Fitch Ratings-Chicago-19 July 2017: Fitch Ratings has affirmed the Long-Term Issuer Default Rating for Spirit Airlines, Inc. at 'BB+'. The Rating Outlook is Stable. Fitch has also affirmed the ratings on Spirit's 2015-1 series of enhanced equipment trust certificates. A full list of ratings follows the end of this release.
The rating is supported by Spirit's solid profitability, healthy liquidity, and low cost structure. Spirit's cost advantage over its peers remains a significant ratings factor as it provides the company a meaningful cushion to operate through potential future economic downturns while maintaining adequate financial health. The ratings are also supported by an improving unit revenue environment among U.S. air carriers.
Fitch's primary rating concerns include leverage and cash flow metrics that have weakened beyond the agency's prior expectations driven by steep unit revenue declines over the past two years. The carrier continues to grow at a rapid pace, and heavy capital spending on new aircraft and higher debt balances may cause credit metrics to deteriorate modestly in the near-term. Continued increases in leverage due to heavier than expected borrowing, deteriorating margins from increased competition, or failure to manage future capacity growth could lead to negative rating actions. These concerns are offset by our longer-term expectations for these metrics to trend in a positive direction. Other concerns include a difficult competitive environment among US carriers and ongoing labor negotiations with Spirit's pilot union that will likely drive wages higher in the near-term.
KEY RATING DRIVERS
Operating Margins are Down but Remain Above Average: Spirit remains one of the most profitable airlines in the industry despite facing increased competitive pressure and higher fuel prices. In the latest-12-month (LTM) period ended March 31, 2017, Spirit's EBIT margin was 18.6%, which was five percentage points lower than the same time a year ago due to the headwinds mentioned above. Spirit's margin premium to the industry has declined over the past two years as it faced unit revenue pressures of a greater magnitude than its peers. Nevertheless, Spirit remains highly profitable, and Fitch forecasts that Spirit's margin advantage over its peers is sustainable over the intermediate term, with larger airlines facing some unit cost headwinds while Spirit has opportunities to maintain or incrementally improve its unit cost basis. A significant unknown in Spirit's cost structure is its open pilot contract, which became amendable in August 2015. The ratification of a new contract will likely involve meaningful pay increases for Spirit's pilots, following the trend in the industry. Pay raises may be at least partially offset by work rule changes, the cost benefits from the ongoing upgauging of Spirit's fleet, and benefits of scale as Spirit expands.
Mixed Credit Metrics: Spirit's adjusted leverage has increased over the past year as it has taken on debt to finance aircraft and as margins have declined. On an adjusted basis (including operating leases) Fitch calculates Spirit's total adjusted debt/EBITDAR at 4.1x as of March 31, 2017, which is up from 3.4x a year ago. Spirit's leverage position compared to peers has suffered as leverage metrics for much of the rest of the industry have improved or flattened out as fuel prices remain low and as some airlines have paid down debt or purchased aircraft with cash.
Fitch's concerns regarding Spirit's leverage are offset by the company's low cost structure and high operating margins and large cash balance. Although Fitch generally focuses on gross leverage metrics for airline companies due to the possibility for cash balances to decline quickly in stress scenarios, the size of Spirit's cash balance mitigates some concerns around leverage. As of March 31st Spirit's cash balance totaled 39% of LTM revenue, a level that is well above most peers. Fitch also notes that two thirds of Spirit's adjusted debt is comprised of capitalized operating rent expenses. Debt/EBITDA (not including rent expense) remains modest at 2x. Fitch expects that total adjusted leverage will remain around 4x over the next year depending on fuel prices and the financing preferences, but over the next two to three years, leverage is expected to trend slightly below current levels.
Spirit's coverage metrics are weak compared to some peers because of the company's heavy use of operating leases. FFO/Fixed charge coverage as of March 31st was 2.4x, which is down from 3.1x a year ago and remains weak compared to its peer group. Fitch expects coverage metrics to improve over the next several years due to the benefits of owning some aircraft versus having 100% operating leases.
Unit Revenues to Improve: Fitch expects unit revenues to modestly improve through the remainder of 2017, following declines in 2015 and 2016. Fitch's forecast anticipates that Spirit's 2017 unit revenues will be slightly up compared to 2016 based on some of the actions that Spirit has taken, including adjusting its revenue management practices and modifying its schedule in order to run a more reliable operation. These expectations also reflect broader industry trends with most US carriers reporting a solid demand environment and unit revenue gains for the first time in more than two years.
