Fitch Rates Air Canada's 2015-1 Class A, B, and C Certificates

CHICAGO--()--Fitch Ratings assigns the following expected ratings to Air Canada's (AC; Fitch Issuer Default Rating of 'B+'/Stable Outlook) proposed pass-through trusts series 2015-1:

--$667,370,000 class A certificates (A-tranche) with an expected maturity of March 2027 'A (EXP)';

--$182,010,000 class B certificates (B-tranche) with an expected maturity of March 2023 'BBB- (EXP)';

--$182,010,000 class C certificates (C-tranche) with an expected maturity of March 2020 'BB (EXP)'.

TRANSACTION OVERVIEW

Air Canada (AC) plans to raise $1.031.4 million in an EETC transaction to finance a pool of nine aircraft. The structure of the transaction mirrors the post-2009 EETC template utilized by U.S. carriers with similar terms and structural enhancements. However, instead of Section 1110, which is available only to U.S. air carriers, the legal protection for AC 2015-1 certificate holders is provided by the Cape Town Convention (CTC), which Canada implemented as federal, provincial and territorial law in all applicable provinces and territories effective as of April 1, 2013.

The A-tranche will be sized at $667.4 million with a 12-year tenor, a weighted average life of nine years, and an initial loan-to-value (LTV) of 54.6%. The A-tranche will feature a $318.8 million balloon payment at year 12, equal to 47.8% of the original principal balance. This represents a slightly larger balloon compared to some recent EETC transactions.

Both the B and C tranche will be sized at $182 million. The B tranche will be structured with an eight-year tenor and a six-year average life. The C tranche will be structured with a five-year bullet. Initial LTVs through the B and C tranches will be 69.2% and 84.4%, respectively.

Collateral Pool: The transaction will be secured by a perfected first priority security interest in nine new Boeing 787s including one 787-8 and eight 787-9s. Fitch considers both members of the 787 family to be high-quality Tier 1 aircraft.

Prefunded Deal: Like many U.S. EETCs, proceeds from the transaction will be used to pre-fund deliveries through March 2016. Accordingly, proceeds initially will be held in escrow by the designated depository, Natixis ('A'/'F1'/Stable Outlook), until the aircraft are delivered.

Liquidity Facility: Class A and class B certificates benefit from a dedicated 18-month liquidity facility which also will be provided by Natixis.

This transaction features a 35-day replacement window in the event that the liquidity facility provider should become ineligible. This is inconsistent with Fitch's counterparty criteria, which generally stipulates a maximum 30-day replacement period. However, Fitch does not consider the longer replacement window to be material to the ratings given that the additional time period is not significant. Risk is also mitigated by Natixis' 'A/F1' rating, which is in line with the current rating of the class A certificates.

Cross-default & cross-collateralization provisions: Each equipment note will be fully cross-collateralized and all indentures will have immediate cross-default provisions, which limit AC's ability to 'cherry-pick' aircraft within an EETC in a potential insolvency, offering the same level of creditor protection as modern EETCs issued in the U.S.

No Conditional Sale Agreement: This transaction features a minor structural difference compared to the AC 2013-1 transaction, in that AC 2013-1 included an intervening orphan special purpose vehicle (SPV) that stood between Air Canada and the pass-through trusts. The orphan SPV purchased the aircraft and then sold them to Air Canada under a conditional sale agreement. This transaction will not include an orphan SPV; the equipment notes will be issued by Air Canada directly to the pass-through trusts.

Cape Town: The transaction is governed by the CTC. Importantly, Canada has adopted the CTC in the manner that is intended to be favorable to EETC holders in a potential default with all the key declarations including: (i) Alternative A which essentially 'exports Section 1110' into foreign jurisdictions with the same 60-day stay period following an insolvency event, (ii) self-help remedies, (iii) an Irrevocable De-Registration and Export Request Authorization (IDERA) registration, which obligates AC and the Canadian government to assist creditors in the deregistration and export of the aircraft, and (iv) choice of law. CTC Alternative A also requires AC to maintain and preserve the aircraft and its value in accordance with the financing agreement during the 60-day stay period, which is an additional enhancement over Section 1110. Fitch believes that the CTC in Canada would allow creditors to quickly repossess the collateral in the event that Air Canada were to default on its obligations. Unlike Section 1110, CTC has not been tested in Canada; however, Canada has a strong legal regime and would be expected to uphold the provisions of the treaty if Air Canada were to default. Fitch does not make a rating distinction between transactions governed under section 1110 and Cape Town as ratified in Canada.

