Fitch Ratings-Chicago-03 December 2018: Fitch Ratings has affirmed Alaska Air Group, Inc.'s (ALK) Long-Term Issuer Default Rating (IDR) at 'BBB-'. The Rating Outlook is Stable.
The rating affirmation is primarily based on Fitch's expectations that credit metrics will improve from current levels over the next 1-2 years. Fitch views Alaska's credit metrics as weak for the 'BBB-' rating. While Fitch's base case forecast anticipates that metrics will improve over the next couple of years, the forecast is sensitive to fuel prices, the macroeconomic environment, and execution risk. A negative rating action is likely should expected improvements fail to materialize.
Fitch's primary rating concerns center around higher total adjusted debt/EBITDAR caused primarily by lower profitability due to higher fuel prices, non-fuel cost pressures and tough competition. Other concerns involve risks that are typical of the airline industry including cyclicality, intense competition, capital intensity, and an exposure to exogenous shocks (terrorism, disease, etc.).
The current investment grade rating is supported by the company's financial flexibility via its material cash flows, cash on hand and a growing number of unencumbered aircraft. The rating also benefits from management's conservative approach towards the company's balance sheet by reducing cash returned to shareholders during the merger, paying down a significant portion of merger related debt, and by reducing planned growth and capex. Fitch also notes ALK has now completed many critical merger milestones, reducing execution risk related to merger integration.
KEY RATING DRIVERS
Credit Metrics Pressured: Alaska's credit metrics have come under pressure from a confluence of factors over the past year. Jet fuel costs have increased materially, while at the same time labor rates have increased from new collective bargaining contracts, and other costs have been high as the company has worked through the integration of Virgin America. Meanwhile competitive pressures in Seattle, California and Hawaii, along with revenue pressures stemming from the opening of many new markets over the past year, have kept unit revenues down at a time when much of the industry is showing improvement.
Fitch expects these trends to begin to reverse in late 2018 and going in to 2019 as Alaska has gotten past much of its integration work and will begin to see greater benefits from the purchase of Virgin America. The company should also see improving unit revenues as new markets begin to mature and as it moves past some easier comp periods. Revenue initiatives such as ALK's recent decision to increase checked bag fees and to implement a 'basic economy' type fare should also produce tailwinds next year.
Nevertheless, Fitch expects Alaska's credit metrics to remain weak for the 'BBB-' rating for at least the next year. A negative rating action is likely if the improvements fail to materialize or if the operating environment were to turn unexpectedly. Fitch calculates Alaska's total adjusted debt/EBITDAR at 3.5x as of 9/30/2018. Fitch expects it may peak above 4x before improving towards 3x over the next 1-2 years. FFO fixed charge coverage is expected to decline to the mid 2x range before improving to more than 3x over the next several years. FCF is also expected to be weak this year before improving in 2019 and 2020. EBIT margins for the LTM ended September 30 was 10.9%, down from 18% at YE 2017. Fitch expects EBIT margins to expand by 200 - 300 basis points or more next year.
Material Debt Reduction: Management made debt reduction a priority after the merger. Debt repayment has slightly lagged Fitch's initial forecasts from the time of the merger, but has nevertheless been substantial. Over the last twelve months ALK has reduced on balance sheet debt by $688 million. It is also pulling down growth and slowing capital expenditures in 2019 and 2020 in an effort to strengthen cash flows and pay down more debt. The company has reiterated its target debt/cap ratio in the mid- 40% range compared to 49% as of Sept. 30, 2018. Fitch expects total debt balances to fall and remain below $2 billion by 2020. Nevertheless, leverage as measured by adjusted debt/EBITDAR may remain weak for the rating absent material margin improvement.
Higher Labor Costs: Labor agreements reached with various unions over the past year make up the majority of ALK's forecasted 3.2% increase in CASM-ex fuel in 2018. The projected increase in CASM ex is higher than Fitch included in its previous forecast and has put additional pressure on ALK's metrics in a year that has also included stiff competition, sharply higher fuel costs, and on-going integration efforts.
Labor cost and integration cost efforts should be less pronounced in 2019. However, the company will have difficulty arresting cost growth entirely as it is planning to grow the airline at a materially slower pace in 2019. It is typically easier to control unit costs when an airline is growing quickly. Fitch's base case forecast includes a low single digit increase in CASM ex in 2019.
In October of 2017, Alaska agreed on a contract with both the ALK and VA pilots that runs through April 2020. For the top pay rates, the higher wages equate to about a 33% raise for former Virgin America pilots and a 16% raise for ALK pilots, which puts them right behind pilots for the big four in terms of pay scale. This was followed in April 2018 by a new joint collective bargaining agreement with the ALK and VA flight attendants.
