Fitch Ratings - Chicago - 26 June 2019: Fitch Ratings has affirmed the Long-Term Issuer Default Rating (IDR) and senior unsecured debt ratings of Aviation Capital Group LLC (ACG) at 'BBB+'. The short-term IDR has been affirmed at 'F2' and Fitch has assigned a 'F2' rating to ACG's commercial paper program. The Rating Outlook has been revised to Evolving from Positive.
The rating actions follow Fitch's upgrade of ACG's majority owner, Pacific Life Insurance Company (PLIC; IDR of A+/Stable), a subsidiary of Pacific LifeCorp (PLC; IDR of A/Stable), reflecting improving fundamentals at the insurance company level. For more information on the insurance rating actions, please see the rating action commentary entitled 'Fitch Upgrades Pacific Life Insurance Co to 'AA-'; Outlook Stable' dated June 26, 2019.
KEY RATING DRIVERS
IDRs, SENIOR DEBT AND COMMERCIAL PAPER
The revision of the Rating Outlook to Evolving from Positive reflects a potential change in Fitch's assessment of ACG's strategic importance to PLIC and PLC. The Evolving Rating Outlook indicates that the ratings could be raised (potentially to as high as A-/F1) or lowered (potentially to as low as BBB/F2 or BBB-/F3 assuming a stable standalone credit profile) over the Outlook horizon. The three primary factors that will influence the resolution of the Evolving Rating Outlook relate to Fitch's on-going assessment of ACG's ownership composition, ACG's expected future growth rate relative to those of PLIC and PLC and the willingness and ability of PLIC and PLC to extend support to ACG in the event of need. Fitch notes that ACG's standalone credit risk profile remains stable and is not a key driver of the Evolving Rating Outlook.
In March 2019, ACG drew $200 million of primary capital of a total $600 million available to it from its minority shareholder, Tokyo Century Corporation (TC), bringing TC's ownership percentage in the company to 24.5%, from 20% at year-end 2018 (YE18). TC's capital injection is meant to accelerate ACG's business expansion and to create incremental business opportunities. That said, the investment lowered PLIC's ownership percentage to a level very close to the 75% threshold that Fitch has previously stated could be a trigger to reduce the degree of institutional support reflected in ACG's rating, particularly if accompanied by increased strategic influence on the part of minority shareholders. ACG has an additional $400 million of capital available to be drawn at ACG's discretion, which could bring TC's ownership stake above 25%.
ACG's continued growth, combined with PLIC and PLCs relatively stable size, has resulted in ACG representing an increasingly significant portion of PLC's revenue and PLIC's statutory capital, which Fitch believes may increase the likelihood that third party capital is necessary to support ACG's future growth and/or call into question the insurance company's willingness and/or ability to extend credit or liquidity support to ACG in times of stress. To date, support of ACG as a result of financial stress is untested, due largely to the aircraft lessor's strong performance track record, although Fitch acknowledges PLC's strong statutory capitalization and liquidity levels.
The rating affirmations remain supported by ACG's integration within PLC, as one of its five publicly articulated operating divisions. In addition, ACG offers PLC increased portfolio diversification, additional tax efficiency, a different interest rate sensitivity profile relative to the core life insurance business and an efficient use of capital within the context of PLC's risk-based capital standards.
Fitch considers ACG's standalone credit risk profile to be consistent with its investment-grade peers. This reflects the strength of its solid standalone franchise and competitive position as a global lessor and manager of commercial aircraft; management's intention to maintain net debt to tangible common equity below 2.5x; a favorable long-term funding profile comprised entirely of third-party sources; strong balance sheet flexibility relative to peers; and an experienced management team.
Constraints specific to ACG's standalone credit risk profile include modestly weaker, but improving net spreads relative to peers, the unproven nature of ACG's emerging aircraft financing solutions business and the utilization of short-term commercial paper (CP) to temporarily fund aircraft purchases.
Constraints applicable to the aircraft leasing industry more broadly include the monoline nature of the business; vulnerability to exogenous shocks; potential exposure to residual value risk; sensitivity to oil prices; reliance on wholesale funding sources; and increased competition.
Management expects to maintain net leverage below 2.5x over the long term, which is viewed by Fitch to be conservative in the context of ACG's risk appetite, active portfolio management and current and expected fleet profile. Gross debt to tangible equity was 2.0x at March 31, 2019, although Fitch believes leverage will migrate toward the long-term target over time.
The aircraft portfolio remains broadly used by global airlines, supporting stable cash flow generation which can reduce the impact of market volatility. The firm owned and managed 311 aircraft at March 31, 2019, and approximately 91% of the portfolio by count included Boeing B737 and Airbus A320 family aircraft, which Fitch views favorably given the tradability of the aircraft, broad user base and relatively low transition costs. The aircraft portfolio had a weighted average age of 5.3 years at first-quarter 2019 (1Q19), which is consistent with rated peers.
Portfolio growth has been measured over time and ACG has a modest order book relative to peers. As of March 31, 2019, ACG had firm orders for 172 aircraft, which should allow the company to migrate toward a fleet comprised of next generation aircraft through 2023, although order books also entail some placement risk.
ACG's annualized pre-tax return on average assets was 2.2% in 1Q19; below the peer average of 2.7%. The firm's annualized net spread, defined by Fitch as lease yields less funding costs as a percentage of net aircraft assets, was 6.7% in 1Q19, which was consistent with the peer average of 6.7%, given an improvement in overall funding costs. Fitch expects net spreads to remain relatively stable over the outlook horizon, as the weighted average remaining lease term of 6.6 years is relatively well matched to the weighted average maturity of ACG's debt, which mitigates the potential for spread compression if interest rates rise.
