Fitch Affirms Southwest Airlines Outlook Revised To Stable

Fitch Ratings has affirmed the senior unsecured debt rating for Southwest Airlines Co. at `A`, and has revised Southwest`s Rating Outlook to Stable from Negative to Stable. The rating applies to $785 million of outstanding unsecured debt securities.
The `A` rating reflects Southwest`s ability to maintain a solid balance sheet and to generate consistently positive cash flow from operations in the two years since the 2001 industry demand shock. The company is in a unique position to weather cyclical downturns in the U.S. airline industry by carefully managing unit operating costs (still well below the restructured network airline cost benchmark) and exploiting competitive opportunities that arise as the major network carriers shrink. With $2.2 billion in unrestricted cash on hand as of June 30 and an improving outlook for profits and operating cash flow in 2004, Southwest is poised to reduce leverage and grow profitably over the next two to three years. Even after factoring in the ever-present risk of an event-related air travel demand shock, Southwest`s strong operating profile and a high degree of financial flexibility support the affirmation of the unsecured rating.
The revision in the Rating Outlook reflects encouraging revenue trends that provide support for the view that passenger yields and revenue per available seat mile can continue to grow modestly in 2004. Coupled with significant fleet expansion and capacity growth (Southwest`s 2004 available seat mile growth is estimated at 7%), the improving revenue environment should put the airline in a position to fund growing capital spending requirements without relying heavily on new debt issuance.
Southwest continues to occupy a uniquely successful place in the U.S. airline industry. Careful and methodical attention to its growth model and the need to control costs has allowed Southwest to establish a solid competitive advantage in nearly every market it enters. By focusing on secondary airports where it stands to capture a large share of `origination and destination` (O&D) traffic and by offering consistently low fares, the company has been able to find profitable growth opportunities that U.S. network carriers simply cannot match. Southwest`s market share of approximately 64% in its top 100 O&D markets provides solid evidence of its power in the industry.
On the balance sheet, the airline`s very solid liquidity position (cash balances at June 30 represented about 40% of 2002 revenues) provides it with the flexibility to deploy cash in other ways as risks of further weakening in the revenue environment diminish. Management noted in the second quarter earnings call that an evaluation of future liquidity requirements may lead to a reduction in the amount of unrestricted cash on hand. With undrawn credit facility availability of $575 million to support liquidity and good access to the capital markets, some reduction in the cash balance appears to be a prudent step that is consistent with Southwest`s desire to maintain a solid credit profile in a highly cyclical business. A diversion of some cash to fund an estimated $1.7 billion in 2004 capital spending would allow Southwest to expand its pool of unencumbered aircraft and grow its cash flow generation capacity without incurring significant amounts of incremental debt. The airline expects to fund at least 42 Boeing 737-700 aircraft deliveries in 2004 primarily from internally generated cash.
Following the repayment of $100 million in maturing unsecured notes this month, Southwest`s balance sheet debt will fall to approximately $1.5 billion, of which approximately $207 million matures in 2004. Much of the Southwest debt structure consists of unsecured notes ($785 million outstanding as of June 30). Beyond the $207 million (primarily aircraft secured notes) due next year, scheduled debt maturities are $142 million in 2005 and $542 million in 2006. The 2006 payments reflect the maturities of pass-through certificates backed by Boeing 737-700 aircraft.
Excluding special items, operating cost per available seat mile in the June quarter was up only 0.3 percent to 7.46 cents. The good unit cost performance occurred in spite of higher pay rates incorporated in a series of new labor agreements signed in 2002. Solid fuel hedging gains have also contributed to Southwest`s ability to control unit operating costs. Following the re-negotiation of pay rates at the restructured network carriers (American, United, and US Airways), Southwest continues to maintain a very competitive unit cost position (cost per ASM approximately 20% below the restructured network airlines).
One other key risk-limiting factor relative to its peers is Southwest`s methodical attention to fuel price hedging. In light of the ongoing risk of oil supply disruption and more OPEC production capacity constraint, pressures on jet fuel costs could persist for several quarters. Southwest`s fuel hedging program remains by far the best in the airline industry. Fuel exposure is already hedged extensively for next year and beyond. At least 80% of expected 2004 deliveries are hedged with caps averaging approximately $23 per barrel of crude oil. Hedges for 2005 and beyond are being layered on consistently as the airline looks to limit fuel price risk over the long term.
Negotiations related to a new flight attendant labor contract are showing no signs of progress at this time. The contract became amendable in June 2002. In September management requested the involvement of a federal mediator to help resolve pay and work rule issues. The Transport Workers` Union (representing Southwest`s flight attendants) has conducted a number of media events aimed at increasing pressure on management. Although there is no indication at this time that any operational disruption will result from the contract dispute, some escalation of labor-management tensions on the issue may result. A flight attendant agreement, if successfully negotiated, would leave Southwest with no labor contracts amendable until 2005.
Southwest Airlines Co. is the sixth-largest U.S. passenger airline in terms of revenue passenger miles flown. Since its start as an intra-Texas carrier in 1971, the company has grown to serve 59 airports in 30 states. Southwest`s fleet consists entirely of Boeing 737 aircraft, which numbered 379 on June 30, 2003.

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