Fitch Ratings has downgraded Australian airline Virgin Australia Holdings Limited's (VAH) Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'B-' from 'B+' and placed the rating on Rating Watch Negative (RWN). The action follows the sharp drop in demand in the aviation market due to coronavirus as well as the removal of the one notch of shareholder support included in the rating. The RWN reflects our expectations of increased liquidity pressures over the coming months. The RWN will be resolved as Fitch evaluates the development of the outbreak and VAH's liquidity.

The longer the restrictions remain in place, the larger the impact on VAH. In particular, VAH's liquidity could come under pressure quicker than we previously anticipated should the restrictions on travel be longer than three months or demand remains subdued over the longer term, without the airline obtaining additional liquidity over the coming months. The airline's prompt actions to cut capacity in line with demand and government regulations, as well as taking action on staffing levels, has significantly reduced cash outflows. Nevertheless, a high level of fixed costs will remain over the short term. We understand that the airline has further levers available to it in the near term, such as keeping aircraft grounded for longer, handing back leased aircraft and selling aircraft - although there is some time lag associated with implementing the latter two options. Longer term, the airline can delay or cancel aircraft deliveries to preserve cash.

Fitch has also removed the one-notch uplift in VAH's rating, which previously reflected our expectation that the airline would receive financial support from shareholders, in particular Singapore Airlines (not rated). VAH has stated that it does not expect financial support from shareholders during the ongoing COVID-19 outbreak. Furthermore, Singapore Airlines' recent announcement that it would reduce its capacity by 96% and cut costs indicates that it may not have the financial capacity to provide support to VAH as it seeks to maintain its own liquidity.

The RWN reflects the continued uncertainty over the length of the government restrictions on travel throughout Australia and globally. Fitch does not include any government support in VAH's rating under our methodology. However, we have included the impact of the relief that the Australian Government has provided to the aviation sector so far. The government has announced that it will refund airlines' airport charges from 1 February 2020 for 12 months, which it initially expected would be around AUD720 million in support to the sector, with a payment of around AUD190 million to be received by the airlines in the short term - however, with the fleet groundings , this support package could end up being significantly lower. Still, the government has also stated that it will ensure Australian airlines receive the support they need to manage through this situation and it remains committed to ensuring there are two viable airlines in the country.

KEY RATING DRIVERS

COVID-19-Related Impact: VAH's liquidity stress has been amplified due to the unprecedented travel restrictions both in Australia and globally and commensurate declines in demand as a result of the COVID-19 outbreak. Quarantine measures implemented by various Australian state and territory governments effectively prohibit all non-essential travel between cities in Australia. In response, VAH has suspended international operations and announced on 25 March 2020 that it is reducing its domestic capacity by 90% until mid-June 2020 and is standing down 80% of its workforce until at least the end of May 2020. We expect this to have a significant impact on cash-flow generation in the financial year ending June 2020 (FY20), with negative flow-on effects in FY21 reflecting that a full recovery will take a few months as travel restrictions are lifted and confidence returns.

Coronavirus Assumptions : Fitch now forecasts domestic capacity to be down by 90%, alongside a decline in passenger load factors, for the remainder of FY20, before recovering from August to December 2020, both in terms of capacity being reinstated and load factors recovering towards historical levels. Variable costs associated with grounded aircraft have been removed from profit, with these costs returning in line with the reinstatement of capacity in 1HFY21. As a result, we forecast VAH's leverage to rise to 12.9x by FYE20, before recovering to 7.9x by FYE21 and below 5.0x by FYE22. We currently assume the impact of the outbreak will be temporary and anticipate revenue passenger kilometres (RPK) and available seat kilometres (ASK) to gradually recover to close to our previous estimates.

Liquidity Pressure: Fitch expects VAH to experience significant working capital outflows for the remainder of FY20 as customers seek refunds and forward bookings fall significantly, alongside cash outflows for aircraft rent, staff costs and other charges. As a result, VAH's liquidity could come under pressure and this underscores one notch of our downgrade of VAH's IDR, alongside the removal of one notch in shareholder support. Should the travel restrictions remain in place and demand remains subdued for longer than we currently envisage, and if additional funding is not secured over the next few months, this would lead to further negative rating action.

VAH has taken steps in cutting capacity (including fuel and other costs), staff and salary reductions and implementation of initiatives to further cuts in expenses in its domestic and short-haul businesses and pausing key supplier agreements. These actions, combined with its cash on hand of around AUD1 billion, provides VAH with some headroom to manage through the effective shut down. Once operations normalise, VAH plans to bring back capacity in line with demand recovery and this will be critical in maintaining sufficient liquidity over the remainder of the year

We also note that VAH has further levers available to it that we have not specifically incorporated into our short-term liquidity forecasts, including grounding aircraft for longer, handing back leased aircraft and selling or borrowing against owned aircraft. We believe these measures, which would have a lasting impact and affect VAH's ability to recover, would be VAH's last line of defence. In addition, we have not included any potential further relief from the Australian Government to the aviation sector in our forecasts.