KEY RATING DRIVERS

Stress Case: The ratings for the class A certificates are primarily based on collateral coverage in a stress scenario. The analysis uses a top-down approach assuming a rejection of the entire pool in a severe global aviation downturn. The analysis incorporates a full draw on the liquidity facility, and an assumed repossession/remarketing cost of 5% of the total portfolio value. Fitch then applies immediate haircuts to the collateral value.

In its stress analysis Fitch applies a 25% haircut to the base values of both the 787-8 and 787-9. This represents the mid-point of Fitch's Tier 1, 'A' category stress range of 20%-30%. While we view the 787 family as high-quality collateral, the mid-point of the stress range recognizes that the 787 may not enjoy the same level of liquidity as a top-quality aircraft like the 737-800 would have in the secondary market. It also incorporates the aircraft's relative newness.

While both are considered Tier 1 aircraft, Fitch views the 787-9 to be a better piece of collateral than the 787-8. The -9 variant has quickly become the preferred model among the 787 family, capturing nearly all of the new orders over the past year. In addition, some airlines have converted orders for 787-8s to the -9, illustrating the preference for the larger variant within the aircraft family.

These assumptions produce a maximum stress LTV of 84.6% through the life of the transaction, suggesting full recovery for the A-tranche holders. Fitch expects LTV ratios to remain relatively flat through the first several years of the transaction as scheduled principal amortization roughly matches the agency's depreciation assumptions. LTVs are expected to decline gradually later in the life of the deal.

High Collateral Quality: The quality of the collateral pool underlying the transaction is considered solid. Despite technical issues early in the life of the smaller 787-8, backlogs for the aircraft family remain strong and delivery slots are scarce, which would support strong re-sale values if any of these planes were to come on to the market.

Technological advances in the 787 bring big-jet ranges to mid-size airplanes with improved fuel efficiency, making the aircraft a popular choice for long-haul operations. The aircraft's range capability opens up many new markets, making it possible for airlines to connect to smaller international cities, which were previously unserviceable by the 767 (lacks the range), or could not support the larger 777s or 747s (not enough demand to fill 300+ seats). For AC, some of its 787s will replace older 767s, which are being transferred to Air Canada rouge (rouge), AC's lower-cost subsidiary. The company estimates that its 787s will operate at roughly 20%-30% lower cost per available seat mile than the aircraft that they are replacing, thus having a significant impact on the profitability of routes previously flown by 767s.

The 787-8 has proven to be quite popular with the airlines that operate it. Various airlines report that the 787-8 is performing at least as well if not better than expected in terms of efficiency and reliability. Airlines also report that passengers enjoy the aircraft interior and the fact that the cabin is pressurized to a lower altitude. The 787-8 maintains a sizeable backlog of 241 orders as of the end of January 2015. The aircraft is operated by 25 users around the globe, with the highest concentration being in Asia as both All Nippon and Japan Airlines took a significant number of the early delivery -8s.

First flight for the 787-9 was in September of 2013 and the plane officially entered into service with Air New Zealand as the launch customer in July of 2014. The -9 variant has built up a sizeable order book of 467 aircraft as of January 2015, with a total of 30 customers. Carrying 250 passengers in a standard arrangement, the 787-9 acts as a bridge in Boeing's product line between the 787-8 (typical capacity of 224 passengers), and the 777-200ER (300 passengers). In addition, the 787-9 is capable of a similar range as the 777-200ER, but at an improved fuel burn rate.

Affirmation Factor: Fitch considers the importance of a pool of aircraft to the underlying airline and the likelihood that the aircraft would be affirmed in a potential bankruptcy to be a supporting factor for senior tranche ratings and a key factor for subordinated tranche ratings.

