Southwest pulls off EETC but at a cost

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Public markets may be currently on hold for certain airlines and operating lessors, unless of course, the issuer is Southwest Airlines. The airline is back in the market for the first time since 2001 with a $500m EETC financing, backed by 16 Boeing 737-700s with winglets, which were delivered between 1 November 2006 and 31 May. 
What makes Southwest the exception? Well, Southwest is the US’ leading low-cost airline with a Baa1/A- rating (Moody’s/Standard & Poor’s) - among the highest in the industry - and the financing is supported by 737-700s - a darling in the aircraft market.
According to George Godlin, Moody’s vice president-senior analyst, the financing is a cause for guarded optimism in the aviation industry. “It shows that there is investor appetite at appropriate pricing levels for EETC financings, but that said, the bar in terms of issuer quality, structure and collateral has been raised,” says Godlin.
Other market observers believe the Southwest financing is more of an anomaly. “It is important to note that this is Southwest in the market with 737-700s, so of course the market is going to react positively,” says a source involved in the EETC market. “The reaction to this particular EETC doesn’t mean that we should be optimistic about the capital markets, just look at all deals that are waiting to close, such as those belong to ILFC and Babcock and Brown.”
Through this offering, which was oversubscribed, Southwest is able to diversify its sources of financing and to keep its name in the capital markets.
It is also seen as a move to appease investors, which have been making noise about the airline’s stock price and have been demanding an increase shareholder return. During the past 12 months, Southwest has said it needs to adjust its current leverage levels as it believes it has been underleveraged historically.
Certain market observers speculated that the EETC was done to raise cash and due to the declining value of Southwest's fuel hedges, which still enjoy a substantial advantage relative to competitors. However, the airline still had $2.1bn on its books at 30 June.

The $500m offering is small compared with recent offerings. In June, United Airlines refinanced the mortgage and related debt of used 13 widebody aircraft by issuing $694m in EETCs and $270m in special facility revenue refunding bonds at Denver International Airport.  In April, Continental Airlines issued a  $1.146bn EETC to finance 12 Boeing 737-824 aircraft and 18 Boeing 737-924ER aircraft, scheduled for delivery from January 2008 to March 2009.

According to an analyst, who wished to remain anonymous, Southwest may have originally contemplated testing the waters with an EETC of the current size and then, to the extent markets were receptive, up-scaling the size of the deal to exploit scale economics. During the summer 2007 months market appetite, particularly for the airline industry, changed dramatically yet Southwest may have felt compelled to do an EETC of a size that was likely to be placed, because it had already sunk costs into doing this financing.

High Leverage

The loan-to-value (LTV) ratios on this offering are noteworthy as they are high relative to other offerings. The A-tranche has a LTV of 65% and the B-tranche has a commendable LTV of 79%, according to the prospectus. On an EETC financing closed by Continental in April, the A-tranche had a 47.4% LTV, followed by LTVs of 61.3% and 71.9% on the B- and C-tranches, respectively.  As the ratings on EETCs use the credit rating of the issuer as their starting point, the higher leverage is sustainable due to Southwest’s credit rating and the collateral backing the financing.
Also, notable are the preliminary ratings of Aa3/AA- to the class A tranche and Baa1/A on the class B tranche, as assigned by Moody's and Standard and Poor’s, respectively. These ratings make this EETC one of the best-rated offerings post-9/11.
Moody’s rating on the B-tranche is equivalent to the senior unsecured rating of Southwest for several reasons.
“First, the lack of diversity in terms of utility in the collateral pool in addition to a high peak loan-to-value ratio mitigates the expected recovery to holders of Class B Certificates. Second, the subordination of the interests of the holders of Class B Certificates to those of Class A Certificate holders and the lack of a liquidity on the Class B Certificates provides an expected loss profile on the Class B Certificates equivalent to that for holders of the unsecured debt of Southwest,” says the rating agency.

Expensive financing

However, despite being highly rated, the spreads on this deal, compared with similarly structured EETCS during the past year, backed by equally as strong collateral, indicate investors are demanding a higher return to compensate for market risk.
According to an analyst, the pricing on this EETC was high for a deal involving Southwest and the 737 collateral relative to pricing that might have been obtained for a similar deal a year ago. This is due to increased conservatism toward the aviation industry, particularly due to rising fuel prices and passenger demand which, while currently strong, may also exhibit increased elasticity in the wake of increased fuel prices and the fallout in the subprime market.
BNP Paribas is providing a liquidity facility that will support the interest on the A-tranche. The B-tranche will not have the benefit of a liquidity facility.
A potential downside with the collateral is the fact that during a default scenario, cross collateralisation will only provide a modest benefit, says Moody’s. This is because a single model of aircraft is being financed and also the collateral pool comprises a modest number of aircraft.  “(This) indicates a lack of critical diversity in utility of the aircraft to produce a more significant benefit given cross collateralization,” the rating agency says. 
The appraised base value of the portfolio is $634m, according to appraisals from Aircraft Information Services, BACK, Aviation Solutions and BK Associates. The appraisals range from $38.6m for the1 November 2006 delivery to $44.5m for the 31 May delivery, according to the prospectus.
However, all three EETC offerings offer similar lengths of maturity. Southwest’s A- and B- tranches mature in 14.8 years.

Slower Growth

Through the first six months of 2007, Southwest purchased 19 new 737-700 aircraft from Boeing and leased an additional two previously owned 737-700 aircraft from a third party.

As part of the airline’s decision to slow its growth rate during fourth quarter 2007 and for all of 2008, Southwest recently signed an agreement with Boeing to defer five scheduled 2008 deliveries. Southwest  is also exploring other alternatives to reduce its fleet growth, which could consist of either the sale of aircraft, or the return of leased aircraft at the end of their lease terms, among others.  In addition, Southwest exercised certain 737-700 options in 2009 through 2014.   Through these actions, the airline  now expects its fleet to grow by 19 net aircraft during 2008.

Southwest also has the option, which must be exercised two years prior to the contractual delivery date, to substitute -600s or -800s for the -700s.  Based on the above delivery schedule, aggregate funding needed for firm aircraft commitments is approximately $3.6bn, subject to adjustments for inflation, due as follows: $488m remaining in 2007, $735m in 2008, $467m in 2009, $341m in 2010, $444m in 2011, $458m in 2012, $487m in 2013 and $197m thereafter.

In March, Southwest’s board of directors authorized a repurchase of up to $300m of the company’s common stock.  In May, the board authorized an additional repurchase of up to $500m of the company’s common stock.  As of 17 July, Southwest had repurchased 20 million shares for $295m as part of this program.

Standard & Poor's cut its ratings on Southwest by one level on 28 August due to expected weakening of the company's financial profile from higher fuel costs.  S&P cut its ratings one notch to "A-minus," from "A." "We expect pressure on revenues, because of difficulty in raising fares in a more competitive environment; and expenses, in large part because of higher fuel costs as the company's fuel hedges run off," S&P says.