NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded the Issuer Default Ratings (IDR) of US Airways Group, Inc. (LCC) and its primary operating subsidiary US Airways, Inc. to 'B+' from 'B-'. The ratings have been removed from Rating Watch Positive. The ratings were put on Rating Watch Positive on Feb. 14 following the merger announcement with American Airlines (AAMRQ; IDR: 'D'). The Rating Outlook is Positive. The ratings apply to $1.1 billion of term loan debt and $179 million of convertible notes outstanding. See the full list of ratings actions at the end of the release.
The upgrade of LCC's ratings reflects the continued improvement of its credit profile on a standalone basis and does not incorporate potential benefits from its pending merger with American. The Positive Rating Outlook reflects the potential credit benefits from the merger over the next one to two years. Fitch maintains its view that the proposed merger, expected to close in third quarter, enhances LCC's network and credit profile but expects potential benefits to be realized over the longer term. An airline merger is typically a multi-year process. In addition to the customary anti-trust approval from the Department of Justice, the merged airline will require a single operating certificate from the Federal Aviation Administration, which may take 18-24 months, before operations can be fully integrated. The bankruptcy court's approval, also required given AAMRQ's current Chapter 11 restructuring was received last week.
KEY RATING DRIVERS
The upgrade of LCC's ratings reflects the transformation of LCC's business model that has significantly improved its financial profile since the credit crisis. During the past year, LCC produced record revenues, profitability and cash flow, ahead of Fitch's expectations, in spite of a lackluster macro environment and volatile fuel. As a result, LCC's credit metrics notably improved. While significant risks remain, Fitch believes LCC is in a better position to withstand a weak operating environment or higher fuel costs, and the company's credit profile has improved beyond what was implied in the prior rating. Other factors supporting the ratings include structural changes in the U.S. airline industry and LCC's relative cost position (including no defined benefit pension plan) which gives the company significant operating leverage in a growing economy. Fitch's primary concerns for LCC on a standalone basis include the company's high debt levels including looming maturities next year, and limitations on its ability to reduce network capacity based on current pilot contracts, in addition to the cyclicality and event risk inherent in the airline industry. Although LCC's unhedged fuel strategy poses a risk in a severe fuel spike scenario, current industry fundamentals enable LCC and its peers to largely pass on higher fuel costs through higher fares when demand is rising, or cut capacity when demand is falling.
Traffic Performance
With hubs in smaller cities, and a few international routes, LCC's network is not as robust as its legacy peers, but still produces leading traffic results. LCC's passenger revenue per available seat mile (PRASM) rose 4.3% last year reflecting record load factors and a 3.5% increase in yields. Total revenues increased by 5% to $13.8 billion on 2% capacity growth. LCC's yield and PRASM gains reflect higher share of corporate revenues as well as the airline's ability to tactically flex its schedule to better manage off-peak periods and seasonality. For perspective, LCC operates a flex schedule for 104 days of the year, when it flies an extra bank in Phoenix using the same assets, and also tweaks the schedule for off-peak days depending on the time of the year, or day of the week. During the month of December, LCC flies 8% fewer seats during the first half of the month compared to the holiday period during the second half.
Demand trends for both leisure and business travel remains solid as per management guidance, but Fitch expects PRASM gains to moderate this year. Record high load factors support continued yield improvements but the extent to which fares increase this year depends on the macro environment, in Fitch's view. Furthermore, LCC's guidance for a 3% increase in capacity (2.7% domestic, 3.6% international) is expected to pressure PRASM driving Fitch's expectation for PRASM increase in low-single digits this year, and 4%-5% growth in total revenues. LCC's capacity increase reflects 'upgauging' of replacement fleet rather than expansion. In 2013, LCC intends to retire 18 of its smaller-gauge vintage 737-400s and replace them with 16 A321-200s which have 60 additional seats. While the increase in available seat miles (ASMs) weighs on PRASM, it improves profitability as Fitch expects LCC to place larger aircraft on routes where it is likely spilling traffic which should lower operating unit costs (CASM).
Operating Earnings
Overall, LCC continues to maintain a cost advantage relative to its network peers given no pension costs, or labor sweeteners from the 2005 America West merger (pilot groups have yet to agree on seniority integration). LCC's strategy to not hedge for fuel also gives the airline a fuel cost advantage relative to hedged peers who pay a premium. The strategy has worked well over the last couple of years given the tight capacity environment which enables LCC and its peers to largely pass along higher fuel costs through higher fares. However, the lack of downside protection during a potential fuel spike could become risky especially when combined with a soft economy which would likely eradicate any pricing power.
