Fitch Upgrades United's IDR to 'BB-'; Outlook Positive

CHICAGO--()--Fitch Ratings has upgraded the Issuer Default Rating (IDR) for United Continental Holdings, Inc. (UAL) and its airline operating subsidiary, United Airlines, Inc. to 'BB-' 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 rating 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 generally improving credit profiles across the North American Airline sector. United is also seeing large benefits from the lower fuel prices. Fitch expects that substantially lower jet fuel prices will allow United to produce sharply higher free cash flow (FCF) 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 adjusted debt. The Positive Outlook assumes that the current, favorable, operating environment for the U.S. airline industry continues through the next 12-24 months, and that United will use the cash that it is expected to generate over that time to improve its balance sheet. The Positive Outlook also assumes that should the industry experience a downturn the company would take steps to preserve its credit quality such as pulling back anticipated share repurchases and possibly decreasing capital spending.

Fitch's primary concerns include potential weakness and heavy competition in international markets. United is particularly exposed to international demand weakness and foreign currency headwinds as international revenues make up a larger portion of the company's business than its primary rivals. Weaker unit revenues experienced in the first half of 2015 are not a material concern at this point as they have been more than offset by lower fuel costs. Longer term revenue weakness and continued capacity expansion by U.S. carriers could be a concern particularly if unit revenues were to remain pressured in a rising fuel environment. Other concerns include United's high level of capital spending, relatively low profit margins compared to its primary competitors, increased shareholder returns and the cyclicality and high degree of operating leverage that are typical of the airline industry.

Recent management changes also raise potential concerns. Fitch views the departure of United's CEO as having mixed credit implications. It is not known at this time what United's exposure may be to the on-going federal investigation into its dealings with the Port Authority of New York and New Jersey (PANYNJ), but Fitch does not currently expect a material financial impact. The investigation is looking into possible improper dealings related to a route that United added to its network that directly benefited the chairman of PANYNJ.

It is also uncertain at this time if the new CEO will make any major strategic or financial changes in his new role, though this risk is partially mitigated by the fact that Mr. Munoz has been a long-time United board member. Fitch also considers Mr. Munoz' background in the rail industry, as the former COO of CSX Corp., to be a potential positive. The rail industry, like the airline industry, is capital intensive, highly unionized and cyclical.

KEY RATING DRIVERS

Improving Balance Sheet: Lower fuel costs and improving operating cash flows continue to support United's efforts towards reaching its goal of $15 billion in gross adjusted debt over the intermediate term, from around $17.5 billion at June 30, 2015. Note that UAL's adjusted debt figure incorporates capitalized operating leases calculated at 7x aircraft rent. Fitch's adjusted debt/EBITDAR figure includes an adjustment of 8x for both aircraft and non-aircraft rent. Fitch's forecast anticipates that United could reach that goal by 2018, which would translate to an adjusted debt/EBITDAR figure of 3x-3.25x or lower per Fitch's calculations.

Steady debt reduction and growing profitability have allowed UAL to reduce its leverage (total adjusted debt/EBITDAR) to 3.6x at June 30, 2015 from more than 6x just two years ago. Fitch expects leverage to improve incrementally, reaching the mid-3x range over the next year. Estimates are based on a conservative forecast that includes a rebound in jet fuel prices from today's low levels (incorporating crude prices rising to around $80/barrel in 2016), combined with a soft yield environment this year and moderately rising yields next year.

Successful cost control efforts: United's 'project quality' cost control initiative is helping to keep unit costs in check. Through the first half of the year UAL's cost per available seat mile (CASM) excluding fuel decreased by 0.7%, marking an improvement from the 3.4% and 6.3% increases seen in 2012 and 2013, respectively. The performance of UAL's cost control efforts through the first part of the year give Fitch confidence that UAL will be able to hit its guidance of keeping CASM-ex fuel to between flat to up 0.5% for the full year and 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.

Unit revenue weakness not yet a material concern: Through the first part of the year, higher capacity levels have pressured ticket prices, causing relatively weak PRASM performance for the industry. Fitch expects unit revenues to continue to be pressured through the rest of the year. However, revenue weakness should be more than offset by cheaper fuel prices, leading to expanding profit margins across the industry.

Fitch does not believe that the industry is reverting back to its days of irrational competition. Management teams from multiple airlines have spoken publicly in recent weeks about the importance of continued capacity constraint. As such, Fitch would expect the industry to pare capacity back if faced with higher jet fuel prices or more material contractions in unit revenue. Through the first half of the year United's PRASM fell by 2.9%. Pacific and Latin American markets were weak internationally, while energy-focused markets like UAL's hub in Houston experienced some softness domestically.

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. We estimate that UAL's liquidity is more than sufficient to cover upcoming obligations, while maintaining an adequate cash reserve. As of June 30, 2015, United maintained $6.3 billion in total liquidity including full availability under its $1.35 billion revolver. Liquidity as a percentage of LTM revenue was 16.5%.

