Southwest Airlines Co. (LUV): Debt Rating Warning Won’t Stop This Airline’s High

To the delight of its shareholders, Southwest Airlines Co. (NYSE:LUV) is quadrupling its quarterly dividend to $.04 a share and increasing its share repurchase authorization by 50% to $1.5 billion. While this is great news for shareholders, it could draw the ire of investors that hold any of the airline’s corporate debt.

So concerned about the increases was Moody’s Investors Service that it released a note calling the measures credit negative. It takes issue with Southwest Airlines Co. (NYSE:LUV) not yet restoring its credit metrics to the levels it enjoyed before it acquired AirTran Holdings in May 2011. Furthermore, the rating agency notes that the increased shareholder returns will prolong the time that Southwest Airlines Co. (NYSE:LUV)’s credit metrics will remain above those typical of investment-grade corporate issuers.

Moody’s acknowledges that Southwest’s free cash flow will fund the buyback program, so it won’t have to issue debt to cover it. However, the rating agency takes issue with the effect the share repurchase authorization will have on Southwest’s EBITDA, which is roughly $2.6 billion. The authorization would mean Southwest forgoes a reduction in its debt-to-EBITDA. This could cause a downgrade in its Baa2 rating to Baa3, which would be a more commensurate rating.

Moody’s and other rating agencies have loss credibility among capital and equity market investors, so many may take Moody’s warning with a grain of salt. However, I see value in what the firm is highlighting, especially considering the effects of any dents to the company’s debt rating.

One other thing to point out about the Southwest Airlines Co. (NYSE:LUV)’s debt rating is that it is the only investment-grade rated airline in the U.S. The company touted this as strength when it announced the share buyback program. In doing so, it also had to admit that it has to make $150 million of debt payments for the rest of the year, which means its debt-to-capital leverage will fall below 40% by the end of the year.

Moody’s in May assigned a stable outlook to United Continental Holdings Inc (NYSE:UAL)’s debt. United merged with Continental in 2010. Analysts at Moody’s noted “that the stable outlook reflects its belief that challenging elements of the integration of the airline operations have been substantially addressed, alleviating potential challenges in upcoming quarters as the company focuses on improving its traffic and revenue performance.”

In United Continental Holdings Inc (NYSE:UAL)’s favor is a $1 billion revolving credit that provides it with a sufficient cushion to fund remaining integration costs, debt maturities and other potential calls on cash in the event cash flow from operations was to unexpectedly decline, according to Moody’s. Investors can also take solace in the airline’s debt management policies, as well as its commitment to controlling non-fuel costs. Each of which should help mitigate pressure on earnings during periods of declining passenger counts, Moody’s notes.

Rating concerns aside, airlines represent solid buying opportunities. This can be seen in their total returns. Compared to the S&P 500, Southwest’s total return is up 76.55%. The S&P 500’s total return was up just 31.55%. Southwest’s total return is still lower than Delta Air Lines, Inc. (NYSE:DAL) 83.28%, but it is ahead of United Continental’s increase of 64.98%.

Speaking of the S&P 500, word on the street is that Delta Air Lines, Inc. (NYSE:DAL) could be rejoining the index, which could boost its attractiveness to investors. It was cut from the prestigious list in 2005 before it filed for bankruptcy. The only other airline that is listed as an S&P 500 company is Southwest.

Southwest Airlines Co. (NYSE:LUV)’s gross and operating margins (TTM) are in line with competitors Delta and JetBlue Airways Corporation (NASDAQ:JBLU). Its gross margin is .22%, compared to .20% for Delta and .27% for JetBlue. Its operating margin is .05%, compared to .04% for Delta and .07% for JetBlue Airways Corporation (NASDAQ:JBLU).

Southwest’s earnings per share fall just about in the middle of those of Delta and JetBlue. It is $.51, compared to $1.05 and $.36 for Delta and JetBlue Airways Corporation (NASDAQ:JBLU), respectively.

Southwest Airlines Co. (NYSE:LUV)’s stock has risen almost 60% over the past six months, hitting a new 52-week high of $14.55 last week. It wasn’t alone in breaking this new high. So did United Continental. It set a new 52-week high of $35.27 last week on the news that its battery problem-plagued 787 jets were flying again.

Key to all of these airlines is maintaining and increasing the number of flights they offer, considering this directly affects their earnings. Airlines had been hampered by volatile oil prices and a slow down in passengers, however, that is projected to change. This year, the industry could see profits of up to $11 billion, according to the International Air Transport Association’s (IATA) projections for this year that show the industry generating $10.6 billion in profits this year, up from their earlier forecast of $8.4 billion.

As Fool writer Rick Munarriz pointed out last week, airlines are flying high again as sector consolidation is boosting airfares and cheaper jet fuel is resulting in widening profit margins. Southwest is poised to take advantage of the resuming good times for the sector, with analysts seeing its earnings nearly doubling this year.

So, Southwest Airlines Co. (NYSE:LUV)’s increased quarterly dividend and share repurchase authorization may cause angst to the holders of its debt. However, these actions, as well as the company’s comparable fundamentals to larger players like Delta Air Lines, Inc. (NYSE:DAL), make it an attractive price at this point.

The article Debt Rating Warning Won’t Stop This Airline’s High originally appeared on and is written by Tedra DeSue.

Tedra DeSue has no position in any stocks mentioned. The Motley Fool recommends Southwest Airlines. Tedra is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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