Fitch affirms Southwest Airlines at 'BBB'; Outlook to stable

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

--Senior Unsecured Debt at 'BBB';

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

--Secured Term Loan due 2020 at 'BBB+'.

Fitch has also assigned a 'BBB+' rating to LUV's $320 million secured term loan due May 2019 and $124 million secured term loan due July 2019.

The Rating Outlook for LUV has been revised to Stable from Negative. Fitch's ratings apply to approximately $2.5 B of outstanding notes and loans.

The ratings reflect LUV's solid liquidity position, its long track record of industry-leading profitability and free cash flow (FCF) generation, and management's continuing commitment to low balance sheet leverage. The revision of the Rating Outlook to Stable reflects the airline's improved margin and cash flow generation prospects for 2010 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 undertake meaningful balance sheet de-levering through the end of 2011.

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 second half of this year, 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. FCF, however, will likely be quite strong (in excess of $700 MM this year and again in 2011).

Although LUV converted four Boeing B737 delivery options to firm orders for next year, a relatively light aircraft order book will constrain capex and boost FCF over the next few quarters. LUV now plans to take 14 new B737-700 aircraft next year, with accelerated B737-300 retirements largely offsetting any impact on scheduled capacity.

In light of strong FCF generation and solid liquidity ($3.1 billion of unrestricted cash and investments on the balance sheet at June 30), cash deployment will likely be targeted toward debt reduction over the next two years. Scheduled debt maturities of $514 million in 2011 and $493 million in 2012 can be funded out of FCF without materially weakening LUV's liquidity position. Assuming low single-digit unit revenue growth next year and relatively stable fuel prices, a resumption of modest share repurchase activity could also occur without delaying significant leverage reduction. On a balance sheet debt to EBITDA basis, LUV's leverage could fall to below 2 times (x) after maturing notes are paid down in late 2011.

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 the second quarter of 2010 (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. For all of 2010, LUV now estimates that fuel prices will average approximately $2.40 per gallon, compared with $1.97 per gallon in 2009.

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.

Stronger RASM growth, however, is countering the unit cost pressure as LUV focuses more attention on schedule optimization, yield management and ancillary revenue streams as key drivers of improved margin performance in a better air travel demand environment. The launch of new business markets over the last year, coupled with schedule adjustments aimed at trimming many less profitable frequencies, is supporting better relative yield, load factor and RASM results. RASM in 2Q'10 grew by 22%, with 17% higher yields, on essentially flat capacity. LUV led the industry in terms of domestic passenger unit revenue growth in the second quarter, and it grew the 'other revenue' line by 47% as product initiatives introduced last year supplement core passenger revenue streams.

LUV's healthy balance sheet cash and investments position is supplemented by an undrawn $600 million revolver that matures in October 2012 and over 300 unencumbered Boeing B737 aircraft (estimated book value of $5.4 billion).

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. A negative Outlook change 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.