CHICAGO--(BUSINESS WIRE)--Fitch Ratings has removed Alaska Air Group Inc.'s (ALK) ratings from Rating Watch Negative and affirmed the ratings at 'BBB-'. The Rating Outlook is Stable. The rating action follows the Department of Justice's decision, announced on December 6, to allow ALK's acquisition of Virgin America to proceed, and Alaska's settlement of a separate civil lawsuit, which was the last significant remaining hurdle to the completion of the acquisition. Fitch expects the transaction will now close in the next week.
Fitch placed ALK on Rating Watch Negative in April of 2016 after the acquisition was announced. The resolution of the ratings watch and affirmation of the rating reflects Fitch's view that ALK will continue to maintain a credit profile that is consistent with an investment grade rating despite higher acquisition-driven leverage, reflecting credit metrics prior to the acquisition, which were strong for a 'BBB-' rating, management's track record of conservative financial management, and Fitch's expectations that the company will actively de-lever its balance sheet in the near-to-intermediate term.
Fitch also believes that the added risk involved with higher debt levels and integration of the two airlines are partially offset by the reduced geographic concentration and better competitive position that ALK gains through the acquisition of Virgin. The affirmation is also supported by ALK's strong margins, solid free cash flow, attractive financing rates, and healthy liquidity, including a still substantial number of unencumbered aircraft.
Fitch views Alaska as temporarily having little cushion at its current rating following the acquisition. Greater than expected integration related problems, material weakening of the operating environment for the US airline industry or failure to pay down debt in the next 18 to 24 months could negatively impact the ratings.
KEY RATING DRIVERS
The 'BBB-' rating is supported ALK's solid financial flexibility and strong operating margins. Fitch believes that ALK's credit metrics following the acquisition will be at the high end of the range for an investment grade rating but will trend towards levels that are solidly supportive of an investment grade rating over the intermediate term. Fitch expects incremental debt to increase ALK's total adjusted debt/EBITDAR to around 2.7 to 3.0x on a pro-forma basis, which is lower than Fitch's initial expectation when the acquisition was announced. ALK's standalone leverage was 1.5x at year end 2015. Fitch anticipates that adjusted debt/EBITDAR will be around the mid 2x range by 2018, which is a level consistent with Fitch's expectations for a 'BBB' category rating.
FFO fixed charge coverage is expected to decline to the 3x to 3.5x range over the forecast period down from its current levels of nearly 6x. Forecasted fixed charge coverage is below ALK's investment grade rated peers (Southwest ~ 4.8x, Delta ~ 6.4x). A sharp drop in ALK's coverage ratio is partially driven by the large amount of operating rent that Virgin brings to the combined entity due to its leased fleet of aircraft, and due to higher interest payments on acquisition-related debt.
The ratings are further supported by Alaska's competitive position in its key markets, which Fitch expects to improve following the integration of Virgin America. Both Alaska and Virgin have generated healthy financial results over the past year despite a competitive industry environment that drove weak unit revenues. Both carriers have generated improved operating margins over the past year, partially due to lower oil prices, but also due to solid non-fuel cost controls at Alaska and better than average RASM performance by Virgin. In the near-term, both carriers also benefit from their focus on the U.S. domestic market, which remains the most profitable region in the global aviation industry, and from their relatively low cost structures.
A key factor in the rating is Fitch's expectation for the combined companies to continue to generate a material amount of free cash flow over the intermediate-term, allowing for debt repayment, flexibility in funding aircraft deliveries, and the capacity to absorb integration related costs. Fitch expects ALK to generate FCF in the low-to-mid single digits as a percentage of revenue over its forecast period.
Strategically, Fitch considers the acquisition to have merit. On a stand-alone basis, ALK's route system is concentrated on the West Coast and in the Pacific Northwest specifically. Its heavy reliance on its Seattle hub has been a standing ratings concern. According to company filings, some 61% of its total passengers in 2015 flew either to or from Seattle. The combination with Virgin America will help to bolster ALK's presence in San Francisco and Los Angeles and further build-out its route network, more firmly establishing its market position on the West Coast.
Virgin America also places a particular emphasis on its transcon business. Fitch estimates that well over a third of revenues are driven by flying between LA, San Francisco and several East Coast markets including New York JFK, Newark, Boston, Washington Dulles and Fort Lauderdale. The growth of ALK's transcon business was one key element of the company's network transformation that has taken place over the last decade. Merging with VA will give ALK additional presence in these markets.
Outside of the transcon markets, ALK and Virgin America have limited overlapping routes, but they do have similar geographic footprints, as the two carriers serve most of the same cities. Prior to the acquisition ALK served 112 destinations compared to Virgin's 24. Following the acquisition, the combined airlines will only serve 114 markets. The overlapping presence of the two airlines will be a benefit in terms of reaching VA's existing customers, and in re-allocating capacity between markets.
