Fitch Assigns Initial 'BBB-' IDR to Alaska Air Group; Outlook Stable

CHICAGO--()--Fitch Ratings has assigned an initial 'BBB-' Issuer Default Rating (IDR) to Alaska Air Group Inc. (ALK). The Rating Outlook is Stable.

The rating is supported by ALK's low leverage, solid financial flexibility, and strong operating margins. Healthy cash balances, a sizeable base of unencumbered assets, and the ability to generate free cash flow support ALK's ability to meet its financial commitments.

Expected performance through a downturn or a period of competitive pressure is also an important factor in the rating. Fitch believes that ALK is much better positioned to operate through future downturns while maintaining adequate credit protection than it was in the past. Fitch's expectations are based on the significant improvements in ALK's balance sheet and cost structure as well as the broadening of the airline's route network since the last recession. Fitch believes that ALK's margins, cash generation and liquidity provide significant downside protection.

ALK's rating is also supported by its leading market share in the Pacific Northwest, fully funded pension plan, industry leading operating performance as measured by on-time arrivals and customer satisfaction scores, and loyal customer base.

Fitch currently has a positive fundamental view of the North American Airline sector. Industry consolidation, capacity constraint, and moderately growing demand for domestic travel have helped to improve the credit profile of the sector as a whole.

Fitch's primary concerns center on the intensifying competitive environment in ALK's key market of Seattle. Fitch expects Delta's expansion in Seattle to pressure yields at least through mid-2015, creating a key rating concern given that more than 60% of ALK's passengers fly into or out of that market. However, Fitch does not expect the increase in competition to materially impact ALK's credit profile.

Other concerns include increasing cash returns to shareholders, ALK's small size and geographic concentration compared to its competitors, and the cyclicality and exposure to exogenous shocks that are typical of the airline industry.

Key Rating Drivers:

Cost Structure:

ALK has made significant strides to improve its cost structure over the past decade. The company now operates with a unit cost advantage compared to the large network carriers.

Fitch expects ALK's unit costs in 2014 to be roughly flat with the year prior with increased IT costs representing the primary headwind. Longer-term, Fitch expects unit costs to continue to decline incrementally as new fuel efficient 737-900ERs replace ALK's older 737-400s. Other initiatives such as reconfiguring the existing narrowbody fleet with slimline seats and densifying cabin layouts are also likely to push unit costs lower.

Fitch considers ALK's low cost structure to be a competitive advantage over its larger network rivals, allowing the company to compete head-to-head by offering low fares, while still maintaining adequate operating margins.

High Operating Margins:

ALK has generated EBITDAR margins in the low to mid 20% range for the past five years, which stands well above most of its North American peers. ALK operates as a full service carrier, maintaining a first class cabin on its mainline fleet and generating a fair amount of business travel, allowing it to generate unit revenues close to those generated by the network carriers, but with a significantly lower cost structure.

Alaska could see some margin pressure in the coming one to two years as competition increases in its main hub. Fitch expects these headwinds to be at least partially offset by other initiatives such as higher bag fees, lower pension expenses, and the benefits of operating more 737-900ERs.

Competition with Delta/Geographic Concentration:

Alaska's dominant position in the Seattle market has been threatened over the past year by Delta, which is expanding its domestic operations in Seattle as a means to build a gateway to Asia. Increasing competitive pressure is a key credit concern particularly because of ALK's relative lack of geographic diversity and the concentration of its business in the Pacific Northwest. More than 60% of ALK's passengers fly into or out of Seattle, so a disruption of that market could materially impact results.

Competing with Delta is likely to be challenging due to the size difference of the two airlines. For comparison, the U.S. Bureau of Transportation Statistics estimates ALK's share of the domestic market at 4% compared to 16% for Delta. ALK generated $5 billion in revenue in the LTM period ended March 31, 2014 compared to Delta's $38 billion.

