Southwest Airlines outlook revised to stable from positive on weaker-than-expected funds from operations, ICR affirmed

S&P Global Ratings today took the rating actions listed above.

We expect Southwest's FFO in 2022-2023 will be weaker than we previously expected due to the operational issues it experienced during the 2022 holiday season, which had a substantial effect on its revenue and costs.

The airline canceled over 16,700 flights between Dec. 21 and Dec. 31, 2022. This was due primarily to weather issues that impacted most of its network in the U.S. While most other airlines operating in the U.S. faced similar conditions, the extent of their cancellations and recovery were much more subdued than at Southwest. Southwest's problems stemmed primarily from two factors that combined to form the perfect storm. First, the company operates a point-to-point network. This is unlike the hub and spoke networks used by other airlines, which allow them to keep their aircraft in more centralized locations that can more easily be returned to service, rather than having them scattered around the country like Southwest. Second, the company's crew scheduling software failed due to its inadequacy, which--combined with the shortage of aircraft--resulted in a lack of crews in places where they were needed.

Southwest has stated that it will refund customers for the canceled flights, reimburse certain expenses, and offer frequent flyer miles for the inconvenience. The company has indicated that it expects to report a loss for the fourth quarter, which compares with the $759 million it earned in the first nine months of 2022. Management has preliminarily estimated a fourth quarter 2022 pre-tax negative impact of $725 million-$825 million (it earned $1 billion of pre-tax income in the first nine months of 2022), which comprises estimated revenue losses of $400 million-$425 million with the balance stemming from associated expenses. There could also be some lasting effects on its performance in early 2023. Therefore, we now expect Southwest's FFO will not return to its pre-pandemic level of $3.5 billion until 2024, which compares with our previous expectation for 2023. Nonetheless, we don't believe the effects from these operational issues will be long lasting due to the company's prior generally good service reputation and its restitution plans (assuming they are carried out). We also expect Southwest will invest in its scheduling software to improve its future performance.

Although we believe spending on air travel will remain strong due to pent-up demand, our expectation for reduced macroeconomic growth increases the uncertainty around the company's performance heading into 2023.

S&P Global Ratings' economists expect that U.S. real GDP will expand by 1.8% in 2022 before declining by 0.1% in 2023, which compares with the 5.7% increase reported in 2021. We also believe there is a high possibility the economy will enter a shallow recession in 2023. Although the demand for air travel has yet to experience a significant decline, we believe demand could fall if inflation reduces consumer discretionary spending. This, as well as lingering effects from the operational issues the company faced in the last week of 2022, could limit its ability to raise its fares to cover the higher costs. Nonetheless, Southwest's lower-cost structure compared with other large airlines, largely domestic route network, and focus on leisure travel will likely help it withstand the potential recession.

We forecast the company's cash levels will decline in 2022 and 2023, primarily due to new aircraft deliveries and debt repayment.

Southwest has maintained significant cash balances since the beginning of the pandemic and bolstered its liquidity through the issuance of primarily unsecured debt. Because we net its accessible cash against its reported debt, this resulted in it having no debt on an S&P Global Ratings-adjusted basis in 2020 and 2021. We expect the company will continue to generate positive cash from operations. We also assume elevated capital expenditures, primarily related to the delivery of delayed Boeing 737 MAX aircraft and debt repayment (the company repaid $2.6 billion of debt in 2022, including $1.25 billion related to the 2023 4.75% notes), will somewhat reduce its cash balances. We now assume cash of about $11 billion in 2022 and $9 billion in 2023, which compares with $15.5 billion in 2021. This will cause Southwest to have a small S&P Global Ratings-adjusted debt position in 2022, which will rise to at least $3 billion thereafter. However, we still expect its credit metrics will remain strong, with FFO to debt of about 400% in 2022 and about 100% thereafter.

The stable outlook reflects our expectation that Southwest Airlines' operating performance will continue to benefit from the ongoing recovery in air travel demand. Although we believe the company faces a potentially weaker macroeconomic environment over the next 12-24 months, with a negative impact from the operational issues it experienced during December 2022, we view it as well-positioned given its position as a large, low-cost carrier primarily serving domestic leisure travelers. We expect Southwest will maintain a strong cash position, supporting FFO to debt of about 100% and debt to EBITDA of less than 1x over the next two years.

We could raise our ratings on Southwest over the next 12-24 months if the recovery in air travel demand continues and is not significantly affected by weaker economic growth. We would also expect the company to generate FFO at least in line with its pre-pandemic levels of $3.5 billion in 2024 and maintain FFO to debt of above 60% on a sustained basis if it no longer maintains a significant cash position.

We could lower our rating on Southwest over the next 12-24 months if we believe weaker economic growth and the effects from the holiday flight cancellations will have a larger and more prolonged effect than we expect, leading to materially weaker operating results, including FFO remaining well below its pre-pandemic levels on a sustained basis.

ESG credit indicators: E-3, S-4, G-1

Environmental factors are a moderately negative consideration in our analysis of Southwest Airlines, which, like other airlines, faces long-term risk from emissions regulations. Its average fleet age is 13 years, which is commensurate with the global average. Social factors have a negative influence on our analysis because Southwest was hurt by declining air traffic amid the COVID-19 pandemic. However, the company is exposed mostly to domestic leisure travel, which has allowed it to recover faster than its peers whose networks feature a greater reliance on intercontinental or business traffic. Governance factors are a moderately positive consideration in our analysis. We view Southwest's management and governance as strong, with a favorable corporate culture and strategy and consistent execution that has enabled it to maintain its profitability even during pre-pandemic downturns.

Related Criteria

• General Criteria: Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021

• General Criteria: Group Rating Methodology, July 1, 2019

• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019

• Criteria | Corporates | General: Reflecting Subordination Risk In Corporate Issue Ratings, March 28, 2018

• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014

• General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013

• Criteria | Corporates | General: Corporate Methodology, Nov. 19, 2013

• General Criteria: Methodology: Industry Risk, Nov. 19, 2013

• General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities, Nov. 13, 2012

• General Criteria: Principles Of Credit Ratings, Feb. 16, 2011

Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column.