Fitch Ratings-Chicago-April 08: Fitch Ratings has upgraded Air Canada's Issuer Default Rating (IDR) to 'BB' from 'BB-'. The Rating Outlook is Stable.
Fitch has also upgraded certain subordinated tranches of the company's EETC transactions and affirmed other tranches. A full list of ratings is shown at the end of this release. The ratings upgrade is supported by improvements to Air Canada's balance sheet, the evolution of its business model through its international expansion, and management's public commitment to conservative financial policies. Fitch expects the company's credit metrics will continue to improve over the intermediate term as management focuses on reducing leverage and growing operating margins.
The Stable Outlook incorporates macroeconomic concerns and the potential for market weakness if economic conditions were to soften. However, Air Canada's ratings may still trend higher over the longer term based on expectations for improving FCF generation as its capital spending declines following peak levels in 2016 and 2017 due to fewer scheduled deliveries of expensive widebody aircraft. The prospect of higher ratings also reflects improvements made in Air Canada's cost structure in recent years and manageable unit cost pressures through Fitch's forecast period. Fitch's primary concerns include the possibility of slowing macroeconomic growth potentially weakening the demand for air travel. Competition is always a concern with Westjet making an effort to establish itself as more of a network carrier and ultra low-cost carriers attempting to grow in Canada. Other concerns are typical for the airline industry and include the possibility of rising fuel prices, cyclicality, high operating leverage, and exposure to exogenous shocks. Fitch is monitoring the potential impact on Air Canada of the global grounding of the 737 MAX fleet. However, Air Canada's credit profile reflects the ability to withstand business interruptions without material damage.
KEY RATING DRIVERS
Financial Targets are Credit Positive Air Canada pulled forward the date that it expects to achieve its target net leverage ratio of 1.2x from 2020 to the end of 2019, though this was prior to the company's decision to withdraw near-term financial guidance due to the grounding of its 737 MAX fleet. Fitch's conservative forecast anticipates leverage will be above that level by year-end but continue to decline over the intermediate term. Fitch's base case forecast anticipates that total adjusted gross debt/EBITDAR will decline to 3.4x by year-end 2019 and to the mid-to-upper 2x range by 2022, a level in line with peers rated in the 'BBB' category.
Fitch views Air Canada's public leverage targets and desire to achieve investment grade ratings as credit positives that illustrate management's commitment toward maintaining a healthy balance sheet. The company's total on-balance sheet debt increased by CAD538 million in 2018 due primarily to the effect of the weaker Canadian Dollar on the company's USD denominated debt along with a modest amount of borrowing to fund aircraft purchases. Roughly 81% of Air Canada's total debt is denominated in USD.
Improving FCF: Fitch expects 2019 FCF to be in line with or modestly lower than 2018 levels but to rise sharply after 2019 as capital spending comes down. Fleet spending was high in recent years as Air Canada renewed its widebody fleet and pursued its international expansion. Going forward fleet capex will focus on replacing older narrowbodies, and growth will be modest. Lower capex combined with solid profitability is expected to generate meaningful FCF starting in 2020. Cash flow generation is expected to be sufficient to allow the company to increase its share repurchase program while maintaining and improving a healthy balance sheet. Air Canada generated FCF of CAD 498 in 2018, and we expect cash flow generation solidly above that level beyond 2019.
737 MAX Grounding Air Canada has taken delivery of 24 737 MAX 8s since October 2017 and has another 37 on order, 12 of which were expected to be delivered during the remainder of 2019. The MAX makes up nearly 20% of Air Canada's current narrowbody fleet (including Rouge) and accounts for about 6% of total flying, making the grounding a material disruption. Air Canada has withdrawn its financial guidance for 2019 and removed the MAX from scheduled service through June of this year. If the grounding were to be prolonged through the end of the year or if it is discovered that there are systemic safety issues with the aircraft, Air Canada's exposure to the MAX could represent a material headwind.
However, Fitch views as positive the fleet flexibility that has allowed Air Canada to cover the majority of its MAX flying. The company's credit profile is also relatively unlikely to be damaged by the grounding due to its solid liquidity balance and expected FCF generation. Our current assumption is that the MAX will ultimately prove to be a successful addition to Air Canada's fleet in the longer-run. There is also the possibility that costs incurred during the grounding could be reimbursed or partly reimbursed by Boeing (NYSE:BA).