Alaska's management admits that the increase in capacity is creating a supply/demand imbalance and having a negative impact on yields. Lower yields will likely present a headwind at least through the first half of 2015 as Delta continues to add new routes. Beyond that it is difficult to predict how much more capacity Delta will continue to add.

Fitch expects ALK will be able to weather the increase in competition without a material impact to its credit profile. Fitch believes that ALK's low cost structure, greater frequencies to key markets out of Seattle, and its strong balance sheet will allow it to compete effectively. ALK also has the advantage of its entrenched position, with a roughly 50% market share of traffic into and out of Seattle, and a loyal customer base. ALK also has the flexibility to reallocate capacity to new markets. Examples include ALK's recent announcements to fly directly from Seattle to New Orleans and Tampa, two markets that previously did not have direct service to Seattle.

Significant Financial Flexibility:

ALK ended the first quarter of 2014 with a cash and equivalents balance of $1.4 billion. Cash on hand plus full availability under its two $100 million secured revolving credit facilities left ALK with total liquidity of 32% of LTM revenue, which compares favorably with its peer group. ALK's two revolving credit facilities have minimum required unrestricted cash balance covenants of $500 million.

Upcoming debt maturities are also manageable, averaging around $114 million annually for the next several years, an amount that could be easily covered either through cash flow from operations or cash on hand.

Fitch considers ALK's sizeable base of unencumbered assets to be a key consideration supporting its financial flexibility. ALK has paid for all of its new aircraft deliveries over the past several years with cash, which sets the company apart from much of its peer group. As a result, ALK now has 66 aircraft that are fully unencumbered by debt, mostly consisting of newer delivery 737-800s and 737-900ERs. Fitch considers these to be high quality assets that could be leveraged to raise cash even in a difficult or unfavorable debt market.

Positive Free Cash Flow:

Fitch expects ALK to continue generating positive FCF for the foreseeable future. Alaska generated free cash flow of $387 million in 2013, equating to a FCF margin of 7.8% which was the highest among Fitch's rated North American airline peer group. Its performance in 2013 was its fourth straight year of positive free cash flow, a streak that has only been matched by Delta and Southwest among North American airlines.

ALK produced positive FCF in 2013 despite the initiation of a dividend. Although Fitch expects the company to steadily increase the dividend going forward (depending on operating performance), dividend payments are not expected to materially impact FCF. Cash flows are also supported by the fully funded pensions, which will translate to lower cash contributions in the future. ALK also has a sizeable share repurchase program in place, which it can pull back on should cash flows deteriorate.

Modest Debt Levels, Solid Credit Metrics:

Total on balance sheet debt as of March 31, 2014 was $834 million, leaving ALK in a net cash position when considering its cash balance of $1.4 billion. All of ALK's debt is secured. Total adjusted debt/EBITDAR was 2.5x, which is the lowest leverage number among Fitch's rated North American peer group, including 'BBB' rated Southwest Airlines which stood at 3.2x. Debt reduction has been a priority in recent years with more than $1 billion in debt paid down since year end 2009.

Importantly, ALK's improved balance sheet leaves it in a much better position to weather future industry downturns. Its adjusted leverage was higher than 5x heading in to 2008 and spiked above 7.5x when fuel prices were at their highest. Improvements in ALK's balance sheet make it unlikely that credit metrics would degrade to that degree when the industry faces another downturn.

Performance in a Stress Scenario:

Fitch's rating for ALK incorporates expectations that the company will be able to maintain its 'BBB-' rating in a temporary stress scenario. It is notable among the North American airlines that ALK managed through both the 2001-2003 and 2008-2009 downturns without filing for bankruptcy protection. Credit metrics did suffer during the most recent recession, with adjusted leverage spiking above 7x and free cash flow turning sharply negative in 2007 and 2008 (though this was partially due to heavy aircraft deliveries at the time).

However, ALK was proactive in reducing costs, cutting its head count sharply, and in reallocating capacity to more profitable markets. As a result, its performance rebounded sharply in 2009. The company has had a solid operating history since that time, producing consistently positive results.