LCC's 2012 operating income of $894 million almost doubled from prior year, reflecting a 6.5% margin, which increased by 300 basis points (bp) despite higher fuel price. The average price per gallon of jet fuel was $3.17 last year versus $3.11 in 2011, although total fuel costs were 3% lower reflecting reduced fuel burn from the induction of new aircraft. The last time LCC paid $3.17 for a gallon of jet fuel was in 2008 when the company generated an operating loss of $606 million and found itself in a liquidity crisis. For 2013, Fitch expects LCC's operating income to approach a $1 billion assuming fuel price of $3.25 per gallon.
While the macro environment has improved since the credit crisis, the sharp turnaround in profitability reflects a number of initiatives that LCC and the industry have implemented to fundamentally change the operating landscape of the U.S. airline industry. Fitch summarizes these initiatives as the four 'Cs' - capacity constraint, consolidation, 'charge-for-everything' (i.e. ancillary revenues) and cost convergence. Notably, LCC management has led the industry on consolidation and the introduction of ancillary fees.
Cash flow and Liquidity
LCC's cash from operations of $1 billion in 2012 more than doubled from the prior year, driven primarily by a similar increase in funds from operations (FFO) and $219 million contribution from working capital. Despite higher capital expenditures, LCC generated $242 million of free cash flow (FCF) last year reversing from the negative FCF recorded a year earlier. LCC's FCF has been positive in two of the past three years. Fitch expects LCC's capex budget to remain elevated in upcoming years due to necessary fleet replenishment and other product investments including Wi-Fi and enhancements to its business-class. Aircraft deliveries for the year include 16 A321-200s and five A330-200s. LCC has already funded a significant portion of its upcoming deliveries through the EETC market. Fitch's base case forecast which includes conservative operating assumptions and gross capex projects FCF to be modestly negative in 2013, but net of aircraft related financing FCF should be positive. LCC has backstop financing for all its single-aisle aircraft through 2015, but Fitch expects the airline to use the loan and/or capital markets or sale leaseback to finance its aircraft deliveries over the next few years.
Debt maturities of $417 million are manageable this year but are substantial in 2014 when $1.1 billion of its term loan matures in March and $172 million of convertible notes come due in May 2014. Fitch expects LCC to refinance the term loan this year, well in advance of its maturity.
LCC's liquidity has improved with the unrestricted cash balance increasing by $429 million to $2.4 billion at year-end 2012, representing 17% of revenues versus 15% at year-end 2011. Unlike its larger peers, LCC does not have a revolving credit facility. LCC also has few unencumbered assets, but a larger collection of under encumbered assets that could be used to shore-up liquidity near term. These include engine and spare parts currently pledged at low advance rates, and the option to issue a C-tranche for its series 2012-2 EETC.
Fitch notes that LCC is highly reliant on capital markets and external sources of liquidity. However, LCC maintains a solid standing in the markets and has had access to diverse sources of funding over the past several years. Importantly, management has shown willingness in the past, to pull different levers including issuing equity even at distressed levels to preserve the balance sheet. Access to capital markets is a very important consideration for LCC's current ratings as the carrier has very few unencumbered assets.
Fitch views LCC's liquidity to be adequate to withstand a moderate fuel or demand shock. Fitch expects LCC to be in compliance with its only financial covenant under its credit facility that requires the company to maintain a minimum unrestricted cash balance of $850 million. Fitch also expects LCC to be in compliance with the minimum liquidity requirements (undisclosed) under its unsecured, frequent flier miles purchase agreement with Barclays.
Capital Structure and Leverage
Despite improving earnings and cash flow, LCC's debt levels remain high. Total debt and capital leases at year-end 2012 stood at $4.8 billion reflecting a net increase of $227 million during the year. Approximately 93% of outstanding debt is secured, including 33% comprised of EETCs. Debt issuance last year included $624 million of equipment notes issued under its 2012-1 series EETC, and is expected to increase again this year as LCC issues equipment notes related to its 2012-2 series.
LCC is also a heavy user of off-balance-sheet operating leases but Fitch expects LCC to own more of its aircraft over time. Fitch calculates adjusted debt by capitalizing lease payments at an 8 times (x) multiple. Fitch evaluates adjusted debt and leverage metrics both on an aircraft rent only basis (Aircraft lease-adjusted) as well as including all rental expenses (Fitch lease-adjusted). Aircraft lease-adjusted metrics are more appropriate for peer comparison while Fitch lease-adjusted metrics enables airline companies to be compared across other industries.
