Fitch Upgrades United Continental Holdings to 'B+'; Outlook Positive

CHICAGO--()--Fitch Ratings has upgraded the Issuer Default Rating (IDR) for United Continental Holdings, Inc. (UAL) and its airline operating subsidiary to 'B+' from 'B'. The Rating Outlook is Positive. Fitch has also taken rating actions on several United EETCs. A full list of ratings follows at the end of this release.

The ratings upgrade is supported by United's improving credit metrics, the benefits that the company is achieving through its on-going cost-savings program, a stronger balance sheet, and a generally healthy operating environment for the North American Airlines. United also stands to benefit from the recent fall in fuel prices. Fitch expects that substantially lower jet fuel prices will allow United to produce sharply higher free cash flow in 2015 despite relatively heavy capital spending. The Positive Outlook reflects Fitch's expectations that United's credit metrics will continue to improve as it works towards achieving its stated goal of reaching $15 billion in gross debt and as margins expand based on both fuel and non-fuel related cost savings.

Primary ratings concerns include the cyclicality and high degree of operating leverage typical of the airline industry. Other concerns include potential weakness and heavy competition in international markets, United's relatively weak operating margins compared to its peers, and heavy upcoming capital spending.

KEY RATING DRIVERS

Successful Cost Control Efforts: United announced its 'project quality' initiative in late 2013, with the goal of reducing non-fuel costs by $1 billion annually by 2017. The initiative yielded results in 2014 with non-fuel CASM increasing by 1.3%, an improvement from the 6.5% and 2.7% increases seen in 2013 and 2012 respectively. The performance of UAL's cost control efforts last year increases Fitch's confidence that the company will be able to hit its target of 0 - 1% non-fuel cost growth in 2015, and in keeping CASM-ex below 2% annually going forward.

Successful cost control should help boost United's operating margins from their currently low level compared to their primary competitors. United generated an EBIT margin of 7.2% in 2014, up from 4.6% in 2013. Fitch expects that margins could expand to above 10 - 13% in 2015.

Healthy Domestic Travel Environment: Demand trends continue to be stable, particularly in the U.S. domestic market. Fitch expects modest GDP growth in the U.S. in 2015 and 2016 driving demand for air travel. The growing demand for domestic travel combined with plans for the large U.S. carriers to keep capacity growth reasonable in the near-term should support a stable yield environment in the coming 1 - 2 years. Total capacity growth in the industry has remained below passenger demand, supporting high load factors for many years now with industry-wide load factors for 2014 averaging 83.2%. That number has risen steadily over the past decade from the low 70% range.

International Markets Present a More Mixed Picture: Yields in the Pacific region were pressured for all U.S. carriers last year due to a weak Yen and increased competition from Asian carriers. United's passenger revenue per available seat mile PRASM was down by 3.6% in the region for the year. Continued capacity additions will likely keep pressure on yields and load factors. Weakness in the Pacific region is a particular concern for United because it has more exposure to that part of the world than its main competitors. Importantly, Asian markets, and China in particular, continue to experience a high amount of growth for international travel demand, meaning that Asia will represent an important market for United carriers going forward. United's Pacific route network remains an asset despite the recent weakness.

Yields in the Atlantic market have been strong for the past year, despite some concerns around the European economy. There is some concern that a weaker Eurozone could pressure Transatlantic travel in 2015. The Latin American market has also experienced some overcapacity, putting pressure on yields.

A healthy operating environment has led to solid financial results for the North American airlines group. Fitch estimates that EBIT margins for the North American airlines improved by roughly 300 bps on average in 2014. Greater improvement is expected in 2015 primarily due to lower fuel prices.

Improving Balance Sheet: Lower fuel costs and improving operating cash flows should support United's efforts towards reaching its goal of $15 billion in gross debt (from around $18 billion at year end 2014) over the intermediate term. Steady debt reduction and growing profitability have allowed UAL to reduce its leverage (total adjusted debt/EBITDAR) to 4.5x at year end 2014 from more than 6x just two years ago. Fitch expects that metric to improve quickly over the next year, potentially reaching the mid-to-low 3x range in the next year to 18 months. Leverage in that range, along with continued improvement in other credit metrics, could support credit ratings in the 'BB' category, as reflected in the Positive Rating Outlook. Estimates are based on a conservative forecast that includes a rebound in jet fuel prices from today's low levels combined with a flat yield environment. Fitch's forecast incorporates a range of jet fuel prices between $2.10 and $2.30/gallon in 2015.

