, 2025. The revised outlook reflects Fitch’s belief that Southwest could adopt a less conservative financial policy and capital allocation, which might affect its competitive position.

Fitch’s concerns stem from strategic changes Southwest is implementing, such as introducing bag fees and allowing flight credits to expire. These moves could potentially weaken Southwest’s competitive edge compared to other airlines. Additionally, a lack of progress towards improving margins or an increase in capital deployment might lead to a negative rating action.

Despite these concerns, Southwest’s IDR is still supported by the company’s current capital structure, financial flexibility, and point-to-point market position in U.S. domestic travel. The rating also takes into account expectations for improvement in margins from their recent low levels.

Southwest’s recent changes in policy, such as charging for checked bags and offering a basic economy product, are expected to boost operating profits to over $4 billion by the end of 2026, a significant increase from the $457 million earned in 2024. However, Fitch’s forecast is more conservative, considering potential negative impacts on customer preference and ongoing economic uncertainty.

Fitch is also closely watching the potential evolution of Southwest’s financial policy. Recent public comments from the company show a commitment to maintaining an investment-grade credit rating, but they also indicate flexibility regarding target leverage levels. Southwest’s recent appointment of a new CFO, influence from new directors on its board, and an accelerated share repurchase program suggest a shift to a less conservative financial stance.

Uncertainty in the demand environment is another area of concern. Recent government spending cuts and lower consumer sentiment have led to a decrease in demand and increased uncertainty for the remainder of the year. Despite these challenges, Fitch believes Southwest has the flexibility to manage through a slowdown by pausing future share repurchases and selling aircraft.

Southwest’s credit profile is supported by its current net cash balance. Fitch expects the company’s gross debt to further decline in 2025 as it repays its $1.6 billion convertible notes in cash. Southwest’s fleet monetization strategy is also expected to generate significant cash inflows, reducing the need for borrowing to finance aircraft deliveries.

Southwest’s financial flexibility is demonstrated by its significant unencumbered assets, which can be leveraged during downturns. At the end of 2024, Southwest reported a book value of unencumbered assets exceeding $16 billion. This figure rises to $40 billion when including the value of Southwest’s loyalty program.

Fitch views Southwest’s fleet monetization strategy as prudent, though the details are still evolving. The strategy involves using proceeds to defray capital costs or reduce debt. However, a shift towards shareholder returns or asset sales that significantly reduces unencumbered assets could put pressure on the ratings.

Key assumptions in Fitch’s analysis include low-single digit traffic growth in 2025 and 2026, load factors maintained in the low 80% range, jet fuel prices averaging about $2.50 through the forecast, and the repayment of 2025 convertible bonds and the first tranche of PSP loans in 2025.

Fitch outlines several factors that could lead to a negative rating action or downgrade, including sustained adjusted debt/EBITDAR above 2.5x or EBITDAR/gross interest plus rent falling below 4.0x, structurally lower operating margin, or a deviation in capital allocation and financial policies leading to a reduction in financial flexibility.

Conversely, factors that could lead to a positive rating action or upgrade include Southwest effectively managing its strategic shift and fleet modernization plan, reducing gross debt balance, achieving revenue and productivity goals, and managing non-fuel unit costs effectively.

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