Negative FCF: Fitch expects Spirit's free cash to remain negative for the intermediate term as high capital spending is sustained by heavy aircraft deliveries in the coming years. Fitch forecasts that 2017 FCF may be below 2016's deficit of -$241 million. FCF in 2018 may trend closer to neutral due to a temporary lull in aircraft deliveries.
EETC Ratings: The 'A' rating on the 2015-1 class A certificates is primarily based on a significant amount of overcollateralization and a high quality pool of underlying assets. Since Fitch initially rated the transaction, loan-to-value ratios have deteriorated slightly compared to our initial expectations; nevertheless, the transaction remains heavily overcollateralized. The maximum LTV in Fitch's stress scenario is 89.9%, suggesting a full recovery for 'A' tranche certificate holders with ample headroom in a harsh stress scenario where Spirit enters financial distress and chooses to reject the aircraft.
The class B certificate rating of 'BBB+' is notched up from Spirit's corporate rating of 'BB+'. The three notch differential reflects Fitch's view that the affirmation factor for this pool of aircraft is high, and due to the presence of an 18-month liquidity facility.
Spirit's 'BB+' rating is supported by its low cost structure and high operating margins compared to peers. Operating margins compare favorably to North American Airlines that Fitch rates in the 'BBB' category such as Delta Air Lines and Southwest Airlines. These factors act as an effective buffer against economic downturns as they allow its ability to operate profitably while offering low fares. Spirit also maintains a sizeable liquidity balance compared to its peer set. As of March 31, 2017, Spirit had a cash balance equal to 39% of LTM revenue, which is notably higher than peers rated in the 'BB' or 'BBB' category. Spirit's liquidity advantage is offset by its comparatively small base of unencumbered assets.
Spirit's ratings are constrained by its relatively high gross adjusted leverage compared to peers. Fitch calculates Spirit's adjusted leverage at 4.1x as of March 31 2017, which is higher than other 'BB' rated peers such as United ('BB'/3.3x) and JetBlue ('BB-'/2.3x). Unlike the major network carriers (Delta, United, and American) Spirit has no pension obligations, which partially offsets its higher gross leverage ratio (Fitch does not include pension deficits in total debt) Free cash flow is also weak compared to peers rated in the 'BB' category, however this is largely attributable to Spirit's high rate of growth.
Fitch's key assumptions within our rating case for the issuer include:
--Capacity growth sustained in the mid teens throughout the forecast period.
--Continued moderate economic growth in the U.S. over the near-term, translating into stable demand for air travel
--Jet Fuel prices equating to brent crude averaging in the low to mid $50/barrel range for 2017, increasing to ~$60/barrel by 2019
--Neutral to slightly positive RASM increase in 2017 followed by low growth thereafter
Future Developments That May, Individually or Collectively, Lead to Positive Rating Action
--Total adjusted debt/equity credit falling below 3x on a sustained basis (Debt/EBITDAR as of March 31, 2016: 3.4x);
--Free cash flow trending towards positive;
--FFO fixed charge coverage ratio sustained at or above 3x.
Future Developments That May, Individually or Collectively, Lead to Negative Rating Action
--Total adjusted debt/EBITDAR sustained at or above 4x;
--Liquidity as a percentage of LTM revenue falling below 20% on a sustained basis (as of March 31, 2017: 39%);
--Material weakness in revenue or a sharp uptick in costs resulting in EBIT margins sustained below 12% (as of March 31, 2016: 18.6%);
--Difficulties managing planned capacity growth which cause Fitch to make material negative revisions to its financial projections.
Solid Financial Flexibility: As of March 31, 2017 Spirit had cash and equivalents of $918 million, equal to 39% of LTM revenue. Spirit's financial flexibility is supported by the absence of significant near-term debt maturities, the fact that it has no pension obligations. The company is unencumbering some assets including seven A319s and two spare engines. In 2016 Spirit used cash to acquire seven A319s, which were formerly under lease agreements, with a total fair value of $95.7 million.
Spirit's cash equivalents consist of highly liquid money market funds and a $100 million in short term investments. The company also maintains two lines of credit totaling $70.1 million. The credit lines consist of a $23.6 million line related to corporate credit cards which the company uses for interrupted trip expenses and crew hotels among other things, and a $46.5 million line available for both physical fuel delivery and jet fuel derivatives As of March. 31, 2017, the company had drawn $12.0 million on the former and $9.0 million on the latter. The company also maintains $25.2 million in unsecured standby letter of credit facilities. As of March 31, 2017, the company had $17.4 million in outstanding letters of credit under this facility.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
Spirit Airlines, Inc.
--Long-Term IDR at 'BB+'.
Spirit Airlines Pass Through Trust Certificates, Series 2015-1
--Class A certificates at 'A';
--Class B certificates at 'BBB+'.