NEW YORK--(BUSINESS WIRE)--
Fitch Ratings has assigned an initial Issuer Default Rating (IDR) of 'B' to Air Canada (AC). The ratings apply to $1.1 billion of outstanding debt. A full list of ratings actions follows at the end of the release. The Rating Outlook is Positive.
AC's IDR reflects the company's leveraged balance sheet, adequate liquidity position and high, but improving cost structure mitigated by AC's extensive global network and dominant market positions across all segments. With C$12.1 billion in revenues, a fleet of 351 aircraft (in conjunction with its regional partners), AC ranks as the 15th largest airline in the world, carrying 35 million passengers to 178 destinations across Canada, U.S.A. and around the world. AC has exclusive route rights to several international markets as Canada's flag carrier and benefits from limited proliferation of Gulf carriers at its primary hubs Toronto, Montreal and Vancouver, which represent strong international gateways to Canada as well as the U.S. via sixth-freedom traffic. AC is one of the five founding members of Star Alliance, currently the largest global alliance which further expands its international network. Fitch's rating also takes into consideration AC's dominant market positions in its domestic (55% market share) and U.S. transborder (35% market share) segments, as well as mounting competitive pressures in those markets. Fitch views the duopoly construct of the Canadian airline industry as a positive ratings factor for AC but also acknowledges that the company faces a formidable rival in WestJet (WJET), one of the strongest operators in North America.
KEY RATING DRIVERS
After a challenging year, AC entered 2013 with a renewed business and financial strategy. Although AC commands a revenue premium relative to peers, it also has the highest cost structure amongst North American carriers, making it difficult to compete with low-cost carrier WJET on the domestic and transborder markets. However, management has made significant strides in addressing the issues that typically plague a legacy carrier, including new labor agreements and extension of pension relief. AC's entry into the EETC market is also expected to shore up liquidity as the company enters a heavy fleet investment period. The stage has been set for major transformation at Canada's largest airline, but much work remains to propel AC to stable and sustainable profitability levels, which will be the primary driver of further ratings momentum.
New Pilot Contract Provides Much Needed Flexibility and Improved Cost Structure
AC has been addressing its legacy cost structure since the credit-crisis, exceeding its C$530 million target in annual run-rate savings from its 2009 cost reduction program by year-end 2011. However, it was the arbitrated collective bargaining agreement with its pilot union in July 2012 that finally gave AC the operational flexibility it needs to structurally lower its cost base. The new five-year contract includes compensation, benefits and profit-sharing in-line with North American industry standards, but also provides a reduction in pension benefits (amounting to C$1.1 billion when combined with other unions and non-unionized employees and management) and significant fleet flexibility. AC now has the ability to transfer smaller, uneconomical aircraft from its mainline to regional partners, such as the fifteen EMB 175s being assigned to Sky Regional (with three transferred to-date). Importantly, the new pilot contract enables AC to form rouge, a new low-cost subsidiary targeted for leisure markets. Rouge will enable AC to optimize fleet costs with its mainline operations, use a lower cost model to serve the leisure segment and overall leverage opportunities to transform AC into a more cost-competitive carrier. AC is also implementing several other initiatives to improve operating efficiency including improving aircraft productivity and fuel consumption (turnaround times, use of ground power etc.) and lower operating expenses related to call centers and maintenance. The March 2012 liquidation of Aveos, which was AC's sole maintenance provider, gave AC an opportunity to sign new agreements on a cost competitive basis with new maintenance system providers.
Reduction in Pension Benefit and Extension of Pension Relief
AC's new labor contracts with all five major unions and the recent agreement with the government on the extension are expected to alleviate the company's pension burden. Although defined- benefit (DB) plans are frozen to new hires that enroll in defined-contribution or hybrid pension plans, the company's past funding obligations remain substantial with an underfunded deficit of C$4.2 billion reflecting a funded status of 72.5% as of Jan. 1, 2012. The next required valuation later this year is expected to reduce the deficit amount to approximately C$3.7 billion as the 14% return on plan assets in 2012 offsets the increase from lower discount rates. Furthermore, once AC receives regulatory approval of the C$1.1 billion benefit reduction from new labor contracts, AC's the pension liability is expected to further decline to C$2.6 billion.
In March 2013, the government also agreed to an extension of the 2009 pension relief which was set to expire next year. This extension continues to cap AC's current deficit funding for an additional seven years (until January 2021). The agreement with the government still requires AC to fund its DB plans but the minimum cash contribution of C$150 million (capped at C$200 million) is more manageable as AC enters a heavy fleet investment period over the next couple of years. Without this extension Fitch estimates AC's annual cash contribution would have increased to about C$500 million even with the expected reduction in pension deficit. Like most underfunded DB plans, AC's pension obligations are highly sensitive to interest rates. For perspective, a 1% increase in the discount rate results in a C$1.8 billion decrease in liability, while a 1% decrease results in a C$2.3 billion increase, based on the most recent valuation.
