Fitch upgrades Delta Air Lines to ‘BBB-‘; Outlook Stable

Dino D'Amore
By Dino D'Amore May 20, 2016 14:00

Fitch upgrades Delta Air Lines to ‘BBB-‘; Outlook Stable

Fitch Ratings has upgraded Delta Air Lines’ Long-Term Issuer Default Rating (IDR) to ‘BBB-‘ from ‘BB+’. Fitch has also upgraded Delta’s Seattle project bonds to ‘BBB-‘ from ‘BB+’ and affirmed the 2007-1 Class A certificates at ‘BBB+’. The Rating Outlook is Stable.

The upgrades reflect the material improvements in Delta’s credit profile in recent years as the company has paid down debt, improved profitability, and firmly established its ability to generate meaningful free cash flow (FCF). Reducing the level of risk in the business has been a major focus for Delta in recent years, and that has translated into consistently declining leverage metrics, solid profitability, a growing base of unencumbered assets, and ongoing efforts to address the company’s pension deficit.
The rating actions are also supported by Delta’s position as a leading carrier in a consolidated North American industry. Delta maintains a dominant position in its key hubs, and has made strides in improving operational reliability in recent years, improving its competitive position among North American carriers. Importantly, the ratings are based on Fitch’s projections of the company’s performance through the economic cycle, and are predicated on Fitch’s expectation that Delta’s liquidity position, cost structure and FCF generating potential will provide the company with sufficient financial flexibility to maintain an investment-grade credit profile in a period of economic stress.

The ratings also reflect concerns including Delta’s substantial annual cash needs for capital expenditures, dividends, and debt maturities; the large underfunded pension position; continuing pilot contract negotiations; and the typical operating leverage of an airline, which leads to noticeable financial sensitivity to economic conditions and input prices.

Delta continues to make progress in de-leveraging its balance sheet, which has been a major focus in recent years. The company maintains a target of $4 billion in adjusted net debt by 2020 from around $7 billion at March 31, 2016. This represents a slower pace of debt reductions than the company has achieved in recent years as the focus shifts towards reducing its pension deficit. Fitch views this shift in priorities as prudent given the level of debt reduction that Delta has already accomplished. In the past year, the company has reduced on-balance sheet debt by $1.1 billion. Total debt reduction since year-end 2009 is nearly $8.8 billion.

Strong revenue performance and margin expansion have driven leverage down quickly. Fitch calculates Delta’s total adjusted debt to EBITDAR at 1.7x as of March 31, 2016, down from more than 9x at year-end 2009. Funds from operations (FFO) adjusted leverage stands at 1.8x. Although Delta’s credit metrics have been aided in recent years by low fuel prices and a healthy airline market in North America, Fitch believes that Delta will be able to maintain credit metrics supportive of an investment grade rating even in a moderate to harsh economic downturn.

Delta’s adjusted leverage is now notably lower than either United or American, its two primary network competitors and is in-line with Southwest Airlines which is rated ‘BBB+’/Outlook Stable. Fitch expects Delta’s leverage to remain relatively flat through the forecast period, as further debt reduction may be offset by higher fuel prices and wage inflation. Relatively low leverage is partially offset by Delta’s sizeable pension obligations, which are larger than any of its peers’.

Delta’s pension obligations remain a credit concern, though Fitch believes that the company’s cash flow profile and improved balance sheet make this risk manageable. As of year-end 2015, DAL’s pension plan was underfunded by $11.2 billion, down from $12.5 billion at year-end 2014. Delta plans to make annual contributions of around $1.3 billion to its pension plans to reduce the outstanding balance. Minimum required contributions are likely to remain around a half billion dollars per year. Through April of 2016, the company has already contributed $1.2 billion to the plans including $350 million of Delta stock, completing its planned contributions for the year.