Sustained Profitability
Fitch expects operating margins on average over the next few years to be in line with or slightly below levels produced in 2018. However, Fitch's forecasts are conservative including minimal unit revenue gains in coming years reflecting some uncertainty around the macro environment. In the near term, costs will also be pressured by items like higher customer service expenditures stemming from new passenger bill of rights legislation in Canada and higher depreciation. Fitch's forecast also includes headwinds from the grounding of Air Canada's 737 MAX 8s. Pressures will be at least partially offset by Air Canada's purchase of Aimia Canada, Inc., and the rollout of its new loyalty program in 2020, along with a more favorable capacity purchase agreement with Jazz, Air Canada's largest regional operator. Air Canada produced an EBIT margin of 6.5% in 2018, down from recent peak levels primarily due to higher fuel costs, but still above the levels that the company produced prior to 2013. Air Canada's CASM ex-fuel was up by a modest 0.3% in 2018 reflecting the benefits of the cost initiatives taken over the past several years as well as the effects of growing ASMs and stage-lengths as Air Canada has focused on international growth.
Fitch expects unit costs to be up in the low single digits in 2019. Purchase of Aeroplan Air Canada finalized its purchase of Aimia Canada, Inc. from Aimia in January 2019. Aimia Canada was owner and operator of Aeroplan, Air Canada's loyalty program. Prior to the purchase, Air Canada did not manage its own loyalty program, which was sub-optimal. Fitch expects the purchase to be a longer-term credit positive. Loyalty programs and co-branded credit card partnerships tend to be the highest margin portion of an airline's business, and bringing Aeroplan in-house may help Air Canada to bridge the margin gap with its American peers. The purchase also bolstered liquidity.
Air Canada purchased Aimia Canada for CAD$450 million in cash. However, concurrent with the transaction close, Air Canada received combined cash payments of CAD$822 million from TD, and CIBC, two of its partners in the Aeroplan program. The payments represented consideration for the banks' continued participation in Aeroplan following the transaction. Air Canada also received CAD$400 million from TD and CIBC as a pre-payment towards future mileage purchases. As a result, liquidity has materially improved, this was offset by the assumption of CAD$1.9 billion in mileage liability.
EETC Ratings
Fitch has reviewed Air Canada's EETC ratings concurrent with the review of Air Canada's corporate IDR. Fitch affirmed the 2017-1 class AA and A certificates at 'AA' and 'A', respectively, and the 2015-1 and 2013-1 class A certificates at 'A'. Fitch upgraded the 2017-1, 2015-1, and 2013-1 class B certificates to 'BBB+', reflecting the upgrade of Air Canada's IDR. Fitch upgraded the 2015-1 class C certificates to 'BBB-'. The Air Canada 2015-1 class C certificates and the 2013-1 class B certificates were previously Under Criteria Observation following the 2018 revision of Fitch's EETC rating criteria. The Air Canada 2013-1, 2015-1, and 2017-1 class A certificates remain sufficiently overcollateralized to pass Fitch's 'A' level stress tests and the 2017-1 AA certificates continues to pass our 'AA' level test when incorporating the latest available aircraft appraisal data. This suggests that senior tranche debt holders would be expected to achieve full principal recovery prior to the expiration of the transaction's liquidity facility even in a harsh downturn scenario. Levels of overcollateralization have remained sizeable for these transactions as appraised values for 777-300ERs (for 2013-1), 787-s and 787-9s (for 2015-1 and 2017-1) have held up well over the past year.
737 MAX values experienced value depreciation above our assumed rate due to the normal depreciation that can be expected for new delivery aircraft. Updated values for the MAX do not yet include any potential impact from the on-going grounding. Stressed loan-to-value ratios remain in the high 70% to mid-80% range for senior tranches in all three transactions representing some of the higher levels of overcollateralization in Fitch's rated universe of EETCs. 2017-1 737 MAX Exposure The Air Canada 2017-1 transaction has material exposure to the current problems with the 737 MAX 8, which makes up 44% of the collateral pool by asset value. Should the grounding of the airplane lead to longer-term problems (i.e. inability to resume flying in a timely fashion, damage to passenger reputation sufficient to materially damage demand for the plane) Fitch may consider increasing its stress rate on the plane or moving it to a lower tier.
We have not changed our fundamental view of the aircraft at this time for two main reasons:
1) we believe the most likely scenario will be a temporary grounding lasting several months that should not affect long-term valuations
and 2) sheer demand for narrowbody aircraft like the 737 MAX 8 make it likely that the plane will go on to have a successful future.