Leverage measured by Fitch lease-adjusted debt / EBITDAR improved by over a turn to 6.2x at year-end 2012 from 7.4x a year ago, and was in-line with Fitch's estimates. For 2013, Fitch expects leverage to remain relatively flat, but improve to approximately 5x in two years with continued earnings growth. Aircraft lease-adjusted debt is slightly lower at 5.5x at year-end 2012 compared to 7.2x at year-end 2011. LCC's heavy debt burden will remain a limiting factor for further improvement in the company's credit profile on a standalone basis.
RATING SENSITIVITIES
The Outlook is Positive which indicates that further positive rating action is possible over time following the successful completion of the pending merger with AAMRQ. Fitch's analysis of the merger's benefits will focus on a more detailed analysis of the combined entity's capital structure, margin and cash flow profile, the strategic position of the 'new American' and the integration plan.
Once merged, Fitch expects the credit profiles of the two carriers to be stronger together than apart. The merger expands the reach of both airlines' individual networks, as the two currently have relatively little overlap in their route structures, and is expected to create the nation's largest airline with leading positions in key U.S. markets.
The combination of LCC's profits, AAMRQ's restructured costs and terms of the tentative pilot agreement suggest that the margin profile of the 'new American' could potentially be at par or possibly exceed its peers near term. The memorandum of understanding for the pilot group stipulates lower wages than Delta (DAL) and United (UAL) until 2016, and notably excludes profit-sharing (incremental $522 million of contractual improvements over six years instead) which adds approximately $250 million-$400 million to DAL and UAL's operating expenses. The 'new American' also anticipates $1 billion in synergies, including $900 million from revenues, and $150 million from costs.
However, like all airline mergers, integration challenges are a concern, especially those related to IT functions and labor. Labor risks are largely mitigated by the tentative agreements currently in place for all labor groups including the pilots. Also, LCC management is experienced in the merger process including integrating an airline operating in Chapter 11. Nonetheless, Fitch anticipates execution risks through the integration process, both for merging the technology platforms as well as integrating the pilot seniority lists, which could delay the combined entity's ability to realize expected synergies.
Fitch expects a possible upgrade would most likely be one notch, depending on the credit profile of the combined airline. The ratings could be affirmed at the current levels and the Outlook Revised to Stable if the merger is not completed, or if Fitch considers the merger's potential benefits to be insufficient to raise the credit profile. A negative rating action is not anticipated at this time absent a drastic and sustained fuel shock or other unexpected severe drop in demand for air travel, or difficulty accessing the capital markets.
US Airways' EETCs
In conjunction with the upgrade of LCC's IDR, Fitch has upgraded the subordinate tranches for LCC 12-1 and LCC 12-2. Fitch assigns subordinate tranche EETC ratings by notching up from the IDR as per Fitch's EETC criteria, therefore the subordinate tranche ratings have been upgraded lock-step with LCC's IDR. For LCC 12-1, Fitch has upgraded the Class B certificates to 'BB+' and the Class C certificates to 'BB-' maintaining the three notch and one notch uplift for the subordinate tranches, respectively. For LCC 12-2, Fitch has upgraded the Class B certificates to 'BB+', maintaining the three notch uplift from the IDR.
However, for senior tranche ratings, Fitch's EETC criteria prescribed a 'top-down' approach with a secondary dependence on the airline IDR. Accordingly, senior tranche ratings for LCC 12-1 and LCC 12-2 have been affirmed. Please see full list of ratings actions at the end of the release.
Fitch has taken the following ratings actions:
US Airways Group, Inc.
--IDR upgraded to 'B+' from 'B-';
--Senior secured term loan due 2014 upgraded to 'BB+/RR1' from 'BB-/RR1';
--Senior unsecured convertible notes due 2014 and 2020 upgraded to 'B-/RR6' from 'CCC/RR6'.
US Airways Inc.
--IDR upgraded to 'B+' from 'B-'.
US Airways Pass Through Trusts Series 2012-1
--Class A certificates affirmed at 'A-';
--Class B certificates upgraded to 'BB+' from 'BB-';
--Class C certificates upgraded to 'BB-' from 'B'.
US Airways Pass Through Trusts 2012-2
--Class A certificates affirmed at 'A-';
--Class B certificates upgraded to 'BB+' from 'BB-'.
The Rating Outlook is Positive.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 8, 2012);
--'Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers' (Aug. 14, 2012);
--'Rating Aircraft Enhanced Equipment Trust Certificates' (Sept. 13, 2012).
Applicable Criteria and Related Research
Rating Aircraft Enhanced Equipment Trust Certificates
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=688711
Corporate Rating Methodology
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684460
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=693773
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