Fitch Revises Outlook on Air Canada to Positive; Ratings Affirmed at 'B+'

CHICAGO--()--Fitch Ratings has revised its Rating Outlook on Air Canada to Positive from Stable. The long-term Issuer Default Rating (IDR) has been affirmed at 'B+'. In addition, Fitch has upgraded Air Canada's senior unsecured debt to 'B+/RR4' from 'B/RR5'.

The rating action is supported by Air Canada's improving financial results, reduced pension obligations, and longer-term commitment to de-leveraging. The Positive Outlook reflects financial results for 2015 that came in above Fitch's prior expectations, driven in part by lower fuel prices, but also by the company's ongoing efforts to reduce operating costs, increase ancillary revenues, and optimize its fleet through cabin upgrades and by growing its low-cost subsidiary, rouge. The Positive Outlook is also supported by an overall strengthened North American aviation market, which has led to improved credit profiles for most industry participants.

Fitch's primary concerns remain the heavy capital spending required over the next couple of years as Air Canada works to renew its fleet. The large slate of 787-9s to be delivered over the next two years will push capital spending to above-average levels that are only heightened by the recent weakness of the Canadian dollar compared to the U.S. Dollar. Heavy capex requirements are expected to pressure free cash flow and limit AC's opportunities to de-lever in the near term. These concerns are offset by the considerable savings the company stands to gain from lower fuel prices. Other concerns include the on-going unit revenue weakness across the industry as well as the risks that are typical for the airline industry including heavy cyclicality, high operating leverage, and exposure to exogenous shocks.

KEY RATING DRIVERS

Improving Financial Performance:

Air Canada's financial performance has improved over the past year aided by low fuel prices, AC's efforts to reduce unit costs, ongoing fleet modernization and higher ancillary revenues. Over the intermediate term, Fitch expects AC to continue generating solid financial results, with operating margins remaining well above historical levels produced prior to 2013. Operating margins have room to expand incrementally in 2016 as low fuel prices and the arrival of more efficient 787s help on the cost side. These items will be at least partially offset by unit revenue weakness, a portion of which is by design. AC expects some unit revenue degradation as it grows its average stage length and focuses on more leisure travel. Fitch also expects some industry-driven unit revenue pressure as low fuel prices and heavy competition keep fares compressed.

Air Canada's CASM ex-fuel was roughly flat in 2015 reflecting the benefits of the cost initiatives taken over the past several years, offset by the weakness of the Canadian dollar. The company is experiencing the benefit of flying its reconfigured, high-density, 777s on long-haul routes, as well as the lower operating costs of the 787s, and the growth of flying at rouge. Fitch expects AC's unit cost performance to continue to improve over the next several years as it updates its widebody fleet and grows rouge to its full fleet size of 50 aircraft by next year. AC also has the benefit of having locked in long-term deals with most of its major labor groups. While several competitors in the industry are negotiating potentially significant pay increases with their labor unions, Air Canada's pilots, flight attendants, maintenance workers, and dispatchers all have contracts that run into the middle of the next decade.

Above-Average Capacity Growth

Fitch expects the company's ASM growth to be in line with or higher than last year when capacity grew by 9.4%. Beyond 2016, Fitch expects ASM growth to remain well above that of other major network carriers, likely in the mid- to high-single-digit range, as AC receives more widebody planes and expands its international presence. While the total amount of growth is substantial, much of the extra capacity will be added at low incremental costs, either by adding routes at rouge, by flying larger-gauge aircraft such as the 787 in place of 767s, or by densifying its existing fleet of 777s. Air Canada has managed its recent expansion efforts well, growing operating margins by more than 6 percentage points over the last two years.

Credit Metrics Strong for the Rating

Fitch expects Air Canada's leverage metrics to remain steady or improve marginally over the next two to three years, remaining at levels that are much improved from a few years ago. Total adjusted debt/EBITDAR declined to 3.9x at year-end 2015, which was higher than Fitch had previously forecast, primarily due to higher debt levels resulting from a weak Canadian dollar. AC's adjusted leverage remains higher than its peers in the 'BB' category, though AC has the benefit of having eliminated its pension deficit, whereas the three large U.S. network carriers all carry sizeable pension obligations.

