DBRS Confirms Issuer Rating of Air Canada at B, Stable Trend

DBRS has confirmed Air Canada’s (AC or the Airline) Issuer Rating of B with a Stable trend. The rating reflects AC’s continued exposure to operating in the highly competitive and volatile global airline industry, its high (but improving) cost structure, its leveraged balance sheet and its relatively weak debt coverage ratios. In confirming the rating, DBRS recognizes that through a series of actions taken in the past two years to improve its cost efficiency, capacity management and product quality, the Airline has shown positive results in earnings, efficiency measures and brand recognition. The favorable demand conditions and stability provided by labour agreements since 2012 have also helped AC’s operating performance. In addition, the pressure of making a cash contribution to cover the Airline’s underfunded pension obligations was moderately relieved by a combination of agreements with the Canadian government on new funding relief, the adoption of a defined contribution plan for new employees and negotiated reduced pension benefits under the labour agreements concluded in 2012, increased discount rates applicable during 2013 and a good return on plan assets. However, DBRS believes that AC’s rating will remain constrained by its high debt level and limited financial flexibility, as a significant portion of its assets are encumbered. Despite improving operating cash flow, liquidity and lowering financing costs through the refinancing of high-cost debt, DBRS expects deleveraging and improvements in financial metrics, absent any material equity issuance, could be limited by the high committed capital expenditures (capex) in the next five years as the Airline takes delivery of new aircraft.

DBRS notes that the airline industry is one of the most challenging in our economy, and in accordance with the methodology “Rating Companies in the Airline Industry”, DBRS has concluded that the business risk rating of the airline industry is BB (low). These challenges include weak profitability affected by: (1) demand seasonality and sensitivity to economic conditions and consumer confidence, (2) high capital, energy and labour intensities, (3) a low barrier of entry, and (4) the high costs of regulation.

DBRS believes AC’s overall business risk profile is near the industry average. AC is the largest airline in Canada, with a dominant market share (55% in 2012) in domestic, Canada-U.S. transborder (35%) and other international routes connecting to Canada (37%). Its strong market position and customer loyalty (especially among business travellers) are supported by its participation in Star Alliance (the world’s largest airline alliance) and Aeroplan (the most popular loyalty program in Canada), as well as its frequently scheduled flights between major North American cities among Canadian airlines. Despite AC’s dominant market position in Canada, the Airline’s growth is constrained by the modest size of the Canadian market for air travel. Competition in the domestic market is intensifying, as aviation markets are deregulated and the entry barrier is low. Low-cost and regional carriers are active, especially in domestic short-haul routes and flights to holiday destinations, pressuring fares. Despite their brief existences, new entrants with aggressive business plans have been disruptive to the passenger market. The Airline’s revenue source is highly concentrated in passenger travel (89% in 2012), with modest contributions from cargo and services.

AC’s competitive position in the North American market is strong, having been awarded “Best International Airline in North America” consecutively since 2009 by Skytrax (a U.K.-based consultancy and research firm focusing on commercial airlines), and its fleet’s average age of about 13 years is relatively young among North American legacy airlines. This has given the Airline a competitive advantage in the Canada-U.S. transborder market and in attracting U.S.-originated customers to use AC and Canadian major airports as hubs for their transcontinental travel (also known as “sixth freedom” traffic). However, AC faces intense competition in the faster-growing markets in Asia-Pacific and the Middle East from international airlines based there that enjoy stronger Skytrax rankings for product quality and services and have younger, more fuel-efficient fleets, lower-cost bases and stronger financial resources.

DBRS recognizes the more recent improvements in product quality, brand recognition and operating costs, thanks to the implementation of numerous initiatives in the past three years. AC has improved its product offerings with more focused marketing efforts and improvement in service quality and improved flight frequency and destinations. These efforts have resulted in improved customer loyalty, particularly that of higher-margin business travellers, and were recognized by Skytrax by upgrading AC to a four-star rating (from three-star) in January 2013 based on product and service delivery. AC is now the only North American carrier with a four-star rating.