Alaska's credit profile has improved markedly since 2008 and is now in a much better position to handle a future recession or other market disruption. Heading in to the prior recession, ALK's adjusted leverage was around 5.5x compared to 2.5x today. In addition, it had very limited unencumbered assets and had an unfunded pension liability of $146 million that grew to nearly $450 million by the end of 2008. Today the company's pension plans are fully funded; it has a sizeable pool of new, high quality aircraft that are unencumbered by debt; and it has continued to improve its cost structure. Therefore Fitch feels that ALK has built a considerable cushion to navigate through the cyclical downturns that can be expected in the airline industry.

Fully Funded Pension:

As of year-end 2013 ALK's defined benefit plans were slightly overfunded, compared to an underfunded position of $355 million at year end 2012. Its fully funded pension is another point that distinguishes it from the legacy carriers which have sizeable pension liabilities. At year end 2013 pension plans at United, American, and Delta were underfunded by $1.6 billion, $4.8 billion, and $10.1 billion respectively. Lower pension contributions will represent a cash tailwind in 2014, as ALK does not plan to make meaningful contributions, compared to the $83 million in cash contributions that it made in 2013.

Returning Cash to Shareholders:

ALK's focus on increasing returns to shareholders represents a concern, though Fitch expects the company to manage dividends and share repurchases within the limits of its internal cash generation. ALK initiated a dividend in July of 2013 at $0.20/share which equates to roughly $60 million a year in total payments. In February of 2014 ALK increased the dividend by 25% to $0.25/share or roughly $70 million per year.

Alaska is alone with Delta and Southwest in North American airlines that pay a regular dividend. The company initiated the dividend at a modest level that did not represent a significant draw on cash flow. Fitch expects ALK to steadily increase the dividend depending on operating performance, but does not expect management to raise the dividend to the point of putting significant pressure on FCF.

ALK also recently announced its largest ever share repurchase authorization ($650 million). While this represents a sizeable increase over its previous repurchase program ($250 million authorization announced in 2012) Fitch expects the company to be flexible and adjust repurchases based on available cash. If ALK were to increase leverage to fund repurchases it could have a negative impact on the rating.

Rating Sensitivities:

Future actions that may individually or collectively cause Fitch to take a negative rating action include:

--Increasing competitive pressure causing EBITDAR margins to fall and remain below 20%;

--Gross adjusted leverage rising and remaining above 3.0x (FFO adjusted leverage above 3.3x);

--Significant loss of market share in ALK's key city of Seattle;

--Persistently negative free cash flow;

--Liquidity (including revolver availability) falling to 15% of LTM revenue or lower;

--The rating could also be negatively impacted if ALK were to merge with or be acquired by a lower rated airline.

Fitch does not expect to take a positive rating action in the foreseeable future. Fitch views ALK's credit profile as somewhat constrained at its current level due to its geographic concentration in the Pacific Northwest and due to the inherent cyclicality of the airline industry.

Additional information is available at 'www.fitchratings.com'

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (May 28, 2014).

Applicable Criteria and Related Research:

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=834839

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Contacts

Fitch Ratings, Inc.
Primary Analyst
Joe Rohlena, CFA
Director
+1-312-368-3112
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser
Managing Director
+1-212-908-0310
or
Committee Chairperson
Stephen Brown
Senior Director
+1-312-368-3139
or
Media Relations:
Brian Bertsch, New York, +1 212-908-0549
brian.bertsch@fitchratings.com

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Contacts

Fitch Ratings, Inc.
Primary Analyst
Joe Rohlena, CFA
Director
+1-312-368-3112
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser
Managing Director
+1-212-908-0310
or
Committee Chairperson
Stephen Brown
Senior Director
+1-312-368-3139
or
Media Relations:
Brian Bertsch, New York, +1 212-908-0549
brian.bertsch@fitchratings.com