For instance, there are currently nearly 1,300 737 NGs in service that are more than 15 years old that will need to be replaced in the next 10-15 years just to maintain current global capacity. Airbus cannot produce sufficient quantities of A320s to meet global demand for narrowbody aircraft, meaning that many airlines will continue to rely on the 737 barring the unlikely event that the plane cannot return to service. The upgrade of the class B and C certificates reflects the one-notch upgrade of Air Canada's IDR.
Fitch rates subordinated tranches of EETC transactions via a bottom-up approach, notching off of the underlying airline rating, thus the upgrade of Air Canada's IDR drove a one-notch upgrade of the certificate ratings. The two notch upgrade of the 2013-1 class B certificates also reflects the assignment of a one-notch uplift for recovery prospects that was not previously applied. The additional notch reflects stable collateral coverage along with a lowered threshold for achieving ratings uplift that was published in Fitch's most recent update of its EETC criteria. Each of the class B certificates are rated four notches above Air Canada's IDR, reflecting a high affirmation factor (+2 notches), the presence of a liquidity facility (+1 notch), and high recovery prospects (+1 notch). Our assessment of the affirmation factor (the likelihood that these aircraft would be affirmed in a distress scenario) is unchanged for each of these transactions from our previous review.
DERIVATION SUMMARY
Air Canada's 'BB' rating is in-line with United Airlines and JetBlue and is one notch above American Airlines. Fitch calculates Air Canada's adjusted debt/EBITDAR at 3.8x at year-end 2018, which is comparable to United (3.9x) and is better than American's (4.9x). JetBlue's 'BB' rating reflects healthier credit metrics compared to both United and Air Canada, which is partially offset by JBLU's more limited route network and a degree of concentration along the East Coast. Air Canada has historically underperformed both United and American in terms of operating margins. Fitch views Air Canada's ratings trajectory as favorable to American's due to Air Canada's more conservative financial policies and its publicly stated goals to reduce leverage over the next several years. EETC Derivation Summary: The 'AA' rating on the 2017-1 class AA certificates is in line with Fitch's ratings on recent senior classes of EETCs issued by United and American. Fitch believes that this transaction compares well to recent precedents. LTVs for the class AA certificates in this transaction are slightly lower than those seen in other transactions rated at 'AA', and the quality of the underlying collateral pool is as good or better. The same holds true for the 'A' rating on the class A certificates. The quality of the collateral pool is offset by uncertainties around the 737 MAX 8, and ratings could be impacted if the 737 were to experience prolonged issues. 'A' ratings on the 2015-1 and 2013-1 class A certificates are likewise supported by stress scenario LTV ratios that are in line with or better than peers. The 2015-1 transaction benefits from relatively low LTVs and high quality collateral, but suffers somewhat from a lack of diversification. The 2013-1 collateral pool is weak compared to 'A' rated peers, featuring only the 777-300ER, but benefits from relatively low LTVs. The 'BBB+' rating on the 2017-1, 2015-1 and 2013-1 class B certificates is one notch above several series of class B certificates issued by United (also rated 'BB'), with the key differential being higher recovery prospects for the Air Canada transaction. Note however, that we will be reviewing several United EETCs in the near term, and multiple United class B certificates may warrant upgrades to 'BBB+' based on improved recovery prospects. Affirmation factor for each of these transactions is comparable to other EETCs that achieve the maximum uplift under Fitch's criteria due to the strategic importance of the MAX 8s and 787-9s and 777-300ERs to Air Canada's fleet plans.