Key Risks
Fitch's primary rating concerns center around the merger integration and the inherent risks involved with attempting to combine two complex operations. In the past, airline mergers have proven to be difficult. Some have gone fairly smoothly (American/US Airways) while others have caused long-term damage to the participating entities (United/Continental).
ALK will also face some margin headwinds as it works to fold a less profitable carrier into its network. VA generated positive net income for the first time in 2013 after generating years of losses since its first flights in 2008. Margins have improved sharply since then, partially due to a pause in the company's aggressive growth rates and partially due to low fuel prices and a highly favorable U.S. aviation market. Nevertheless, VA generated an EBIT margin of 12% in 2015 compared to 23.8% at ALK and an industry average of around 17.5%. Fitch believes that ALK's high level of profitability and sustained efforts towards reducing unit costs reflect well on ALK's management team and we believe that ALK may be able to drive better results into VA's operations over time. Nevertheless, some near-term headwinds are likely.
Other concerns involve risks that are typical of the airline industry including cyclicality, intense competition, capital intensity, and an exposure to exogenous shocks (terrorism, disease, etc.).
New Debt Will Encumber Some Existing Aircraft
Prior to the acquisition, Fitch considered ALK's large fleet of unencumbered assets to be a material source of support for the company's financial flexibility. The company has now utilized the bulk of its previously unencumbered fleet as collateral for the acquisition-related debt, causing the total number of unencumbered planes to drop from 101 at June 30, 2016 to around 50 following the transaction, though that number is likely to increase over time.
Aircraft tend to be readily financeable assets, and the reduction in unencumbered planes reduces one of ALK's easiest and potentially cheapest sources of future financing. Nevertheless, we believe that ALK will still have plenty of capacity to tap the debt markets in the future if it were in need of capital given the company's relatively low leverage, history of free cash flow generation, and relatively strong credit profile.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for ALK include:
--Sustained modest macroeconomic growth in the United States;
--Mid-single digit annual capacity growth for the combined carriers;
--A conservative fuel price assumption with crude oil rising to around $70/barrel by 2019;
--A significant portion of free cash flow being directed towards debt reduction over the forecast period.
RATING SENSITIVITIES
Future actions that may individually or collectively cause Fitch to take a negative rating action include:
--Failure to de-leverage the balance sheet within 18 to 24 months of the transaction close;
--Gross adjusted leverage rising and remaining above 3x;
--Significant merger related difficulties potentially leading to lost customer loyalty and declining profitability;
--Increasing competitive pressure causing EBITDAR margins to fall and remain below 20%.
Fitch does not anticipate taking a positive rating action in the near term due to the additional risks ALK faces related to the merger integration and higher financial leverage.
Nevertheless, future actions that may individually or collectively cause Fitch to take a positive rating action include:
--Adjusted debt/EBITDAR sustained around or below 2.0x;
--FFO fixed charge coverage increasing towards 4x to 4.5x;
--Free cash flow margins sustained in the high single digits;
--Evidence that the merger with Virgin America is progressing smoothly (i.e. achieving a single operating certificate, successful integration of reservation systems, etc.)
LIQUIDITY
ALK ended the third quarter of 2016 with cash and marketable securities of $3.2 billion which is inclusive of roughly $1.5 billion in new debt raised in the third quarter ahead of the acquisition. ALK has benefited from attractive interest rates for aircraft secured debt, reporting an average cost of funding of less than 3%. Cash on hand plus full availability under its two $100 million revolving credit facilities and a $52 million revolving credit facility left ALK with total liquidity of 60% of LTM revenue, which represents a temporary high point. Following the acquisition, ALK aims to maintain a liquidity balance of around 25% of LTM revenue. Upcoming debt maturities following the acquisition should be manageable through cash flow from operations or cash on hand.
FULL LIST OF RATING ACTIONS
Alaska Air Group, Inc.
--Long-Term Issuer Default Rating at 'BBB-'.
Additional information is available on www.fitchratings.com
Summary of Financial Statement Adjustments
Fitch sets aside a certain amount of cash as 'not readily available' to reflect a minimum amount of cash that may be necessary for the company to carry on day-to-day operations and is thus not immediately available for things like debt payments or capital expenditures. Fitch estimates this amount at roughly 10% of LTM revenue less availability under ALK's revolver.
Applicable Criteria
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
https://www.fitchratings.com/site/re/885629
Rating Aircraft Enhanced Equipment Trust Certificates (pub. 29 Sep 2016)
https://www.fitchratings.com/site/re/887869
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