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
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1016211
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1016211
Endorsement Policy
https://www.fitchratings.com/regulatory
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