Fitch Ratings-Chicago-13 April 2018: Fitch Ratings has affirmed Air Canada's (AC) Issuer Default Rating at 'BB-' and revised its Rating Outlook to Positive from Stable. Fitch has also upgraded its ratings on Air Canada's series 2015-1 class B certificates to 'BB+' from 'BB' and affirmed its existing ratings on the other tranches of the series 2017-1, 2015-1 and 2013-1 pass through trust certificates. A full list of ratings follows at the end of this release.
The Positive Rating Outlook is supported by Fitch's expectations that Air Canada's credit metrics will continue to improve over the intermediate term as company management focuses on reducing leverage and growing operating margins. The outlook also incorporates expectations for improving FCF generation as Air Canada's capital spending declines following peak levels seen in 2016 and 2017, reflecting fewer scheduled deliveries of high dollar-value widebody aircraft. The prospect for higher ratings also reflects the improvements made in Air Canada's cost structure in recent years and prospects for manageable unit cost pressures through Fitch's forecast period.
Fitch's primary concerns include fuel prices that rose quickly in the back half of 2017, which Fitch believes may pressure margins in the near term. The competitive environment in Canada may also present longer-term headwinds particularly as ultra-low cost carriers look to grow into the Canadian market. Other concerns are typical for the airline industry and include the possibility of rising fuel prices, cyclicality, high operating leverage, and exposure to exogenous shocks.
KEY RATING DRIVERS
Fitch expects operating margins on average over the next few years to be roughly around levels generated in 2017. AC produced an EBIT margin of 8.6% in 2017, down from 9.8% in 2016, but still well above the levels that the company produced in the 2010-2014 time period. Fitch expects margins to be pressured in 2018 by higher fuel costs, but margins should rebound over time as AC gets the benefit of flying its more efficient and dense 737 MAXs, the first of which were delivered in the second half of 2017. Air Canada has also set a goal of maintaining EBITDAR margins of between 17%-20% between 2018 and 2020.
Unit Cost Improvement
Air Canada's CASM ex-fuel was down by 3% in 2017 reflecting the benefits of the cost initiatives taken over the past several years as well as the effects of growing ASMs and stage-lengths as AC has focused on international growth. Fitch calculates that AC's ex-fuel CASM for 2017 was down by nearly 10% compared to 2010 levels, at a time when much of the industry has been contending with labor and other cost pressures leading to broadly increasing unit costs.
Fitch expects ex-fuel unit costs to remain roughly flat in 2018. The company stands to benefit from its new aircraft and from continued growth, but will face near-term headwinds from things like start-up costs related to its new loyalty program, new uniforms, investments in customer service, investments in technology, pilot training for the company's new 737 MAXs, etc. Fitch views Air Canada's cost cutting efforts as a credit positive, but it is worth noting that AC will continue to operate at a cost disadvantage to its U.S. peers for the foreseeable future, partially due to higher airport costs in Canada versus the U.S.
Competitive Operating Environment
Several start-up ultra-low cost carriers (ULCCs) have either launched service or are intending to begin serving the Canadian market. Air Canada's status as the dominant carrier in what is essentially a duopolistic market (between AC and the much smaller WestJet) is an important factor to its credit profile, and the entrance of new competition could pressure results over the longer term. Although it is too early to predict the magnitude of any impact that ULCCs may have on AC, Fitch is not overly concerned at this time. Fitch believes that Air Canada has an effective means to compete through its Rouge operations (AC's low cost brand). We also believe that new entrants may have a difficult time in Canada since both incumbent airlines are financially healthy and are expected to compete vigorously with any new airlines.
WestJet's plans to launch its own ULCC and to grow its international operations may present bigger risks to Air Canada than any new entrants. WestJet plans to launch a ULCC branded as Swoop by the summer of 2018 using 10 high-density 737-800s to offer low-cost domestic service. WestJet will also receive 10 787-9s between 2019 and 2021 that will be used to expand its currently limited international presence. WestJet is a financially healthy company that has proven to be a tough competitor as it has grown rapidly within Canada in recent years. Fitch believes that WestJet's newest expansion plans could contribute to a tough competitive environment over the intermediate-to-long term.
