Fitch Affirms United Airlines at 'BB'; Outlook Stable

Fitch Ratings-Chicago-08 September 2017: Fitch Ratings has affirmed the Issuer Default Rating (IDR) for United Continental Holdings, Inc. (UAL) and its airline operating subsidiary, United Airlines, Inc. at 'BB'. The Ratings Outlook is Stable. Fitch has also affirmed the ratings for United's outstanding enhanced equipment trust certificates (EETCs). A full list of rating actions is shown at the end of this release.

The ratings affirmation reflects financial performance at United that marginally underperformed Fitch's expectations over the past year, and Fitch's forecast that credit metrics are likely to deteriorate marginally in the short-term before improving beyond 2017. Weaker metrics reflect higher operating costs, fuel expenses, and a soft unit revenue environment. Nevertheless, Fitch's expectations for medium term adjusted leverage metrics in the mid-to-high 3x range, EBITDAR margins sustained around 20%, and prospects for improving free cash flow (FCF) are all supportive of the 'BB' rating. Fitch believes that United's ratings could move higher over the longer term should it improve operating margins compared to peers, demonstrate consistently positive FCF and maintain adjusted debt/EBITDAR in the low 3x range.

KEY RATING DRIVERS

Weaker Margins in 2017: Fitch expects United's operating margins to be down materially in 2017 as labor and fuel expenses increase amid the lingering soft unit revenue environment. Margin degradation was expected in 2017 after two particularly good years in 2015 and 2016, though actual results may come in slightly below prior expectations. Fitch's current forecasts includes EBIT margins in 2017 that are down more than 500 basis points from the 13.6% that United posted in 2016, though the impact of Hurricane Harvey could lead to a more material decline. Beyond 2017, Fitch expects margins to improve as UAL moves beyond the increases in labor expense that it is experiencing this year and as the company sees the full effects of its basic economy initiative and cost savings efforts. UAL is also building regional connectivity through some of its hubs and re-banking others, which may provide near-term margin benefits.

Higher Near-term Debt: Debt financing of aircraft deliveries will push United's total debt and leverage higher at least through 2017. Higher on-balance sheet debt will be partially offset by lower capitalized rent expenses as the company has recently purchased some aircraft off of lease. In total, Fitch expects United to end 2017 with an adjusted debt/EBITDAR ratio just below 4x, up from 3x at the end of 2016. Leverage should trend towards or below 3.5x over the next several years after United moves beyond this year of particularly heavy capital spending.

Hurricane Harvey Impact: Houston represents United's second largest hub, meaning that United had greater exposure to the damage caused by Hurricane Harvey than other major airlines. Longer-term impact is uncertain at this time as the extent of the damage is still being assessed, but Fitch does not expect this event to materially affect United's credit profile at this time. Given the size and importance of the Houston economy, Fitch expects business travel to the area to rebound, though potential future growth could be impacted. United estimates that the storm will have a 150 basis point impact on unit revenues in the third quarter.

Improving Operational Performance: United's efforts to improve its operational performance are proving effective. Achieving better operational performance has been a key focus of United's new management team over the past one to two years. The company has reported better on-time arrival rates and significantly decreased mishandled bags. Cancellations accounted for 0.58% of mainline flights through the first six months of the year, down from as high as nearly 1.5% in 2014. These improvements represent good strides towards catching up with Delta, which has led the way in operational performance over the past several years. Running a smoother operation can have some cost headwinds in the form of increased block times, but these can be offset by lower costs related to cancelled flights, mishandled bags, and the benefits of more satisfied travellers.

Uncertain Unit Revenue Environment: Unit revenues for U.S. air carriers have been persistently weak for more than two years. The environment began to improve in the back half of 2016, but continued heavy competition is keeping a lid on any material unit revenue growth this year. Most carriers are anticipating low single digit growth in the third quarter. United expects PRASM to be down by 3%-5%, lower than its primary competitors as it struggles with the impacts of Hurricane Harvey, heavy competition, and weaker demand in the Pacific region. Fitch's forecast includes flat-to-slightly down unit revenues for full year 2017 though that number is subject to revision based on the impact of Hurricane Harvey and the persistence of the current competitive pricing environment. Beyond 2017, unit revenues should benefit from various initiatives such as changing its revenue management practices and achieving the full potential of its basic economy product.

Above Average Capacity Growth: United expects to grow available seat miles (ASMs) by 2.5%-3.5% in 2017 compared to around 1.5% at American and 1% at Delta. Domestic flying will grow the fastest, particularly as United adds frequencies into smaller markets in an effort to increase connectivity at its hubs to attract profitable connecting passengers, and as it continues to upgauge away from small regional jet flying. Fitch does not view the capacity increase as a concern as it represents a rational effort to increase the competitiveness of its hubs. United also reports that much of its new flying is expected to be margin accretive in the near term.

FCF to Improve Beyond 2017: Fitch expects United's FCF to turn negative in 2017 to more than $1 billion due to a high level of capital spending along with cash outflows related to usage of airline miles purchased in advance. FCF should improve towards or above $1 billion in 2018 and remain positive thereafter as capital spending declines. United plans to spend between $4.6 billion and $4.8 billion in capex in 2017, and around a billion less than that in 2018. Heavy capital spending this year reflects a large number of widebody aircraft deliveries, higher pre-delivery payments for aircraft, and increased spending on technology infrastructure.