Waning Integration Risk: Fitch believes that integration/operational risks have decreased as Alaska has moved past the bulk of the integration work related to its December 2016 purchase of Virgin America. Airline mergers tend to be complex undertakings, so the completion of that work removes a significant amount of uncertainty. The company also expects merger synergies to increase once integration related hurdles are removed.
FCF to Improve Beyond 2018: Fitch expects FCF to be roughly neutral in 2018 before turning positive again in 2019 and 2020. ALK's ability to consistently generate significantly positive FCF is one of the items that separates it from its lower rated peers. FCF for full-year 2018 will be pressured by increased costs and relatively high capital spending. Fitch expects capital spending to total around $1 billion this year, in line with spending in 2017, two years in which capex has been high due to the integration with Virgin. Fitch views as a credit positive Alaska's efforts to proactively reduce planned capital spending in 2019 and 2020 in an effort to improve FCF and pay down debt. ALK restructured its aircraft delivery schedule and pared down planned growth to bring its capex budget to $750 million in each of the next two years, which should allow for substantial FCF generation. Fitch forecasts that FCF will reach the mid single digits as a percentage of revenue in 2019 and 2020.
ALK, like Southwest Airlines (LUV: BBB+), benefits from its strong brand and history of profitability. As of Sept. 30, 2018, the company generated LTM an EBIT margin of 10.9%, which was significantly lower than the company's margins of 20.8% over the same period in the previous year, but remained above lower rated competitors like American and United. Rising fuel costs and merger integration have had a major impact on the company's unit costs over the past year, driving margins to their lowest level since 2013. ALK has produced positive FCF for the last seven years, which is a streak similar to LUV and Delta Airlines (BBB-). While ALK has historically operated with a healthy balance sheet and industry leading margins, recent performance and increased leverage from the VA acquisition has caused company metrics to hover near or outside of our expectations for an investment grade company, which could lead to a negative rating action absent near-term improvement.
Although ALK's financial profile is very comparable to LUV, ALK had been materially behind LUV in terms of network size and strength. The acquisition of VA., which has given the company more diversification in its network and has enhanced the airline's position at key airports in California, has reduced that gap, albeit very modestly. As of September 30, the company had total liquidity of 22.1% of LTM revenue, which compares favourably with its peer group. Additionally, unlike the major network carriers (Delta, United, and American) ALK does not have material pension obligations.
Fitch's Key Assumptions Within Its Rating Case for the Issuer
--Capacity growth of just under 6% in 2018 followed by low single digit growth through the remainder of the forecast
--Continued moderate economic growth in the U.S. over the near-term, translating into stable demand for air travel;
--Jet Fuel prices remaining around $2.30/gallon through the forecast period, roughly in-line with levels seen in the first nine months of 2018. Note that Fitch's forecast does not incorporate the recent/significant decline in crude oil price;
--Low single digit decrease in RASM in 2018 followed by mid-single digit growth in 2019 and low single digit growth thereafter.
--Low-single digit ex-fuel CASM growth in 2019 and through the remainder of the forecast.
Developments That May, Individually or Collectively, Lead to Positive Rating Action
--Adjusted debt/EBITDAR sustained around or below 2.0x;
--FFO fixed charge coverage increasing towards 4x - 4.5x;
--Free cash flow margins sustained in the high single digits.
Developments That May, Individually or Collectively, Lead to Negative Rating Action
--Actions that signal a more aggressive capital structure compared to current standing;
--Gross adjusted leverage rising and remaining above 3x;
--Significant merger related difficulties potentially leading to lost customer loyalty and declining profitability;
--Increasing competitive pressure causing EBITDAR margins to fall and remain below 20%.
Fitch views the company's liquidity as supportive of the rating recommendation. As of Sept. 30, 2018, ALK had cash and cash equivalents balance of $1.4 billion. Including availability under its two primary revolvers, liquidity as a percentage of LTM revenue was 22.1%, which is above the level maintained by many peers. As of September 30, short-term debt maturities totalled only $55 million. ALKs upcoming debt maturities are manageable at $267 million in 2019 and $381 million in 2020.
ALK maintains a simple capital structure. Outstanding debt consists solely of aircraft backed secured bank notes with maturities extending through 2028, the majority of which feature variable interest rates. ALK also maintains a $250 million revolving credit facility that matures in 2021 and is secured by aircraft, a $150 million revolver maturing in 2022 secured by A/R, spare parts and engines. The revolvers stipulate that ALK must maintain a minimum cash balance of $500 million. The company had full availability under its revolvers as of Sept. 30, 2018.
Fitch has affirmed the following rating:
Alaska Air Group, Inc.
--Long-Term Issuer Default Rating at 'BBB-'.