Financial Targets are Rating Positive
Air Canada has established an adjusted net leverage target of 1.2x that it plans to achieve by 2020. Fitch believes that Air Canada's target is achievable, and views the company's commitment to lower leverage to be a notable credit positive. Fitch's base case forecast anticipates that total adjusted gross debt/EBITDAR will decline to 2.8x by year-end 2020 (note that Fitch concentrates on gross adjusted leverage and uses an 8x multiple to capitalize operating leases, whereas Air Canada focuses on net leverage using a 7x multiple). Air Canada reduced its adjusted debt/EBITDAR to 3.7x as of Dec. 31, 2017, down from over 5x where it stood between 2010-2013. The company's total on-balance sheet debt decreased by CAD603 million in 2017 due primarily to the effect of a stronger Canadian Dollar on the company's USD denominated debt along with a modest reduction in debt on the balance sheet driven by scheduled amortization.
Fitch expects FCF to turn solidly positive beyond 2018 as capital spending comes down from elevated levels seen in 2016 and 2017. Expected improvement in FCF is particularly meaningful as it is expected to be sustainable despite continued and material spending on aircraft as Air Canada works to refresh its narrowbody fleet. While spending will be down from peak levels, Fitch expects capital spending to remain around 8%-10% as a percentage of revenue. Fitch expects FCF to be roughly neutral in 2018 compared to FCF of CAD$316 million that AC generated in 2017, as moderately lower capex is offset by higher fuel costs. Air Canada's financial targets include cumulative positive FCF of CAD2 billion-CAD3 billion over the 2018-2020 time period.
Fitch's has reviewed Air Canada's EETC ratings concurrent with the review of Air Canada's corporate IDR. All existing EETC ratings have been affirmed aside from the AC 2015-1 class C certificates, which were upgraded to 'BB+' from 'BB'. The affirmation of class AA and A certificates reflects Fitch's top-down methodology, which relies primarily on collateral value and where the credit quality of the airline is a secondary factor.
The Air Canada 2013-1, 2015-1, and 2017-1 class A certificates remain sufficiently overcollateralized to pass Fitch's 'A' level stress tests and the 2017-1 AA certificates continues to pass our 'AA' level test when incorporating the latest available aircraft appraisal data. This suggests that senior tranche debt holders would be expected to achieve full principal recovery prior to the expiration of the transaction's liquidity facility even in a harsh downturn scenario. Levels of overcollateralization have remained sizeable for these transactions as appraised values for 777-300ERs (for 2013-1), 787-s and 787-9s (for 2015-1 and 2017-1) and 737 MAX 8s (2017-1) have held up well over the past year. Stressed loan-to-value ratios remain in the high 70% to mid 80% range for senior tranches in all three transactions representing some of the higher levels of overcollateralization in Fitch's rated universe of EETCs.
The upgrade of the 2015-1 class C certificates reflects an improvement in Fitch's recovery expectations in a downturn for those certificates driven by scheduled principal amortization of the senior tranches and by steady values for the underlying 787s in the collateral pool. Fitch rates subordinated tranches of EETC transactions by notching up from the underlying corporate rating based on three factors; 1) the likelihood of affirmation, 2) the presence of lack of a liquidity facility, and 3) recovery expectations. The 'BB+' rating represents a two notch uplift from Air Canada's IDR of 'BB+' consisting of two notches for the likelihood of affirmation. Fitch previously applied a one notch downward adjustment to the C certificates based on weaker recovery prospects. Based on updated appraisal data, Fitch now expects the class C certificates to retain adequate recover prospects through to maturity even in a stress scenario.
There has been no change to Fitch's view of the strategic importance of these pools of aircraft to Air Canada's fleet and therefore no change to our view that the subordinated tranche ratings are supported by high affirmation factors (i.e. the likelihood that the collateral aircraft would be affirmed in a potential bankruptcy scenario).
Air Canada's 'BB-' rating is in-line with American Airlines and is one notch below United Airlines and JetBlue. Fitch calculates Air Canada's adjusted debt/EBITDAR at 3.7x at year-end 2017, which is comparable to United (3.9x) and is better than American's (4.9x). JetBlue's 'BB' rating reflects healthier credit metrics compared to both United and Air Canada, which is partially offset by JBLU's more limited route network and a degree of concentration along the East Coast. AC has historically underperformed both United and American in terms of operating margins. Air Canada is at a structural cost disadvantage partially due to the higher cost of operating out of Canadian airports. Fitch views Air Canada's ratings trajectory as being favourable to American's due to AC's more conservative financial policies and its publicly stated goals to reduce leverage over the next several years.