Historically, the Airline has a high fixed-cost structure resulting from a unionized workforce and high aircraft ownership costs, although DBRS notes that AC’s revenue per available seat miles and yields have been consistently higher than those reported by other legacy carriers in North America. Therefore, capacity management and utilization are critical to profitability. Additionally, fuel, which is highly volatile, accounts for about 30% of operating costs. As fuel and most of its maintenance and debt servicing costs are denominated in U.S. dollars and overseas operating costs are denominated in foreign currencies, while the Airline’s revenue base is in Canadian dollars, the variability between the two compounds the Airline’s operating challenges. As a result, fuel price and currency exchange fluctuations have contributed to AC’s track record of volatile earnings, although the volatility could be partially offset by the high correlation between fuel prices and the Canadian dollar. Cost transformation initiatives taken since 2011 together with more fuel efficient and higher-density aircraft entering into service and lower staff cost at Air Canada Rouge and DBRS expects more meaningful reduction of operating costs (as measured in cost per available seat miles in the next two years.

Notwithstanding the aforementioned positive developments in AC’s business profile and market position, the Airline continues to operate with a weak financial profile and limited financial flexibility, which constrains its rating. The Airline’s balance sheet leverage, despite recent improvements in cash flow and EBITDAR, is still aggressive for a company operating in a highly cyclical industry with high fixed costs. The high leverage largely reflects the Airline’s extensive use of aircraft debt and lease financing and the accumulated losses over the years. The high debt and operating lease levels also result in material fixed charges (interest and aircraft rental expenses), which historically have consumed 50% to 55% of AC’s EBITDAR, leaving limited cash resources for its capex requirement and debt reduction, although the ratio has reduced since 2012 to 45% to 50% as a result of improved EBITDAR and reduced interest rates.

With improved operating cash flow and limited capex in the past two years due to delayed deliveries of new aircraft from Boeing, AC was able to reduce its adjusted debt level (including capitalized operating leases) to $6.5 billion at September 30, 2013, from $7.0 billion at December 31, 2010. As a result, adjusted cash flow-to-debt moderately improved to 14% for the last-12-month (LTM) period ended September 30, 2013, from 11% in 2010 while adjusted debt-to-EBITDAR improved to 4.9 times (x) from 5.1x during the same period. However, DBRS expects that further improvement in financial metrics, if any, will be limited because of the expected increase in debt to finance the large committed capex aggregating to $4.1 billion between the fourth quarter of 2013 and the end of 2017. DBRS understands that AC has publicly stated that it targets the adjusted net debt-(defined as adjusted debt net of cash balance)-to-EBITDAR ratio to stay within 3.5x (3.1x for LTM September 30, 2013). DBRS estimates that the target would correspond to adjusted debt-to-EBITDAR of 5.2x, based on the cash balance as at September 30, 2013, and EBITDAR for the LTM September 30, 2013.

Liquidity is adequate. AC’s cash and cash equivalent was $2.3 billion at September 30, 2013, or 19% of LTM June 30, 2013, revenue (compared to $1.0 billion, or 9% of revenue, at December 31, 2008). AC secured financing for its new B777-300ER aircraft purchase through the issuance of a USD 715 million enhanced equipment trust certificates (EETCs) in April 2013. In addition, the Airline has recently refinanced its $1.1 billion secured notes issued in 2010 with a combined $1.4 billion credit package comprising first-lien secured notes and secured credit facility maturing in 2019 and second-lien secured notes of USD 300 million maturing in 2020. The EETCs, which are governed by the recently ratified Cape Town Convention and Protocol governing international security interests in aircraft equipment, have given the Airline access to an additional funding market while the credit package has extended debt maturity and lowered financing costs. Despite the improvement, AC’s financial flexibility remains constrained by its high debt level and limited unencumbered assets.

In summary, the Airline’s business risk profile is close to the airline industry average, but its overall rating is weighed down by its weak financial profile and burdened by its high debt load and weak debt coverage ratios, limited (but improving) financial flexibility and large (but lessening) underfunded position in its pension plans. Therefore, DBRS has concluded that an Issuer Rating of B is appropriate. The Stable trend reflects that there is limited upside in the rating despite recent improvements, unless the Airline materially reduces its debt level through equity injection, which is not expected at this point. DBRS could consider a positive trend on the rating in the event that AC’s financial metrics improve materially from the current level, either through better than expected cash flow generation or equity injection. Conversely, the rating could be pressured if AC’s liquidity weakens (with cash and short-term investments falling materially below 15% of annual revenue), or if its operating cash flows materially decline for a sustained period of time, due either to operational disruptions or erosion in its market position.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology is Rating Companies in the Airline Industry which can be found on our website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.