Fitch expects Delta’s healthy operating profits and manageable upcoming capex will allow the company to produce sizeable FCF for the foreseeable future. In our base forecast, Fitch anticipates that FCF will top $4 billion this year and could exceed $10 billion on a cumulative basis between 2016-2018 in a moderately rising fuel price scenario. Fitch notes that Delta maintains some flexibility as to how it deploys its cash. The company spent roughly $3.3 billion on share repurchases in 2014 and 2015, which could be reduced if needed to maintain liquidity. Its largest obligations in coming years will consist of capital spending on aircraft, and while Fitch expects the company to generate sufficient cash to pay for its aircraft, those assets are readily financeable in the debt markets. Delta has now produced positive cash flow in each of the past seven years, with cumulative FCF totalling nearly $12.7 billion over that time period. The capacity to consistently produce positive FCF is a key consideration in the upgrade of the ratings.
Delta has a history of pursuing strategic initiatives that set it apart from its peers, which Fitch views as an advantage for the company. Examples include Delta’s leading position in taking minority stake in foreign airlines (Virgin Atlantic, Gol, Aeromexico, and China Eastern), its opportunistic purchases of mid-life aircraft, and its purchase of an oil refinery. Equity investments in airlines have given Delta greater access to foreign markets through relatively minor up-front investments. Likewise, its use of older aircraft has kept capital spending in check. Delta’s recent order for up to 125 CSeries aircraft is another example of an opportunistic purchase of an aircraft type at a time when they were likely able to negotiate a favourable price given Bombardier’s desire to win an order from a major network carrier.

Fitch does not expect returns to shareholders will harm Delta’s credit profile in the near term, as evidenced by management’s continued public statements about reducing net debt, contributing to pension plans, and improving its credit profile. Although shareholder cash deployment is expected to be sizeable in the coming years, Fitch expects it to be manageable given Delta’s strong cash generation. Fitch would have a negative view of any future dividends or buybacks were to occur at the expense of Delta’s balance sheet health or at the expense of necessary investments in the business. Delta is currently operating with a $5 billion share repurchase program, the remaining $3 billion of which is to be completed by May of 2017, some seven months earlier than previously announced. The company also recently increased its dividend by 50%, bringing its annual payout to $625 million.

The industry is experiencing a period of unit revenue weakness driven by low oil prices, higher competitive capacity, economic weakness in certain markets, and foreign currency pressure linked to the strong dollar. United, American and Delta reported average unit revenue declines of -6% in the first quarter of 2016. Delta fared relatively well compared to its peers, posting a 4.6% unit revenue decrease. Fitch anticipates further unit revenue declines through much of 2016. RASM pressures across the industry are expected to gradually ease heading into 2017 as year-over-year comps become easier, and as various revenue supportive measures take effect. Delta has cited the retirement of its 747 fleet, its decreasing dependence on 50-seaters, and its ability to quickly pull capacity out of markets if unit revenues remain weak.

All three major network carriers have announced minor downward adjustments to previous capacity guidance in an effort to shore up unit revenues. Much of the reduction will be in international markets, particularly in the Pacific and in Latin American markets like Brazil, with more minor adjustments to be made to domestic growth. Recent unit revenue weakness has been more than offset by lower fuel prices, allowing the industry to produce historically positive results over the past year. Fitch does not believe that the current revenue weakness presents a material credit concern, unless it persists for longer than anticipated or if revenues were to remain pressured in a higher fuel price scenario.
Delta’s pilot contract became amendable in December of 2015, and is currently in mediation. There is a high likelihood that the pilot union will be successful in negotiating a material pay increase given that the industry is operating at record profit levels. Although increasing pilot pay rates will represent an area of cost pressure in the coming years, Fitch believes that it can be at least partially offset by savings in other areas. Delta has further room to improve in areas like reducing its reliance on 50-seat regional jets, upgauging its narrow body fleet, and increasing its fuel efficiency as it begins to retire older aircraft.

Note that Delta raised wages for its non-pilot employees by 14.5% effective as of December of 2015. The impacts of that decision are working their way through Delta’s financial results in 2016. Pay increases were accompanied by a change in the company’s profit sharing policy, which now bases the payout percentage on the previous year’s pre-tax earnings, rather than on a set dollar amount of pre-tax earnings.
Delta maintains an advantage over many of its competitors in that its workforce is largely non-unionized, says Fitch. Only 18% of its workforce is unionized (pilots, dispatchers, and flight attendants at its regional subsidiary, Endeavor).

Dino D'Amore
By Dino D'Amore May 20, 2016 14:00