Sufficient Liquidity: United's liquidity position is supportive of the rating. Fitch's liquidity analysis combines current cash on hand with our forecast for two years of operating cash flow compared to upcoming debt maturities and capital expenditures. The agency estimates that UAL's liquidity is more than sufficient to cover upcoming obligations, while maintaining an adequate cash reserve. UAL also benefits from having a significant base of unencumbered assets. As of Dec. 31, 2014, United maintained slightly more than $5.7 billion in total liquidity including full availability under its $1.35 billion revolver. Liquidity as a percentage of LTM revenue was 14.7%.

Better Free Cash Flow: Fitch expects FCF to turn sharply positive in 2015 and beyond though capital spending is likely to remain high throughout our forecast period. FCF could exceed $2 billion this year or potentially higher depending fuel costs and a stable demand environment. Fitch expects capital spending in 2015 to total around $3.1 billion. This year will represent a peak year for new aircraft deliveries, potentially leading to some reduction in capex beyond 2015. Lower fuel prices are expected to be the single largest driver of improved cash flow, though UAL's on-going cost control efforts and its increasingly new/efficient fleet will also provide a benefit going forward. United is not yet a significant payer of cash taxes, therefore improvements on the income statement directly benefit free cash flow.

United has posted negative free cash flow for the past three years after seeing several positive years coming out of the recession. Merger related problems, weaker than expected operating cash flow and heavy aircraft deliveries were the main drivers of negative FCF for the past several years. Cash flow from ops improved substantially in 2014, but FCF remained negative at -$466 million as UAL spent some $3.1 billion in capex.

Returning Cash to Shareholders: United announced in mid-2014 that they would initiate a $1.0 billion share repurchase program. UAL is remaining flexible on the timing of its share repurchases, setting a target of completing the program within three years of its announcement. Through the end of the year the company spent $320 million to buy back stock. Fitch views the repurchase program as a modest concern given that cash being directed towards repurchases could otherwise be used to pay for aircraft or pay down debt. However, UAL's tactic to remain flexible is more conservative than either Delta or American, both of which have initiated dividends, which could prove harder to cut in the case of a downturn. Despite the spending on share repurchases Fitch expects UAL's leverage and FCF to continue improving over the forecast period.

KEY ASSUMPTIONS:

--Stable demand environment for air travel in the U.S. in the near term.

--United is expected to grow capacity in the low single digits annually. Yields are assumed flat or slightly negative through the forecast period.

--Fitch's base forecast incorporates a conservative assumption for crude oil, with Brent moving to $70 and above in the near-term.

--UAL is able to maintain CASM ex fuel growth at below 2% annually.

--These assumptions lead to a sharp uptick in FCF. Fitch assumes United will use the increased cash flow to both pay down debt and increase returns to shareholders.

RATING SENSITIVITIES

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

--Adjusted debt/EBITDAR sustained below 4x;

--EBITDAR margins expanding towards or above 20%;

--FFO fixed charge coverage above 2.5x;

--Sustained positive free cash flow.

A future ratings upgrade would be evaluated in the context of a downside scenario. Further confidence that United would be able to maintain a 'BB' category rating in a cyclical downturn could support a ratings upgrade.

Fitch does not expect to take a negative action in the near term. However, future actions that may individually or collectively cause Fitch to take a negative rating action include:

--Adjusted debt/EBITDAR rising above 5x;

--EBITDAR margins deteriorating into the low double digit range;

--Persistently negative free cash flow.

EETC RATINGS

Concurrent with its review of the United Airlines IDR, Fitch has affirmed the ratings for the United Airlines Pass Through Trust series 2014-2, 2014-1, 2013-1, and 2012-2 class A certificates at 'A'.

