Southwest Aims To Keep It's Costs Lower Than Competitors' By Saying “No” To More Federal Debt

Southwest Airlines says it doesn’t want – or need – to borrow any money from Uncle Sam after all.

Earlier this year Southwest, which carries more passengers annually than any other airline, accepted a grant of $3.2 billion offered by Congress via the CARES Act rescue package approved in March. It subsequently signed a non-binding agreement to take out a $2.8 billion loan from the Treasury Department, also offered via the CARES Act.

But in a federal filing on Wednesday the Dallas-based carrier reversed course and officially turned down that loan offer. It said it no longer needs the extra cash badly enough to justify the high cost associated with taking out that loan from the government.

And just what was that high cost?

Per the terms of the government loan offer, Southwest – and any other airline that accepts such a loan – would be required to issue the Treasury Department warrants convertible into shares of its stock. Accepting those terms would have diluted the value of Southwest shareholders’ existing shares and likely would have triggered another lowering of its debt rating.

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Just last week S&P lowered its rating on Southwest’s bonds to BBB, the lowest of S&P’s investment grade ratings. S&P also placed Southwest on its negative watch list, meaning the airline is in danger of being dropped one notch further – into “junk” bond territory. Currently Southwest is the only U.S. carrier – and just one of three in the world – with an investment grade debt rating.

Falling into junk territory also likely would make it much more expensive for Southwest to raise capital through the public debt markets. The airline in its filing on Wednesday specifically cited its belief that it if it needs additional liquidity going forward it will be able to raise that money on more favorable terms via the commercial debt markets. But doing that likely would be much more expensive and difficult were Southwest’s debt rating to fall into the junk category.

The combination of taking on an additional $2.8 billion in debt via the CARES Act and significantly diluting the carrier’s equity base as a result would further undermined Southwest’s debt-to-equity structure. And that likely would be enough to trigger the feared debt down rating.

Southwest is, to date, the only U.S. carrier to turn down the government’s offer of a loan. And it was able to do so primarily because it has been able to use its investment grade debt rating to raise $13.2 billion this year in debt at low interest rates via the public debt markets and its banks. It also has sold $2.2 billion in additional stock this year. Combined with the $3.3 billion in government grants, the carrier has raised $18.8 billion in liquidity since the pandemic’s impact began being felt in late February.

Meanwhile the airline says it has lowered is daily cash burn rate, which in the spring was north of $50 million a day, from $23 million to about $20 million daily in just the last few weeks. That’s low enough, according to Southwest executives, that it could hang on at least two more years at its current cash burn rate. Of course, Southwest – like its competitors – is working feverishly to find a way to return to positive cash flow, and eventually to profitability, long before it otherwise would run out of cash.

In May and June CEO Gary Kelly was among the industry’s most optimistic leaders in terms of his expectations of a recovery. He suggested that based on the return of leisure travel demand to that point Southwest expected by year’s end to rebuild it’s flight schedule to around 90% of what it was in 2019, before the pandemic. In March, Southwest’s flight schedule had fallen to around 10% of what it was 12 months earlier. As a group, U.S. carriers saw travel demand in March fall by a staggering 96% from March of 2019.

But on Wednesday Southwest said it now expects its third quarter capacity to be only 65% to 70% of what it was in the third quarter of last years. Previously Southwest had been expecting its third quarter capacity to be slightly larger, at between 70% and 80% of what it was in the year ago period. That implies that instead of having fourth quarter capacity of about 90% of what it was in the fourth quarter of 2019, Southwest’s fourth quarter capacity now will likely be only about 75% and 85% of what it was in the year-ago period.

Still, Southwest’s capacity and overall recovery plans appear to be more aggressive than those of its more conventional big airline rivals, American, United and Delta. And turning down the CARES ACT loan and retaining its investment grade debt rating positions Southwest to be able to grow its capacity at a much lower unit cost than can any of its big rivals. Thus Southwest remains well positioned to grab an out-sized share of travelers returning to the air as overall air travel demand rebuilds.

Still, revenues are likely to be significantly slower to recover than capacity at all airlines, meaning they all be expected to report previously unimaginably large annual losses.

Southwest said Wednesday that it expects its operating revenues for 2020 to be down 70% to 75% of what they were in 2019. That would seem to guarantee that the airline will report its first annual loss in 47 years. Southwest lost $1.24 billion in the first six months of this year.

The $3.2 billion cash grant Southwest accepted previously from the government was, per the terms of the CARES Act, restricted to the use of paying for the salaries and benefits of airline employees through Sept. 30. Like all its competitors Southwest agreed not to involuntarily layoff any workers through that date. Thereafter airlines are free to lay off workers.

Hopes that Congress might pass a second airline recovery or bailout package – theoretically extending the ban against airline layoffs – were damaged severely when the House left Washington without taking up a plan proposed by Senate Republicans. It’s not impossible that the Congress could return and pass such a measure by Sept. 30. But given the launch of the election season with the Democratic National Convention this week and the Republican National Convention next week, chances of Congress taking up that issue before Sept. 30 now seem remote.

Last week Southwest indicated that it does not now plan to layoff anyone once the restrictions against layoffs expires. However, like all of its U.S. competitors Southwest aggressively has sought volunteers among its staff to accept incentives to retire early, take extended leaves of absence with little or no pay, or to leave the company with a small cash payout or vestiges of their employee benefits. More than 17,000 Southwest employees – more than 20% of the carrier’s pre-Covid-19 staff – accepted those offers and already have begun phasing out of the company – temporarily or permanently.

In its 49 years of existence Southwest has never issued an involuntary layoff, though company leaders earlier this year said they feared that layoffs may be necessary as a result of the unprecedented drop in travel demand caused by the Covid-19 pandemic. Subsequently, they have said such layoffs are off the table for the rest of this year but have not extended any guarantees beyond that.

Southwest, which began life as a tiny intra-Texas outfit operating under a low-cost, low-fare discounting business plan that would not have been allowed had it been subject to the now-defunct Civil Aeronautics Board, now ranks as the largest domestic airline. In passenger miles flown Southwest is the fourth-largest U.S. carrier because it historically has not flown beyond the contiguous 48 states and only began flying to the Caribbean and Mexico in the last few years. It launched service to Hawaii just last year.

At around $11.5 billion, Southwest’s current debt is less than half of United’s $25 billion in debt, only a third of Delta’s $31 billion in debt, and just a quarter of American’s $40 billion in debt. Meanwhile, it has the least amount of so-called financial leverage among the Big Four. Currently Southwest’s debt is about 2.5 times greater than its EBITDAR (Earnings Before Interest Taxes Debt Amortization and Restructuring (or Rent) costs – a closely watched metric that speaks to a company’s general financial health and its ability to handle its debt given its revenues and costs. American, conversely, has a debt-to-EBITDAR ratio of about 4-to-1. The difference indicates that Southwest should be able to bring debt back to relatively low and healthy levels much sooner than can American and the two other large U.S. airlines. It also indicates that Southwest should be able to return to profitability faster than its rivals.

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