The 'AA' rating on 2017-1 class AA certificates is in line with Fitch's ratings on recent senior classes of EETCs issued by United and American. Fitch believes that this transaction compares well to recent precedents. LTVs for the class AA certificates in this transaction are slightly lower than those seen in other transactions rated at 'AA', and the quality of the underlying collateral pool is as good or better. The same holds true for the 'A' rating on the class A certificates in all three transactions.
The 'BBB' rating on the 2017-1 and 2015-1 class B certificates is in line with Fitch's ratings on several existing American Airlines class B certificates. Both Air Canada and American Airlines have corporate credit ratings of 'BB-', and Fitch considers the affirmation factor and recovery prospects for the AC 2017-1 and 2015-1 transactions to be comparable to those seen in the recent American transactions. The 'BBB-' rating on the 2013-1 transaction reflects lower recovery prospects and a qualitatively weaker collateral pool (777-300ERs compared to 787s and 737 MAXs).
The 'BB' and 'BB+' ratings on the Air Canada 2013-1 and 2015-1 class C certificates compare favourably to similar C tranches in legacy US Airways transactions, which were rated at 'BB-' due to better recovery prospects and a higher affirmation factor for the Air Canada C tranches.
Fitch's Key Assumptions Within Our Rating Case for the Issuer Include:
--Continued moderate growth in demand for air travel through the forecast period.
--Fuel prices remaining in the low-to-mid $60/barrel range through the forecast.
--Air Canada's capacity growth slows to 7% in 2018 and to the mid-single-digits annually thereafter.
Developments That May, Individually or Collectively, Lead to Positive Rating Action
--Sustained adjusted debt/EBITDAR around 3.5x;
--FFO fixed charge coverage sustained above 3x-3.5x
--EBITDAR margins sustained above 15%, EBIT margins above 10%;
--Neutral or positive FCF generation over the intermediate term.
Developments That May, Individually or Collectively, Lead to Negative Rating Action
--Weaker than expected margin performance or higher than expected borrowing causing leverage to reach or exceed 4.5x;
--FFO fixed charge coverage around or below 2.5x;
--Weaker than expected financial performance causing free cash flow to be notably below Fitch's expectations;
--A decline in the company's EBIT margin to the low-single-digits, EBITDAR margins into the high-single-digits.
As of year-end 2017, total liquidity was CAD3,804 million, which consisted of CAD642 million in cash and equivalents, CAD3,162 million in short-term investments plus CAD377 million available on AC's revolvers. Total liquidity as a percentage of LTM revenue was 26%, which Fitch considers more than adequate for the rating. Debt maturities range between CAD531 million and CAD869 million between 2018 and 2021. Debt maturities are manageable considering Air Canada's current liquidity balance and Fitch's expectation for the company to generate cash flow from operations over the ratings horizon. AC's financial flexibility is also supported by a solid liquidity balance, a growing base of unencumbered assets, and the fact that upcoming capital expenditures consist of highly financeable aircraft.
Air Canada's debt structure primarily consists of aircraft secured financings which include EETCs, JOLCO financings, and bank debt. The bulk of Air Canada's aircraft debt is denominated in U.S. dollars, with smaller amounts being denominated in Canadian dollars and Japanese yen. The company also maintains a USD1.1 billion credit facility which consists of an USD800 million term loan and a USD300 million revolver. The facility is secured by certain real estate, ground service equipment, airport slots and leaseholds, and the routes rights and slots associated with the company's Pacific business. The company also has USD400 million in senior unsecured notes that mature in 2021.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
--Long-Term IDR at 'BB-';
--Senior secured term loan B at 'BB+/RR1';
--Senior secured revolving credit facility at 'BB+/RR1';
--Senior secured notes at 'BB+/RR1';
--Senior unsecured debt at 'BB-/RR4'.
The Rating Outlook for Air Canada has been revised to Positive from Stable.
Air Canada Pass Through Trust Series 2017-1
--2017-1 class AA certificates due 2030 at 'AA';
--2017-1 class A certificates due 2030 at 'A';
--2017-1 class B certificates due 2026 at 'BBB'.
Air Canada Pass Through Trust Series 2015-1
--2015-1 class A certificates due 2027 at 'A';
--2015-1 class B certificates due 2023 at 'BBB';
Air Canada Pass Through Trust 2013-1 Pass Through Trust
--2013-1 class A certificates due 2025 at 'A';
--2013-1 class B certificates due 2021 at 'BBB-';
--2013-1 class C certificates due 2018 at 'BB'.
Fitch has also upgraded the following rating.
Air Canada Pass Through Trust Series 2015-1
--2015-1 class C certificates due 2020 to 'BB+' from 'BB'.