Fitch Upgrades Air Canada to 'B+'; Outlook Stable
Fitch has also affirmed the ratings on the Air Canada 2013-1 Class A certificates at 'A'. Fitch has upgraded the Air Canada 2013-1 Class B certificates to 'BBB-' from 'BB+' and the Class C certificates to 'BB' from 'BB-'.
The ratings upgrade is supported by Air Canada's improving financial results, successful cost cutting initiatives, pension surplus, adequate financial flexibility, and lower fuel prices. Fitch believes that lower fuel costs and AC's cost cutting initiatives could produce notable margin expansion in 2015. Importantly, Fitch expects AC to use any additional cash generated in the coming year to improve its credit profile by funding capital expenditures or addressing debt maturities. The upgrade considers the recently ratified collective bargaining between Air Canada and its pilots union which reduces the near-term risk of labor disruptions. Fitch also notes that the first full year of operations of its low-cost airline rouge have proven successful. The launch of rouge was seen as a potential risk, and while the operation is still in its infancy, Fitch is now has more confidence that the rouge business strategy may prove successful. The ratings are also supported by the company's leading market position in Canada.
While Fitch believes that Air Canada's credit profile is improving, notable risks still remain. Concerns include significant upcoming aircraft deliveries that will pressure cash flows and likely drive debt balances higher beyond 2015, heavy competition from WestJet, and a fluctuating USD/CAD exchange rate. Other concerns include those that are typical of the airline industry, such as a high degree of operating leverage, cyclicality, and an exposure to exogenous shocks such as disease or acts of terrorism.
Key Rating Drivers:
Improving Financial Performance: Air Canada's financial performance has improved over the past year as the company makes strides toward its goal of reducing unit costs by 15% from 2012 levels, a trend which should continue over the intermediate term. Fitch expects Air Canada's unit costs to benefit in 2015 from increased flying of efficient aircraft. AC is scheduled to receive five additional 787s in 2015 after receiving its first six in 2014. Unit costs will also benefit from the continued growth of AC's rouge. The rouge fleet is expected to grow from 28 aircraft to 36 by year-end 2015, with those incremental aircraft operating at a significant CASM reduction compared to AC's mainline flying.
Regional operating costs are expected to improve following the renegotiation of the capacity purchase agreement between Air Canada and its largest regional operator, Chorus Aviation. The new contract moves to a fixed fee structure and away from the previous cost-plus structure. It also calls for a smaller total fleet featuring larger gauged aircraft.
Air Canada's CASM ex-fuel was down by 2.6% in 2014 reflecting the benefits of the cost initiatives taken over the past several years. The company is experiencing the benefit of flying its reconfigured, high-density, 777s on long-haul routes, as well as the lower operating costs of the 787s, and the growth of flying at rouge.
Stable Demand Environment: On the revenue side, the demand environment for air travel in Canada and the U.S. appears stable. Fitch expects modest macroeconomic growth in those two markets in 2015 which should drive increased traffic in the near term. Canadian domestic and U.S. transborder operations make up 57% of AC's passenger revenue. While demand appears steady, unit revenues are likely to trend lower with both Air Canada and its main rival Westjet planning to add domestic capacity in 2015. For its part, Air Canada anticipates some yield pressure as a consequence of growing long-haul international and leisure passengers. Fitch expects lower unit revenues to be offset by declining unit costs from flying aircraft with denser seating arrangements and with the continued growth of rouge.
System-wide, Air Canada expects to grow capacity between 9%-10% in 2015, which is significantly higher than most other large North American airlines. While the total amount of growth is substantial, much of the extra capacity will be added at low incremental costs, either by adding routes at rouge or by flying larger gauge aircraft such as the 787 in place of 767s.
Long-term Pilot Contract: Fitch views the ratification of a new 10-year contract with AC's pilot union as a credit positive. The long-term of the new contract provides some visibility around wage rates and reduces the risk of possible labor interruptions. Ratification of a new contract more than a year ahead of the scheduled expiration date of the previous contract represents a dramatic change in labor relations compared to the previous round of negotiations in 2012 that led to work disruptions and ultimately had to be settled in arbitration. The new contract also provides AC with some new flexibility as to the narrow body/wide body mix at rouge and added flexibility in Air Canada's regional operations.
Leverage Remains a Concern: Air Canada remains highly leveraged. Although Fitch expects AC's total debt balance to increase over the next two years, leverage may come down as operating margins improve on decreased unit costs and lower fuel prices. Total adjusted debt/EBITDAR has decreased to an estimated 4.7x at year-end 2014 from 4.8x the year prior with AC's growing EBITDAR offsetting a \$910 million increase in on-balance sheet debt. Fitch notes that AC's leverage remains at the high end of its peer group; however, leverage levels for the industry have come down in recent years.
Financial Flexibility: Air Canada's liquidity is supportive of the ratings upgrade. At year end the company had a cash and short-term investments balance of \$2.3 billion and an undrawn revolver of \$210 million. Total liquidity is equal to 19% of LTM revenue, and is well above AC's minimum cash target of \$1.7 billion. While AC's liquidity balance is sizeable, Fitch expects that the company will be required to borrow incrementally over the next two years to fund upcoming aircraft deliveries.