Mounting Competitive Pressure in Domestic/Transborder Markets
AC's overall traffic performance has been healthy evidenced in the steady increase in load factors, currently in the low-80% range, similar to U.S. peers, as well as yields. AC's industry leading premium product and level of service have also supported AC's unit revenue gains in the premium category. On the international front, AC continues to benefit from its extensive route structure which supports travel to and from Canada as well sixth-freedom traffic. As a result, AC has demonstrated consistent revenue growth across all segments over the last five years.
DOMESTIC AND U.S. TRANSBORDER: Year-to-date traffic stats still point to a healthy operating environment for AC. However, Fitch anticipates AC to be challenged in defending its dominant positions in its core domestic and U.S. transborder markets as competition intensifies with WestJet later this year. WJET plans to expand into AC's turf with the launch of its new regional airline 'Encore' for express service in Canada and the U.S. in the second-half, and is also growing in the eastern triangle with expanded service and cabins reconfigured with premium economy to attract AC's corporate travelers. In response, AC is also enhancing its domestic schedule especially to Western Canada and realigning fleet for gauge optimization, to better compete with WJET in core markets.
Still, Fitch expects the new capacity coming online in the second-half to pressure AC's domestic and U.S. transborder segments later this year. Fitch's base case forecast assumes a decline in the transborder revenues this year reflecting continued pressure on yields against a backdrop of relatively low load factors (in the high-70%). Fitch expects the impact on domestic yields to be less acute as the planned 2.6% increase in ASMs, based on capacity guidance from AC and WestJet could still be supportive of a healthy operating environment as long as demand remains stable.
Outlook For International Solid Despite Execution Risk
The outlook for the international segment remains solid underpinned by AC's extensive network including Star Alliance partners and exclusive route rights to several destinations and continued growth in sixth-freedom traffic up 20% in 2012 and 150% since 2009. AC is focused on expanding its share of international markets with several initiatives for its mainline operations and is also planning to launch rouge, a new low-cost subsidiary targeted for leisure markets.
MAINLINE: For its mainline, AC is enhancing its service offerings by revamping its widebody fleet and expanding in Asia. The company plans to add five new 777-300ERs by February next year, and induct the 787s starting next year to replace older 767s which are being transferred to rouge. In addition to the fuel and operating efficiency, AC's new widebody fleet will feature a new cabin configuration with industry leading on-board products that are also expected to enhance the revenue potential of these ships. The new aircraft will feature three classes of service including Executive First, a new Premium Economy cabin and Economy in 36/24/298 layout for a total of 458 seats, which is 109 more than the standard configuration, or about 40% more seats than what other full-service carriers typically offer. Premium economy typically generates 1.5x more revenues than standard economy without utilizing too much space. AC also has made significant investments to improve the on-board product including full lie-flat beds in First Class, in-seat audio/video, and power ports in all cabins. Other investments include an enhancements to its frequent-flier program (Altitude), Maple Leaf lounges and mobile-friendly booking and check-in process.
ROUGE: AC expects to commence service with rouge in July 2013 with two 767-300ERs and two A319s that are being transferred from mainline with reconfigured all economy cabins. With rouge management's strategy envisions servicing leisure destinations in Europe and the Caribbean sun markets, that are either currently underserved, or do not generate adequate profitability with AC's existing cost structure. Rouge will be formed as a separate company with its own operating certificate, labor contracts and dedicated management team as part of AC's integrated leisure group including AC's tour operator business.
Fitch is somewhat concerned about this initiative as the concept of starting an airline within an airline has failed for North American carriers, including AC (Tango in 2001 and Zip in 2002). However, with rouge, AC management is looking to replicate Qantas and Jetstar, which are part of a successful two-brand strategy with Qantas competing in the premium business market and Jetstar focusing on leisure markets in Australia. Like AC, Qantas is a large airline burdened with legacy costs, residing in a home market that is vast in territory but light in population. Australia also resembles Canada in that both are high-income economies rich in natural resources, home to many immigrants and influenced by a stable currency.
The execution risk is mitigated by rouge's experienced leadership at the helm, and the business plan which includes several of the key factors that made Qantas successful in launching Jetstar. Specifically, similar to JetStar/Qantas, rouge/AC will be an independent operation but with a holistic approach, and feature different brands targeting different customers which limits mainline traffic cannibalization. Importantly rouge will have separate pilot and crew agreements which enables AC to serve popular leisure destinations at a much lower cost, which was the key ingredient missing in previous efforts by AC and U.S. carriers. With a fleet of 10 aircraft by year-end 2013, rouge will provide immediate international growth opportunities at a higher margin while AC awaits the arrival of its 787s in 2014 which is expected to further enhance AC's international growth plans for its mainline operations, along with its 777 fleet. Over time, depending on demand, Rouge may operate up to 20 767-300ERs and 30 A319s, for a total of 50 aircraft.
Overall, Fitch views AC's strategic focus on international routes as a positive ratings factor as they offer higher revenue potential and play to the carrier's strength given its extensive route structure, as long as management can execute on rouge as planned.