KEY ASSUMPTIONS
Fitch's Key Assumptions Within Our Rating Case for the Issuer Include: --Continued moderate growth in demand for air travel through the forecast period. --Fuel prices remaining in the low-to-mid $60/barrel range through the forecast. --Air Canada's capacity growth slows to 5% in 2019 and in the low to mid-single digits annually thereafter. RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action Sustained adjusted debt/EBITDAR around 3.0x. FFO Fixed charge coverage sustained above 3.5x. EBITDAR margins sustained above 15%, EBIT margins above 10%. Positive FCF generation over the intermediate term. Developments That May, Individually or Collectively, Lead to Negative Rating Action Weaker than expected margin performance or higher than expected borrowing causing leverage to reach or exceed 4.0x. FFO fixed charge coverage around or below 3x. Weaker than expected financial performance causing free cash flow 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. LIQUIDITY As of year-end 2018, total liquidity was CAD5,725 million, which consisted of CAD630 million in cash and equivalents, CAD4,077 million in short-term investments plus CAD1,018 million available on Air Canada's revolvers. Total liquidity as a percentage of LTM revenue was 32%, which Fitch considers more than adequate for the rating. Debt maturities range between CAD357 million and CAD1,020 million between 2019 and 2022. Debt maturities are manageable considering Air Canada's current liquidity balance and Fitch's expectation for the company to generate cash flow from operations over the ratings horizon. Air Canada's financial flexibility is also supported by a solid liquidity balance, a growing base of unencumbered assets, and the fact that upcoming capital expenditures consist of highly financeable aircraft. Air Canada's debt structure primarily consists of aircraft secured financings which include EETCs, JOLCO financings, and bank debt. The bulk of Air Canada's aircraft debt is denominated in U.S. dollars, with a smaller amount denominated in Canadian dollars and a relatively minor amount of Japanese Yen debt. The company amended and extended its USD$1.1 billion credit facility during 2018 to $1.2 billion, now consisting of a USD$600 million term loan and a USD$600 million revolver, maturing in 2023. Previously, the facility consisted of an USD$800 million term loan maturing in 2023 and USD$300 million RC maturing in 2021. The facility is secured by certain real estate, ground service equipment, airport slots and leaseholds, and the routes rights and slots associated with the company's Pacific business. The company also has USD$400 million in senior unsecured notes that mature in 2021.
FULL LIST OF RATING ACTIONS
Fitch has taken the following rating actions: Air Canada --Long-Term IDR upgraded to 'BB' from 'BB-'; --Senior secured term loan B affirmed at 'BB+'/'RR1'; --Senior secured revolving credit facility affirmed at 'BB+'/'RR1';
--Senior secured notes affirmed at 'BB+'/'RR1'; --Senior unsecured debt upgraded to 'BB'/'RR4' from 'BB-'/'RR4'. The Rating Outlook is Stable Fitch has upgraded the following EETC ratings: Air Canada Pass Through Trust Series 2017-1 --2017-1 class B certificates due 2026 to 'BBB+' from 'BBB'. Air Canada Pass Through Trust Series 2015-1 --2015-1 class B certificates due 2023 to 'BBB+' from 'BBB' --2015-1 class C certificates due 2020 to 'BBB-' from 'BB+'. Air Canada Pass Through Trust Series 2013-1 --2013-1 class B certificates due 2021 to 'BBB+' from 'BBB-'. Fitch has affirmed the following EETC ratings: Air Canada Pass Through Trust Series 2017-1 --2017-1 class AA certificates due 2030 at 'AA'; --2017-1 class A certificates due 2030 at 'A'. Air Canada Pass Through Trust Series 2015-1 --2015-1 class A certificates due 2027 at 'A'. Air Canada Pass Through Trust 2013-1 Pass Through Trust --2013-1 class A certificates due 2025 at 'A'. Contact: Primary Analyst Joe Rohlena, CFA Senior Director +1-312-368-3112 Fitch Ratings, Inc. 70 W. Madison Street Chicago, IL 60602 Secondary Analyst Craig Fraser Managing Director +1-212-908-0310 Committee Chairperson Stephen Brown Senior Director +1-312-368-3139 Summary of Financial Statement Adjustments - Fitch has made an estimate of Air Canada's total operating rent expense that is equal to 110% of reported aircraft rent. Air Canada does not separately disclose non-aircraft rent. Fitch has also capitalized aircraft rent at 7x, as opposed to our standard multiple of 8x. Media Relations: Elizabeth Fogerty, New York, Tel: +1 212 908 0526, Email: elizabeth.fogerty@thefitchgroup.com. Additional information is available on www.fitchratings.com Applicable Criteria Aircraft Enhanced Equipment Trust Certificates Rating Criteria (pub. 27 Nov 2018) https://www.fitchratings.com/site/re/10052891 Corporate Rating Criteria (pub. 19 Feb 2019) https://www.fitchratings.com/site/re/10062582 Corporates Notching and Recovery Ratings Criteria (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10024585 Sector Navigators (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10023790 Additional Disclosures Dodd-Frank Rating Information Disclosure Form https://www.fitchratings.com/site/dodd-frank-disclosure/10069061 Solicitation Status https://www.fitchratings.com/site/pr/10069061#solicitation Endorsement Policy https://www.fitchratings.com/regulatory
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