Reset of Strategy: Fitch expects VAH's profitability to improve once its operations normalise, as we believe that the airline will bring back profitable routes and re-align its cost structure to its revenue-base and strategy as it focuses on improving efficiencies. In our view, the airline remains committed to taking necessary actions to achieve these goals - this has been evidenced by the response to the COVID-19 restrictions and statements from the company. The public commitment to these targets supports our view, and we believe that the government relief received, and any future government relief, will increase VAH's accountability to deliver.

Entrenched Position in Australia: VAH's position in the Australian aviation market is supported by the infrastructure it has in place - including strong access to Australian capital city airports, which we understand has been guaranteed for both domestic airlines as their fleets remain grounded. Furthermore, we believe that the Australian Government wants to ensure that Australia has two viable domestic airlines to avoid a monopolistic market. A competitive airlines sector is beneficial to Australia's tourism, and top of mind for the government given that 8% (based on latest government data from 2016-17) of Australia's workforce was employed in the tourism sector. We believe VAH's infrastructure will ensure its entrenched position and provide barriers to entry, limiting any risk of loss of market share to new or existing competitors as a result of the current travel restrictions.

DERIVATION SUMMARY

VAH's rating compares well with that of Public Joint Stock Company Aeroflot - Russian Airlines (Aeroflot, BB/Negative). Aeroflot benefits from its position as Russia's flagship carrier, as well as the diversification of its route network, favourable hub position and competitive cost structure. VAH's business profile is comparable with that of Aeroflot as well. VAH has a strong market position as a result of the structure of the Australian aviation market and the end-of-the-line protection of its main domestic operations.

The main factors underscoring the four-notch differential are Aeroflot's rating benefits from a two-notch uplift under Fitch's Government-Related Entities Rating Criteria, with the remaining two notches attributable to Aeroflot's better business profile due to larger scale and the deterioration of VAH's financial profile - which has led to one of the two-notch downgrade - as it responds to the pandemic.

Latin American peers, GOL Linhas Aereas Inteligentes S.A. (B/RWN) and LATAM Airlines Group S.A. (B+/RWN) have also been downgraded to account for strong cash-flow burn associated with the pandemic. The rating differential with VAH's reflects the stronger liquidity position of the LATAM peers.

KEY ASSUMPTIONS

Fitch's Key Assumptions Within Our Rating Case for the Issuer

- COVID-19-Related Assumptions: Domestic ASK to reduce by 90% and load factors and price to fall in 4QFY20. ASK capacity cuts to reduce during 1HFY21, with load factors and prices to recover towards FY19 levels from August 2020. Domestic ASK to reflect FY19 levels in FY22.

International ASK to reduce by 100% in 4QFYE20. ASK capacity to gradually be replaced in 1HFY21, however, overall ASK to be reinstated to be below historical levels. Load factors and prices to recover to FY19 levels.

Associated cost saves from grounding of aircraft to be achieved, aircraft reinstated in 1HFY21 in line with ASK reinstatements.

- Group capacity to expand by low single digits in FY23 across all group airlines, with group-wide load factors to improve to around 82.5% by FY23.

- Velocity revenue to stabilise in FY21 and increase by 5% to 10% a year from FY22 to FY23.

- Jet fuel requirements to move in line with changes in ASK. Prices are based on Gulf Coast Jet Fuel Platts swap prices from September 2019 to February 2023.

- VAH to realise guided annual AUD75 million in employee cost savings and other supplier savings by FYE21.

- Capex of AUD400 million in FY20, AUD326 million in FY21, AUD517 million in FY22 and AUD650 million in FY23.

RATING SENSITIVITIES

Developments That May, Individually or Collectively, Lead to Positive Rating Action

- If VAH is able to improve liquidity through additional funding, then we may look to review the rating watch.

Developments That May, Individually or Collectively, Lead to Negative Rating Action

- If VAH is unable to obtain additional liquidity support over the next three months, we may look to downgrade the IDR.

LIQUIDITY AND DEBT STRUCTURE

Liquidity Pressures: Fitch expects free cash flow to be negative in FY20 and FY21 and put liquidity under pressure as it responds to the COVID-19-related disruption. We believe that actions taken so far to reduce cash outflows, in particular the prompt grounding of fleet, has given VAH additional time to manage through the situation. However, liquidity will increasingly come under pressure the longer travel restrictions remain in place and VAH's access to additional funding over the coming months will remain crucial to its ongoing viability.

VAH reported unrestricted cash of AUD900 million and had AUD166 million in undrawn committed facilities at end-1HFY20. The airline's next significant debt maturity is a USD350 million facility in October 2021. The airline has aeronautical finance facilities in place; however, we understand that VAH has limited unencumbered assets against which it can raise further secured debt to shore up liquidity.

ESG CONSIDERATIONS

ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies).  For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.