Lufthansa issuer rating affirmed at BBB-, Outlook Negative, following provision of state aid
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Rating action
Scope Ratings has today affirmed the issuer credit rating of Deutsche Lufthansa at BBB- and assigned an Outlook of Negative. Senior unsecured debt was affirmed at BBB- and junior subordinated debt was affirmed at BB. The short-term rating of S-3 was also affirmed. These rating actions resolve the review for a possible downgrade from the last rating action dated 31 March 2020.
Rating rationale
The rating actions follow the provision of state aid by the German Federal Economic Stabilisation Fund (‘WSF’) and the approval of the state aid by Lufthansa shareholders and the European Commission. This has affected two areas: i) the financial risk profile, notably the liquidity assessment; and ii) supplementary rating drivers, leading to a two-notch uplift of Lufthansa’s standalone credit quality.
Scope has updated Lufthansa’s financial forecasts for 2020 and 2021. The base case for a gradual in-fleeting of grounded aircraft remains unchanged. According to Lufthansa’s plans, 90% of originally planned short-haul connections and 70% of long-haul connections will be served via its new flight schedule by September 2020. This should lead to a gradual increase in revenues from the passenger business. In view of the significant decline in air travel worldwide, Scope has lowered the forecasted revenue contributions of Lufthansa Technik and the catering business. The cargo business should remain resilient given that most belly-space capacity from passenger aircraft is unavailable to the market, leading to higher freight rates.
Scope expects a negative EBITDA for 2020. Free operating cash flow in 2020 is forecast to be negative at around EUR 5.5bn-6.0bn, though the magnitude will depend on the repayment of unused flight documents. Scope forecasts capital expenditures in 2020 of less than EUR 2.0bn. The state aid provided by WSF is enabling Lufthansa to bridge the cash flow shortfall from ongoing operations.
The financial risk profile assessment places more emphasis on 2021 and continues to assume a normalisation of flight traffic in 2020. Cost-cutting measures initiated by Lufthansa combined with lower jet fuel prices should feed into operating earnings in 2021. Currently, Scope forecasts EBITDA of about of EUR 2.5bn and capex of below EUR 2.0bn for 2021. With a gradual resumption of flight operations, Lufthansa should see higher cash inflow from advance ticket purchases in 2021. At this stage, the Scope-adjusted debt/EBITDA ratio is expected at around 5x and funds from operations/Scope-adjusted debt at around 15% for 2021, with gradual improvements thereafter due to cash inflow from ongoing operations and no dividend payments. Scope still expects revenues in 2021 to be around 30% lower than in 2019, i.e. before the coronavirus pandemic broke out.
The silent capital contribution (‘silent partnership’) from WSF of EUR 5.7bn has been treated as debt in Scope’s financial analysis. While the silent partnership has certain equity characteristics such as an unlimited maturity, subordination and deferrable coupon payments, the criterion of permanence is not satisfied, as Lufthansa is able to repay the silent partnership anytime. In addition, coupon step-ups, from 4% in 2020-2021 to 9.5% by 2027, incentivise early repayment. It is likewise Scope’s understanding that Lufthansa’s management will strive to repay the silent partnership as soon as this is financially feasible. The conversion options for EUR 1.0bn of the silent partnership would only become effective in the event of a takeover attempt and/or if Lufthansa deferred payment on the silent partnership from 2024-2026.
Lufthansa’s business risk profile is unchanged at BBB-, supported by globally diversified operations including the diversified worldwide route network, geographical reach, broad fleet of aircraft and solid position in the premium market for long-haul traffic. The business risk profile is limited by the risks of cyclical changes to discretionary travel that may result from event risks (as is currently the case with the pandemic), the fiercely competitive environment, and high operating leverage.
Lufthansa’s liquidity is adequate, thanks to state aid via the EUR 5.7bn silent partnership, the EUR 3.0bn three-year revolving facility and the EUR 300m direct equity injection. These amounts plus available liquidity (EUR 4.3bn as of March 2020) are sufficient to cover short-term debt (EUR 1.6bn as of 31 December 2019) and the negative free operating cash flow forecast for 2020. For 2021, Scope expects free operating cash flow to be positive, supporting the coverage of financial maturities in 2021F in addition to the unrestricted liquidity.
Supplementary rating drivers in terms of parent support result in a two-notch uplift to Lufthansa’s standalone credit quality. While the German government’s EUR 300m direct equity injection has not resulted in majority ownership, reflecting 20% of voting rights and the provision of the non-voting subordinated silent partnership (EUR 5.7bn), Lufthansa remains strategically important to its new key shareholder. This view is based on the government’s ability to convert some of its silent participation into statutory equity in the event of a takeover attempt of Lufthansa, as well as the political goals served in supporting Lufthansa such as the protection of employment.
Outlook
The Outlook is Negative. Visibility on further developments of the pandemic is low. Further, it remains uncertain whether economic deterioration, including via lower leisure and business travel, turns out more severe than that currently forecasted and incorporated in the assigned rating. Risks regarding a re-emergence of travel restrictions and lockdowns as well as uncertainty about the speed of recovery in air travel add further uncertainty.
A negative rating action would be warranted if travel restrictions including travel bans were to derail the expected gradual improvement in Lufthansa’s important passenger business, leading to further funding needs and lower operating profits in 2021 than envisaged currently. A negative rating action would be indicated by Scope-adjusted debt/EBITDA reaching above 4.0x on a sustained basis. Scope deems a withdrawal or weakening of parent support to be a remote scenario.
A positive rating action appears a remote scenario at this stage. Lufthansa is unlikely to deleverage significantly beyond Scope’s forecasts for 2021 unless capital structure measures were taken that reduce the elevated debt levels caused by the funding of negative cash flows in 2020F. A positive change in the Outlook to Stable would be possible if Scope-adjusted debt/EBITDA fell below 3.5x on a sustained basis.
Long-term and short-term debt ratings
The short-term rating is S-3. Senior unsecured debt has been rated BBB- as Scope does not notch upwards senior unsecured debt of issuers with an investment-grade rating. The outstanding hybrid bond, junior subordinated debt, remains rated at BB, two notches below the issuer credit rating.