AC's pension plans moved to a surplus position of $152 million at the end of the year compared to a deficit of $3.7 billion in 2012.

Up until the second quarter of 2015 Air Canada's pension plans were governed by a special agreement with the Canadian government. The agreement stipulated that beginning in 2014 Air Canada was required to make minimum past service contributions that average $200 million/year for seven years, with no single-year contribution below $150 million. The company opted out of this plan last year, causing the pension plan to be governed under normal Canadian accounting rules. As such, its funding requirements dropped to $96 million in 2015 and AC expects funding requirements to be around $76 million in 2016 compared to the $200 million contributions that otherwise would have otherwise been required.

KEY ASSUMPTIONS

--Continued moderate growth in demand for air travel through the forecast period

--Fuel prices increasing to about $65/barrel by 2018 - note that this is a conservative estimate compared to the forecast published in Fitch's most recent oil & gas price deck

--Air Canada's capacity continues to grow in the high single-digit range

RATING SENSITIVITIES

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

--Sustained adjusted debt/EBITDAR below 4.0x;

--EBITDAR margins sustained above 15%, EBIT margins above 10%;

--Better than expected (neutral or positive) free cash flow generation over the intermediate term.

Although AC's current credit metrics are roughly in-line with those outlined above, future positive rating actions may be driven by expectations for metrics to be sustained amidst a more difficult operating environment (i.e. higher fuel prices or a notable drop in demand).

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

--Weaker than expected margin performance or higher than expected borrowing causing leverage to reach or exceed 5x;

--Weaker than expected financial performance causing free cash flow to be notably below Fitch's expectations;

--A decline in the company's EBIT margin to the low single digits, EBITDAR margins into the high single digits.

LIQUIDITY

Fitch expects FCF to be weak over the next several years due to heavy capital spending, but AC's financial flexibility is supported by a solid liquidity balance, a growing base of unencumbered assets, and the fact that most upcoming capital expenditures consist of highly financeable aircraft like the 787-9. Fitch expects FCF to be negative in the low- to mid-single digits as a percentage of revenue in 2016, with this year representing a peak for new aircraft deliveries. FCF should improve thereafter, with Fitch's base case forecast calling for modestly positive FCF through the remainder of its forecast period. While the heavy upcoming capital expenditures are a concern, Fitch believes that AC's fleet renewal represents an important part of its business plan. The 787s and high-density 777s coming in to the fleet over the next couple of years will operate at a lower unit cost, and will further AC's efforts towards expanding its international footprint.

Air Canada's liquidity is supportive of the rating. At year end the company had a cash and short-term investments balance of $2.7 billion and an undrawn revolver of $210 million. Total liquidity is equal to 21% of LTM revenue. Upcoming debt maturities are manageable given AC's cash on hand and Fitch's expectations for the company to generate cash from operations approaching or exceeding $2 billion in each of the next several years.

Recovery Ratings: Fitch's recovery analysis reflects a scenario in which a distressed enterprise value is allocated to the various debt classes. The 'RR1' Recovery Rating on AC's first- and second-lien secured debt reflects Fitch's assumption that all secured debtholders would receive superior recovery based on the estimate of AC's going concern enterprise value. The 'RR4' on AC's unsecured notes reflects an expected recovery in the 30%-50% range driven by the notes' subordinate position within Air Canada's debt structure which primarily consists of secured obligations. The upgrade from 'RR5' reflects Air Canada's improving EBITDA, which led to a higher estimated enterprise value in our recovery analysis.

Fitch has taken the following rating actions:

Air Canada

--Long-term IDR affirmed at 'B+';

--Senior secured first-lien affirmed at 'BB+/RR1';

--Senior secured second-lien debt affirmed at 'BB+/RR1';

--Senior unsecured debt upgraded to 'B+/RR4' from 'B/RR5'.

The Rating Outlook is Positive.

Additional information is available on www.fitchratings.com

Summary of Financial Statement Adjustments - Fitch has made an estimate of Air Canada's total operating rent expense that is equal to 125% of reported aircraft rent. Air Canada does not separately disclose non-aircraft rent.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

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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
Michael Weaver
Managing Director
+1-312-368-3156
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
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
Michael Weaver
Managing Director
+1-312-368-3156
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com