Fitch expects free cash flow (FCF) to be around zero in 2015 before likely turning negative next year. Air Canada is making heavy investments in its fleet after underinvesting between 2009 and 2012. As a result capital expenditures are expected to be high, and FCF will be pressured. While the heavy upcoming capital expenditures represent a concern, Fitch believes that AC's fleet renewal represents an important part of its business plan. The 787s and 777s coming in to the fleet over the next couple of years will operate at a lower unit cost, and will further AC's efforts towards expanding its international footprint.
Reduced Pension Risk: The status of Air Canada's pension plans has significantly improved over the last two years. AC estimates that its pension plans are in a surplus position of \$780 million on a solvency basis as of year-end 2014 compared to a deficit of \$3.7 billion two years ago. AC is required to make minimum contributions of \$200 million/year based on its current agreement with the Canadian government. However, if the pension plans remain fully funded, Air Canada may decide to exit this agreement as early as this year, which would significantly reduce required cash contributions. The status of Air Canada's pension plan is a credit positive compared to carriers like Delta and American that maintain large unfunded pension deficits.
Recovery Ratings: Fitch's recovery analysis reflects a scenario in which a distressed enterprise value is allocated to the various debt classes. The 'RR1' recovery rating on ACs first- and second-lien secured debt reflects Fitch's assumption that all secured debtholders would receive superior recovery based on the estimate of AC's going concern enterprise value. The 'RR5' recovery rating on AC's unsecured notes reflects an expected recovery at the high end of the 10%-30% range driven by the notes' subordinate position within Air Canada's debt structure which primarily consists of secured obligations.
Key Assumptions:
Fitch's key assumptions within the rating case for AC include:
Stable demand for air travel in Canada and the U.S. in the near term
Fitch expects yields to decline marginally through the forecast period as AC adds capacity focused on leisure travel.
Fitch's forecast includes a conservative fuel assumption for 2015 which is above the current spot rate. Fitch assumes fuel prices increase thereafter.
Lower fuel prices combined with AC's cost cutting initiatives are expected to produce notable margin expansion in 2015.
Fitch expects AC's debt balances to rise over the next two years as the company issues debt to fund aircraft deliveries.
Rating Sensitivities:
Fitch does not anticipate a positive rating action in the near term as heavy capital expenditures will likely lead to increased borrowing. However, future actions that may individually or collectively cause Fitch to take a positive rating action include:
--Continued leverage reduction with adjusted debt/EBITDAR sustained around or below 4x;
--Successful cost control efforts leading to EBITDAR margins exceeding 15%, EBIT margins improving towards 10%;
--Better than expected (neutral or positive) FCF generation.
Future actions that may individually or collectively cause Fitch to take a negative rating action include:
--Weaker than expected margin performance or higher than expected borrowing causing leverage to reach or exceed 5x;
--Weaker than expected financial performance causing FCF to be notably below Fitch's expectations;
--A decline in the company's EBIT margin to the low single digits, EBITDAR margins into the high single digits;
--A change in management strategy to direct cash to dividends/share repurchases at the expense of a healthy balance sheet.
2013-1 EETC:
Fitch's senior tranche EETC ratings are primarily based on a top-down collateral analysis. Since the ratings were previously reviewed, collateral values for the 777-300ERs in this pool have depreciated by slightly more than Fitch's initial expectations. This is based on the most recent data available from Fitch's independent appraiser. However, the transaction remains significantly overcollateralized, and comfortably passes the 'A' category stress scenario. Therefore, the ratings were affirmed at 'A'.
Subordinated tranche ratings are linked to Air Canada's IDR, and therefore the ratings have been upgraded to 'BBB-' and 'BB' for the B and C tranches, respectively.
Subordinated tranche ratings are adjusted from Air Canada's IDR based on three primary factors; 1) affirmation factor, 2) presence of a liquidity facility, and 3) recovery prospects. Fitch considers the affirmation factor for this collateral pool to be high resulting in a plus-3 notch adjustment (maximum is 3) for the B tranche. The B tranche also features an 18-month liquidity facility, providing a further plus-1 notch adjustment. The liquidity facility is provided by Natixis (rated 'A/F1'/Stable Outlook) No adjustment has been made for recovery, resulting in a rating of 'BB+', plus-4 notches above Air Canada's IDR. The two-notch differential between the B and C tranche reflects the C tranche's subordinate position.
Fitch has taken the following rating actions:
Air Canada
--Long-term IDR upgraded to 'B+' from 'B';
--Senior secured first-lien upgraded to 'BB+/RR1' from 'BB/RR1'
--Senior secured second-lien debt upgraded to 'BB+/RR1' from 'BB/RR1'
--Senior unsecured debt upgraded to 'B/RR5' from 'B-/RR5'
Air Canada Pass-Through Trust Series 2013-1;
--Class A certificates affirmed 'A';
--Class B certificates upgraded to 'BBB-' from 'BB+';
--Class C certificates upgraded to 'BB' from 'BB-'.
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