Operating Earnings Expected to Improve
AC is moving in the right direction with regards to lowering its legacy costs, but the competitive and demand environment will ultimately dictate whether AC can leverage a lower cost base to drive higher profitability. WJET has clear intentions on competing with price, but if the demand environment remains strong, the impact on yields would not be as severe as Fitch's base case projections. Fitch also expects the unit cost differential between AC and WJET, which used to be substantial at roughly 50%, to continue to narrow from 29% currently to the high-teens going forward. While this cost-convergence (Fitch's fourth 'C') is encouraging for AC's profitability outlook, it still lags the convergence between LCCs and legacy carriers in the U.S. in recent years, and still reflects one of the highest cost structures for North American carriers. The outlook for international remains promising but could have some operational risk with rouge. Taken together, Fitch expects modest increase in operating earnings and profitability this year, but could grow substantially next year if AC is able to successfully execute on its plan, with operating margins approaching mid-single digits.
Adequate Liquidity and Limited Financial Flexibility
AC's total liquidity position has improved since the credit crisis with unrestricted cash maintained at or above 17% (as a percentage of revenues) over the last three years. FCF has also been positive during this period but more reflective of the significant pullback in the capital expenditures. Fitch expects AC's liquidity to remain adequate at or above management's 15% threshold over the next two years but also assumes a heavy reliance on external sources of capital as FCF is expected to turn negative due to higher capex. In addition to cash pension contributions, AC also faces looming maturities in 2015-2016 when C$1.1 billion of its high-yield come due. However, the company may look to address its upcoming debt towers later this year when the call premium of its high-yield notes steps down, well ahead of scheduled maturity.
AC's entrance into the EETC market is expected to diversify the company's aircraft financing that have historically been provided by the bank and ECA markets. Fitch expects AC to successfully execute its debut EETC issuance now that Canada has adopted Cape Town Convention with all the qualifying declarations that provides credit protection similar to Section 1110, and the inclusion of high-quality Tier 1 collateral, which should set the stage for subsequent issuance for its remaining order book. AC also has backstop financing from Boeing for its 31 of its 37 787 deliveries, and access to Ex-Im bank financing. Fitch also expects AC to explore replacement for its narrowbody fleet, especially for the A319s that are earmarked for rouge.
Similar to most leveraged peers, AC has very few unencumbered assets limiting the carrier's financial flexibility in a potential downturn. Furthermore, AC has already monetized several parts of its business including Jazz, its regional subsidiary, Aveos, its maintenance unit and most importantly Altitude (formerly called Aeroplan), its frequent-flier program recognition (FFP). While the asset sales helped AC shore up liquidity and fund capex, it leaves little value in the company other than its mainline fleet. As noted in Fitch's Airline Sector Credit Factors report, an airline's FFP is considered a storehouse of value for an airline company. Although initiated to encourage travel and inspire loyalty, FFPs have now become a lucrative source of revenues (selling miles is more profitable than selling tickets). They also anchor strategic partnerships with strong financial institutions, which could become a potential source of liquidity as evidenced in the forward mile sales for all the U.S. network carriers during the depths of the credit crisis in 2008. AC does not have this option anymore but maintains strong strategic ties with Aimia, the company that currently owns AC's FFP.
Debt Levels Remain Elevated but Leverage Expected to Improve
AC has been steadily reducing balance sheet debt since the credit crisis, with total balance sheet debt declining to C$4 billion by year-end 2012 from C$5.3 billion at the end of 2008. AC's leverage, measured as lease adjusted debt/EBITDAR, has also meaningfully improved from 10.3x at the peak of the crisis to 5.2x at year-end 2012, reflecting both debt reduction and improved earnings. Although management intends to pay down scheduled maturities, the potential refinancing of its high-yield bonds and entrance into the EETC market is expected to keep debt levels elevated in coming years. Fitch estimates lease-adjusted leverage at approximately 5.5x by year-end but could improve by a turn next year with earnings growth. Notably, leverage remains below 8x in Fitch's stress case scenario which assumes a draconian downturn with $100 crude which is high for the ratings, but below peak leverage during the credit crisis, reflecting the company's improved business and financial profile.
The Rating Outlook is Positive reflecting Fitch's expectations AC to grow into sustainable profitability during a period of significant capital expenditure, and higher debt levels as it enters the EETC market.
A positive rating action could result if:
--Domestic and U.S. Transborder segments perform better than Fitch's expectations, curbing potential share losses to WJET.
--Higher earnings and profitability leads to positive FCF despite higher capex and/or lower leverage in the 4.0-4.5x range.
A negative rating action could result if:
--Domestic and U.S. Transborder segments perform worse than Fitch's expectations leading to significant earnings and margin erosion.
--FCF and leverage is worse than Fitch's expectations due to weak earnings.
Fitch has assigned the following ratings to Air Canada:
--Long-term IDR 'B';
--Senior secured first-lien debt 'BB/RR1'';
--Senior secured second-lien debt 'BB-/RR2'.
The Rating Outlook is Positive.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 8, 2012);
--'Recovery Ratings and Notching Criteria for Nonfinancial Corporate Issuers' (Nov. 13, 2012).
Applicable Criteria and Related Research
Corporate Rating Methodology
Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis
- Security Upgrades & Downgrades
- Fitch Ratings
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