Liquidity is sufficient given ACG's consistent cash flow generation, unrestricted cash balances, and availability under its funding facilities to meet upcoming debt maturities and aircraft funding commitments. As of March 31, 2019, available liquidity included balance sheet cash of $185.9 million, annualized cash flow from operations of around $600 million, and available capacity under its revolving credit facility of $1.9 billion. There are no upcoming bond maturities until April and October 2020, when $154 million and $600 million, respectively, of bonds come due.
At March 31, 2019, unsecured debt, including senior notes, revolving credit facilities and term loans, represented 91.1% of total debt. ACG has among the highest proportions of unsecured debt as a percentage of overall funding compared with peers, which Fitch believes enhances its overall financial flexibility.
Consistent with its funding strategy, ACG continues to diversify its funding sources and broaden its capital markets access. In June 2019, ACG amended its committed revolving credit facility, increasing the capacity by $370 million, to $2.0 billion, and extending the maturity by an additional year to June 2024. Together with another revolving credit facility, ACG had $2.2 billion of commitments from 24 financial institutions globally, proforma at March 31, 2019.
In May 2018, the firm initiated a $1.5 billion private placement CP program. The notes offered under the CP program are senior unsecured obligations, which rank pari passu with ACG's outstanding unsecured indebtedness. The company's existing $2.0 billion revolving credit facility serves as the backstop to the CP issuance. The CP program replaced ACG's use of its revolving credit facilities, which are periodically and temporarily drawn upon to fund individual aircraft purchases until sufficient size is amassed in order to more efficiently execute other forms of long-term financing.
Due to its predominately unsecured funding profile, ACG has a significant pool of available unencumbered assets, which provides material support to the unsecured noteholders and is viewed favorably by Fitch as it provides additional balance sheet flexibility in times of market stress. ACG is required under its debt agreements to maintain a minimum level of unencumbered assets to unsecured debt ratio of 1.25x. At March 31, 2019, this ratio amounted to 1.5x.
The ratings of the unsecured debt are equalized with the long-term IDR of ACG, reflecting the unsecured funding profile and a sufficient level of collateral to support average recoveries in a stressed scenario.
ACG's long-term IDR of 'BBB+' corresponds to a short-term IDR of 'F1' or 'F2' according to Fitch's Short-term Ratings Criteria dated May 2, 2019. Fitch typically assigns the higher of the two short-term IDRs in the case of non-bank financial institutions rated based on institutional support, with the exception of where Fitch believes there may be impediments to the prompt flow of funds to the subsidiary from the institutional support provider, as a result of the regulatory oversight of the parent. ACG's short-term rating is at the lower of the two options, at 'F2', to reflect potential delays or restrictions on the flow of support, which could potentially be imposed by PLIC's insurance regulators.
IDRs, SENIOR DEBT AND COMMERCIAL PAPER
Were the ownership and strategic influence of minority shareholder(s) to increase further, or if Fitch has a reasonable expectation that this may occur over the Rating Outlook horizon due to ACG's growth dynamics relative to is majority shareholder, Fitch could widen the institutional support notching by notching up from ACG's standalone credit risk profile or remove the institutional support altogether and rate ACG based upon its standalone credit risk profile. This outcome could result in ACG being rated 'BBB'/'F2' or 'BBB-'/'F3' assuming a stable standalone credit risk profile.
Conversely, if Fitch concludes that the existing ownership dynamics are expected to remain relatively stable and PLIC and PLC continue to have a high degree of willingness and ability to extend support to ACG in the event of need, Fitch could upgrade ACG by one notch to 'A-'/'F1', which would restore the two notch rating differential in place prior to Fitch's upgrades of PLIC and PLC.
Fitch believes a two notch differential under this scenario would be appropriate because there is a natural limit to the potential strategic alignment and synergy between aircraft leasing and life insurance, particularly relative to bank-owned aircraft lessors that have closer operational and financial synergies with their majority-owned parent companies in Fitch's opinion, and there is a only modest degree of shared branding between the two entities.
The unsecured debt ratings are primarily sensitive to changes in ACG's Long-Term IDR and would be expected to move in tandem. However, a decline in the level of unencumbered asset coverage and/or a material increase in the use of secured debt could result in a widening of the notching between the IDR and the unsecured debt.
ACG's short-term IDR is sensitive to changes in ACG's Long-Term IDR and, by extension, to Fitch's view of institutional support. Should Fitch decide to eliminate institutional support, ACG's short-term IDR would be based on the mapping from its standalone Long-Term IDR taking into account ACG's standalone funding, liquidity and coverage profile.
The CP rating is equalized with the short-term IDR and would be expected to move in tandem.
ACG is a leading global lessor and manager of 483 owned, managed and committed aircraft to approximately 90 airlines in 45 countries. The owned aircraft portfolio totaled $9.4 billion in NBV as of March 31, 2019.
Following today's rating actions, ACG is rated three notches below its majority shareholder, resulting in a rating relationship between the issuer and its majority shareholder, which is not explicitly outlined in the institutional support rating framework in the Non-Bank Financial Institutions Rating Criteria. Fitch views this criteria variation as temporary in nature until such time as the Evolving Rating Outlook can be resolved.
Additional information is available on www.fitchratings.com