Fitch affirms Southwest Airlines at 'BBB'; Outlook stable

Fitch has affirmed the following:

--Issuer Default Rating (IDR) at 'BBB';

--Senior Unsecured Debt at 'BBB';

--$600 million Unsecured Revolving Credit Facility expiring 2012 at 'BBB';

--Secured Term Loans due 2019 and 2020 at 'BBB+'.

The Rating Outlook for LUV is Stable. Fitch's ratings apply to approximately $2.5 billion of outstanding notes and loans.

The affirmation of LUV's ratings reflects Fitch's view that the AAI acquisition represents a good strategic fit, opening up new and attractive revenue and margin expansion opportunities for LUV without driving a significant deterioration of credit metrics. While LUV will be assuming approximately $983 million of balance sheet debt and approximately $1.7 billion of capitalized aircraft operating leases at AAI, the transaction is likely to result in material revenue synergies that the company estimates at $400 million annually by 2013. In particular, margin growth should be supported over time by the establishment of a strong position in the Atlanta market, where LUV expects to stimulate considerable demand through the introduction of increased low-fare service. The AAI acquisition also deepens LUV's market presence in attractive East Coast business markets, including Washington, New York and Boston.

By funding the acquisition with equity and approximately $670 million of excess cash on the balance sheet, LUV avoids the need to increase debt beyond amounts assumed from AAI. Factoring in AAI's heavier reliance on leased aircraft, pro forma lease-adjusted debt to EBITDAR (using Fitch's 8x lease multiple) could fall below 3x by 2012. The main driver of this process will be the expected paydown of over $900 million in scheduled maturities during 2011 and 2012. Assuming jet fuel prices below $2.50 per gallon and a relatively stable revenue environment with moderating growth in passenger revenue per available seat mile next year, pro forma 2011 free cash flow (FCF) will be solidly positive.

Liquidity, both on a standalone basis and after the acquisition will remain very strong. As of today, LUV has over $3.3 billion of unrestricted cash on the balance sheet. In addition, the carrier has access to a $600 million revolving credit facility and retains over $7 billion in unencumbered assets - primarily owned Boeing B737 aircraft. At the time of closing, total unrestricted cash should exceed $3 billion, which represents approximately 20% of combined 2010 revenues.

AAI's low non-fuel unit operating costs (approximately one cent per available seat mile below LUV's) should allow LUV to maintain a very competitive cost profile post-closing. While AAI crew member pay rates will rise, lower AAI unit costs and good productivity should help limit the size of potential cost dis-synergies.

Fitch believes that execution risk for the proposed transaction is relatively low. An antitrust review by the U.S. Department of Justice (DOJ) may be accelerated by the relatively limited degree of overlap between the two carriers' networks. Combined market share for LUV and AAI is greatest at Baltimore and Orlando. Labor force integration is always a wild card in airline combinations, but the expected step-up in pay rates for AAI's relatively junior work force should ease the task of combining the two labor groups.

On a standalone basis, LUV's ratings reflect the carrier's solid liquidity position, its long track record of industry-leading profitability and FCF generation, and management's continuing commitment to low balance sheet leverage. The Stable Outlook reflects the airline's improved margin and cash flow generation prospects and the significant turnaround in the industry revenue environment witnessed during the first months of the economic recovery. After two years of operating challenges, when fuel price volatility and the recession-induced collapse in air travel demand pressured margins and FCF generation, LUV is delivering stronger operating results, and is well positioned from a liquidity standpoint to de-lever its balance sheet even as the AAI acquisition is completed.

At the bottom of the industry demand cycle in 2009, LUV's credit metrics were stressed as the carrier was forced to borrow in a period of extreme credit market tightness. Following the whip-sawing effects of fuel price volatility in 2008 and the subsequent outflow of fuel hedge cash collateral, management focused on liquidity enhancement at the expense of leverage in a highly uncertain operating environment. Since last fall, however, the recovery of demand and passenger yields has driven a notable improvement in operating margins and cash flow generation while capital expenditures have been cut as a result of slower fleet and capacity growth. LUV's operating margin of 13% (excluding special items) in the second quarter represented a continuation of the margin expansion trend that began to emerge in the third quarter of 2009.

For the remainder of 2010, Fitch expects passenger unit revenue growth to slow as comparisons with year-earlier periods become more difficult. Looking ahead to 2011, modest capacity growth is likely to resume on a relatively flat fleet count, and Fitch's base case forecast calls for weaker revenue per available seat mile (RASM) growth rates as a shallow U.S. economic recovery keeps a lid on full-fare demand and passenger yield growth. AAI's relatively light aircraft order book (four firm orders for 2011) should complement LUV's capacity strategy by keeping available seat mile growth rates down after the close of the transaction.

Fuel price volatility remains a major risk factor for LUV and the entire industry. Rising jet fuel prices over the last year have eroded some of the revenue-driven cash flow improvements. For 2Q'10, economic fuel costs (excluding non-cash hedge accounting effects) were 32% higher year over year. LUV has continued to deepen fuel derivative positions going out as far as 2014. In particular, a catastrophic protection hedge position (approximately 70% coverage at equivalent crude oil prices above $105 per barrel in 2011) safeguards against a 2008-style 'super spike' scenario in upcoming quarters.

Other concerns center on rising non-fuel unit operating costs, a trend that has been exacerbated by the slowdown in capacity growth rates since 2008. Excluding fuel and special items, cost per available seat mile (CASM) increased by 6.4% in 2Q'10. Significant pressure on airport costs continues to be a problem for LUV as airport lease rates climb and other airlines' scheduled capacity at some airports falls. Unit labor costs have also been driven higher year-to-date, in part as a result of increased profit sharing accruals in a stronger operating environment. LUV is likely to face continuing challenges with regard to cost inflation in spite of numerous productivity-enhancing initiatives undertaken over the last few years.

Positive revisions to LUV's Rating Outlook are unlikely in the near term as the carrier deploys FCF to pay down maturing debt and reduces leverage to levels more consistent with a 'BBB' IDR. An Outlook revision to Negative could result if an extreme demand or fuel price shock leads to an extended period of minimal FCF generation and weakening liquidity. In such a scenario, LUV could be forced to refinance upcoming maturities rather then pay them down out of internally generated cash flow.

Additional information is available at 'www.fitchratings.com