Improved FCF: Fitch expects FCF to turn sharply positive in 2015, potentially reaching or exceeding $1.5 billion. Fitch's forecast anticipates it will remain solidly positive through our forecast period. 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.

Fitch expects FCF to improve despite capital spending that United anticipates to be between $2.7 billion-$2.9 billion annually for the next several years. United's FCF turned positive in the LTM period ended June 30, 2015 after posting negative FCF for the past three years. Merger related problems, weaker than expected operating cash flow, and heavy aircraft deliveries were the main drivers.

Cash flows also benefit from declining pension obligations. United contributed $800 million to its pension plans in the first half of the year, taking a meaningful step towards addressing the $2.2 billion underfunded position (as of year-end 2014). Fitch expects cash obligations for United's pension plans to be minimal in coming years. UAL's remaining pension obligations are relatively small compared to Delta's year-end unfunded liability of $12.5 billion and American's liability of $6.6 billion.

Returning Cash to Shareholders: United announced in its second quarter 2015 (2Q15) earnings call that it would buy back $3 billion worth of stock by the end of 2017, this comes on top of the $1 billion share repurchase program initiated in 2014. UAL expects to complete the plan in 3Q15.

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, barring an unexpected downturn in the market, Fitch believes United will generate sufficient cash in the intermediate term to fund its planned repurchases while still paying down debt. Share repurchases are also relatively flexible compared to dividends, and could be pared back or suspended to maintain cash in a future downturn.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for UAL include;

--Low single-digit capacity growth through the forecast period;

--Continued stable/slow growth in demand for U.S. domestic travel;

--Mid-single-digit PRASM decline in 2015 followed by relatively flat unit revenues thereafter;

--Conservative fuel price assumption which includes crude oil approaching $80/barrel in 2016 and rising incrementally thereafter.

RATING SENSITIVITIES

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

--Adjusted debt/EBITDAR sustained around 3.5x

--EBITDAR margins expanding towards or above 20%

--FFO fixed charge sustained above 3x

--Sustained positive FCF

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 4x

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

--Persistently negative FCF

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 (OC) 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 OC in each of these transactions has weakened slightly since the ratings were last reviewed. Weaker levels are a result of 737-900ER values that declined at a faster pace than was incorporated into Fitch's original model. However, each series of class A certificates still passes Fitch's 'A' category stress analysis, supporting rating affirmation.

Fitch also affirmed the 2014-2, 2014-1, 2013-1 and 2012-2 class B certificates at 'BBB-'. Fitch has affirmed the 2013-3 class C certificates at 'BB'.

The B and C tranche ratings are notched from the 'BB-' IDR of the underlying airline. The affirmation of the subordinated EETC tranches reflects Fitch's EETC criteria, which allows for a more limited ratings uplift from the airline IDR for airlines rated in the 'BB' category. Fitch's criteria allows for up to +3 notches of uplift to account for the affirmation factor of a given pool of aircraft for airlines rated in the 'B' category, and +2 notches for airlines rated in the 'BB' category. The 'BBB-' rating for the B tranches reflects a high affirmation factor (+2 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).

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 affected 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 in the near term.

Subordinated tranche ratings are based off of the underlying airline IDR. As such, Fitch would likely upgrade the B tranches to 'BBB' if United's IDR were upgraded to 'BB'. Fitch's criteria allow for greater ratings uplift for lower rated carriers, therefore if United were downgraded to 'B+', the subordinated tranche ratings would likely not change.

FULL LIST OF RATING ACTIONS

Fitch has taken the following rating actions:

United Continental Holdings, Inc.

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

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

United Airlines, Inc.

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

--Secured bank credit facility affirmed at 'BB+/RR1'.

United Airlines Pass Through Trust Series 2014-2

--Class A Certificates affirmed at 'A'

--Class B Certificates affirmed at 'BBB-'.

United Airlines Pass Through Trust Series 2014-1

--Class A Certificates affirmed at 'A'

--Class B Certificates affirmed at 'BBB-'.

United Airlines Pass Through Trust Series 2013-1

--Class A Certificates affirmed at 'A'

--Class B Certificates affirmed at 'BBB-'.

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 affirmed at 'BB'.

Additional information is available on www.fitchratings.com

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

Rating Aircraft Enhanced Equipment Trust Certificates (pub. 12 Sep 2013)

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

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 12 Jun 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=867275

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=991019

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=991019

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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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
Stephen Brown
Senior Director
+1-312-368-3139
or
Media Relations:
Alyssa Castelli, +1-212-908-0540
alyssa.castelli@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
Stephen Brown
Senior Director
+1-312-368-3139
or
Media Relations:
Alyssa Castelli, +1-212-908-0540
alyssa.castelli@fitchratings.com