KEY RATING DRIVERS FOR EETCs

Fitch's senior EETC tranche ratings are primarily based on a top-down analysis of the level of overcollateralization (OC) featured in each transaction. Fitch's stress analysis uses an approach assuming the rejection of the entire pool of aircraft in a severe global aviation downturn. The stress scenario incorporates a full draw on the liquidity facility, an assumed 5% repossession/remarketing cost, and various stresses to the value of the collateral.

Based on updated appraisal information incorporated into Fitch's analysis, the level of OC in each of these transactions has decreased slightly over the past year. Each of these transactions continues to pass Fitch's 'A' category stress test, while the UAL 2016-2 and 2016-1 'AA' certificates continue to pass Fitch's 'AA' stress test by a healthy margin. Certain transactions including Continental 2012-2 and United 2013-1 maintain limited headroom within Fitch's 'A' category stress tests as underlying collateral values for the 737-900ER have depreciated by more than Fitch's expectations over the past several years, making those transactions more vulnerable to potential future downgrades.

The B and C tranche ratings are notched from the 'BB' IDR of the underlying airline. The B tranches rated at 'BBB' reflect a two notch uplift based on a high affirmation factor (Fitch's judgment on the likelihood that United would affirm the pool of aircraft in a potential bankruptcy) and a one notch uplift for the presence of a liquidity facility.

DERIVATION SUMMARY

United's 'BB' rating is in between the ratings of its two major network rivals, Delta Air Lines ('BBB-') and American Airlines (BB-). The ratings distinction between the three airlines is reflective of the financial strategies adopted by each airline. For instance, following its merger with Northwest Airlines, Delta aggressively de-leveraged its balance sheet and now maintains a leverage ratio of 2.1x, compared to 3.4x for United. American Airlines on the other hand, has adopted a more aggressive financial policy, borrowing heavily to finance new aircraft deliveries while simultaneously sending material amounts of cash to shareholders via share repurchases. As such, American's debt levels have risen since it exited bankruptcy and it now maintains an adjusted leverage metric of 4.7x. The 'BB' category ratings for both United and American reflect material improvements to financial metrics in the years since the 2008/2009 recession when they were rated 'B' or lower. For instance, UAL posted an EBIT margin of 11.8% for the latest 12 months (LTM) period ended June 30, 2017, up from an average of 5.9% for the period between 2010-2013. JetBlue is rated one notch below United despite having better headline financial metrics (leverage, FCF, operating margins), with the rating differential explained in part by the difference in size and scale of the two carriers.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

--Capacity growth of 3% in 2017 followed by low single digit annual capacity growth thereafter;
--Continued moderate economic growth for the U.S. over the near term, translating to stable demand for air travel;
--Jet fuel prices equating to around $55/barrel on average for 2017, increasing to around $65/barrel by 2020;
--Moderately declining RASM in 2017 followed by modest annual growth thereafter.

RATING SENSITIVITIES

Future Developments That May, Individually or Collectively, Lead to Positive Rating Action
--Adjusted debt/EBITDAR sustained around 3.0x;
--Funds from operations (FFO) fixed charge sustained above 3.5x;
--FCF as a percentage of revenue sustained in the mid-single digits;
--Continued improvements in United's operational performance;
--Evidence of improving unit revenues.

Future Developments That May, Individually or Collectively, Lead to Negative Rating Action
--Adjusted debt/EBITDAR sustained above 4x;
--EBITDAR margins deteriorating into the low double digit range;
--Persistently negative or negligible FCF.

LIQUIDITY

Sufficient Liquidity: As of June 30, 2017, United maintained approximately $6.7 billion in total liquidity including full availability under its $2 billion revolver. Liquidity as a percentage of LTM revenue was 17.8%, which is considered adequate for the ratings particularly given Fitch's expectations that UAL will generate significant cash flow from operations over the next several years. Expected cash flow from operations along with the ability to finance a significant portion of airline capital expenditures should provide United with sufficient liquidity to cover near-term needs, including upcoming debt maturities. The company also maintains a sizeable and growing base of unencumbered assets that can be tapped to raise funds if needed in the case of a downturn.

Maturities of long-term debt and capital leases total roughly $448 million for the rest of 2017, $1.6 billion in 2018 and $1.1 billion in 2019. Fitch considers United's debt maturities to be manageable given its current liquidity balance, expectations for the company to turn FCF positive in 2018 and the flexibility afforded by the company's share repurchase program.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:
United Continental Holdings, Inc.
--IDR at 'BB'
-- Senior unsecured rating at 'BB/RR4'.

United Airlines, Inc.
--IDR at 'BB'
-- Secured bank credit facility at 'BB+/RR1'.

United Airlines Pass Through Trust Series 2016-2
--Class AA Certificates at 'AA';
--Class A Certificates at 'A'.

United Airlines Pass Through Trust Series 2016-1
--Class AA Certificates at 'AA';
--Class A Certificates at 'A'.

United Airlines Pass Through Trust Series 2014-2
--Class A Certificates at 'A';
--Class B Certificates at 'BBB'.

United Airlines Pass Through Trust Series 2014-1
--Class A Certificates at 'A';
--Class B Certificates at 'BBB'.

United Airlines Pass Through Trust Series 2013-1
--Class A Certificates at 'A';
--Class B Certificates at 'BBB'.

Continental Airlines Pass Through Trust Series 2012-2
--Class A Certificates at 'A';
--Class B Certificates at 'BBB'.

Continental Airlines Pass Through Trust Series 2012-3
--Class C Certificates at 'BB+'.