Fitch's senior EETC tranche ratings are primarily based on a top-down analysis of the level of overcollateralization featured in the transaction. Fitch's stress analysis uses a top-down approach assuming a rejection of the entire pool of aircraft in a severe global aviation downturn. The stress scenario incorporates a full draw on the liquidity facility, an assumed 5% repossession/remarketing cost, and various stresses to the value of the collateral.

Based on updated appraisal information incorporated into Fitch's analysis, the level of overcollateralization in each of these transactions has weakened slightly since the ratings were last reviewed. Weaker levels of overcollateralization are a result of 737-900ER values that declined at a faster pace than was incorporated into Fitch's original model. Fitch has also incorporated a 25% stress haircut to the 787s in these collateral pools compared to a 20% stress that was used in the previous analysis. However, each series of class A certificates still passes Fitch's 'A' category stress analysis, supporting rating affirmation.

Fitch has upgraded the 2014-2, 2014-1, 2013-1 and 2012-2 class B certificates to 'BBB-' from 'BB+'. The 2012-2 class B certificates were affirmed at 'BBB-'. Fitch has upgraded the 2013-3 class C certificates to 'BB' from 'BB-'.

The B and C tranche ratings are notched from the 'B+' IDR of the underlying airline. The 'BBB-' rating for the B tranches reflects a high affirmation factor (+3 notches) and the presence of an 18-month liquidity facility (+1 notch). The 'BB' rating for the 2012-3 C tranche reflects a high affirmation factor (+2 notches) partially offset by recovery expectations (-1 notch).

EETC RATING SENSITIVITIES

Senior tranche ratings are primarily based on a top-down analysis based on the value of the collateral. Therefore, a negative rating action could be driven by an unexpected decline in collateral values. For the 737-900ERs in these transactions, values could be impacted by the entrance of the 737-9 MAX, or by an unexpected bankruptcy by one of its major operators. Likewise the Embraer 175s could also be affected by the entrance of the 175 E-2. Concerns for the 787 values largely revolve around the potential for future maintenance or production issues on a scale above and beyond what has already been experienced. Fitch does not expect to upgrade the senior tranche ratings above the 'A' level.

Subordinated tranche ratings are based off of the underlying airline IDR. As such, Fitch would likely downgrade the B tranches to 'BB+' if United's IDR were downgraded to 'B'. Fitch's EETC criteria stipulates some compression of the affirmation factor notching when an airline is rated in the 'BB' category; therefore, if United were upgraded to 'BB-' Fitch would likely affirm the B tranche rating at 'BBB-'.

Fitch has taken the following rating actions:

United Continental Holdings, Inc.

--IDR upgraded to 'B+' from 'B';

--Senior unsecured rating upgraded to 'B+/RR4' from 'B/RR4';

United Airlines, Inc.

--IDR upgraded to 'B+' from 'B';

--Secured bank credit facility upgraded to 'BB+/RR1' from 'BB/RR1';

United Airlines Pass Through Trust Series 2014-2

--Class A Certificates affirmed at 'A'

--Class B Certificates upgraded to 'BBB-' from 'BB+'

United Airlines Pass Through Trust Series 2014-1

--Class A Certificates affirmed at 'A'

--Class B Certificates upgraded to 'BBB-' from 'BB+'

United Airlines Pass Through Trust Series 2013-1

--Class A Certificates affirmed at 'A'

--Class B Certificates upgraded to 'BBB-' from 'BB+'

Continental Airlines Pass Through Trust Series 2012-2

--Class A Certificates affirmed at 'A'

--Class B Certificates affirmed at 'BBB-'

Continental Airlines Pass Through Trust Series 2012-3

--Class C Certificates upgraded to 'BB' from 'BB-'

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

Applicable Criteria and Related Research:

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

--'Rating Aircraft Enhanced Equipment Trust Certificates' (Sept. 12, 2013);

--'Recovery Ratings and Notching Criteria for Nonfinancial Corporate Issuers' (Nov. 18, 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

Rating Aircraft Enhanced Equipment Trust Certificates

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=717763

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=813588

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=982560

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Contacts

Fitch Ratings
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
Peter Molica
Senior Director
+1 212-908-0288
or
Media Relations, New York
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
or
Media Relations, New York
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
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
Peter Molica
Senior Director
+1 212-908-0288
or
Media Relations, New York
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
or
Media Relations, New York
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com