Fitch considers the affirmation factor for this transaction to be high. The 787s in this pool will represent the newest and most efficient wide body aircraft in Air Canada's fleet. The 787 also represents a key part of AC's international expansion strategy. The company is emphasizing the importance of Toronto as a true global hub, and will use the 787-9 to open new markets like Delhi and Dubai, that were previously not served from Canada. Some 787s will also replace the company's older 767s.

The position of the 787 within Air Canada's existing wide body fleet is also supportive of the high affirmation factor. AC's wide bodies are clearly split between older vintage, previous generation aircraft, and newer/fuel efficient aircraft. AC's 767-300s and A330-300s are 21 and 14 years old on average, compared to around 6 years for the 777 fleet. AC's existing 787s have all been delivered within the past year. Air Canada is re-building its wide body fleet around the 787 and 777 families; therefore, if AC were to file bankruptcy and decide to scale back its international operations, it would be more likely to reject its A330s and 767s before getting rid of its new, flagship aircraft.

B-Tranche: The 'BBB-' rating for the subordinate B-tranche is assigned by notching up from AC's IDR of 'B+'. Fitch notches subordinated tranche ratings from the airline IDR based on three primary variables; 1) the affirmation factor (0 - 3 notches), 2) the presence of a liquidity facility, (0 - 1 notch), and 3) recovery prospects. In this case, Fitch has assigned a three-notch uplift (the maximum) based on a high affirmation factor (as discussed above) and a one-notch uplift reflecting the liquidity facility. Although the B tranche exhibits superior recovery prospects and could qualify for an additional notch of uplift under Fitch's criteria, the additional one-notch adjustment has not been applied due to the concentration of the asset pool on one asset type.

C-Tranche: The affirmation factor applies equally to both the B and C tranches (plus three notches). The C-tranche does not feature a liquidity facility, and therefore does not receive notching uplift. While recovery prospects for this transaction are better than some C tranches, and remain in the 'RR4' range through the life of the deal, Fitch applies one notch downward adjustment to maintain separation between the B and C tranches. This is consistent with Fitch's current ratings on the AC 2013-1 transaction.

Fitch recently upgraded Air Canada to 'B+' from 'B'. The upgrade was supported by Air Canada's improving financial results, successful cost-cutting initiatives, pension surplus, adequate financial flexibility, and lower fuel prices. Fitch believes that lower fuel costs and AC's cost-cutting initiatives could produce notable margin expansion in 2015. Importantly, Fitch expects AC to use any additional cash generated in the coming year to improve its credit profile by funding capital expenditures or addressing debt maturities. The upgrade considers the recently ratified collective bargaining between Air Canada and its pilots union which reduces the near-term risk of labor disruptions. Fitch also notes that the first full year of operations of its lower-cost airline rouge have proven successful. The launch of rouge was seen as a potential risk, and while the operation is still in its infancy, Fitch now has more confidence that the rouge business strategy may prove successful. The ratings are also supported by the company's leading market position in Canada.

While Fitch believes that Air Canada's credit profile is improving, notable risks still remain. Concerns include significant upcoming aircraft deliveries that will pressure cash flows and likely drive debt balances higher beyond 2015, heavy competition from WestJet, and a fluctuating USD/CAD exchange rate. Other concerns include those that are typical of the airline industry, such as a high degree of operating leverage, cyclicality, and an exposure to exogenous shocks such as disease or acts of terrorism.

Fitch has assigned the following ratings:

Air Canada Pass Through Trusts Series 2015-1

--Class A certificates 'A (EXP)';

--Class B certificates 'BBB- (EXP)';

--Class C certificates 'BB (EXP)'.

Fitch currently rates Air Canada as follows:

Air Canada

--Long-term IDR 'B+';

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

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

--Senior unsecured debt 'B/RR5'.

Air Canada Pass-Through Trust Series 2013-1;

--Class A certificates 'A';

--Class B certificates 'BBB-';

--Class C certificates 'BB'.

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

Applicable Criteria and Related Research:

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

--'Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers' (Nov. 18, 2014);

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

--'2015 Outlook: North American Airlines (Airline Sector Continues its Ascent)' (Dec. 16, 2014)

Applicable Criteria and Related Research:

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

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

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

2015 Outlook: North American Airlines (Airline Sector Continues Its Ascent)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=834349

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=981106

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