Key Credit Factors: Business And Financial Risks In The Airline Industry

September 18, 2008

ARCHIVE | Criteria | Corporates | Industrials:
Key Credit Factors: Business And
Financial Risks In The Airline
Primary Credit Analyst:
Philip Baggaley, CFA, New York (1) 212-438-7683;

Table Of Contents
Relationship Between Business And Financial Risks
Part 1--Business Risk Analysis
Part 2--Financial Risk Analysis                                                                        1
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ARCHIVE | Criteria | Corporates | Industrials:
Key Credit Factors: Business And Financial
Risks In The Airline Industry
(Editor's Note: Table 1 in this article is no longer current. It has been superseded by the table found in "Criteria
Methodology: Business Risk/Financial Risk Matrix Expanded," published May 27, 2009, on RatingsDirect.)

Standard & Poor's Ratings Services' analytic methodology evaluates the qualitative and quantitative factors of an
issuer to determine a credit rating opinion on that issuer. The analytic framework for industrial companies in all
sectors, including airlines, is divided into two major segments: The first part is fundamental business risk analysis.
This step forms the basis and provides the industry and business context for the second segment of the analysis, an
in-depth financial risk analysis of the company.

Our rating analysis of airlines begins with the industry, business, management, and competitive positions of the
entity before we consider the financial risk profile. The company's business risk profile determines the financial risk
it can bear at a given rating level.

Relationship Between Business And Financial Risks
Before discussing the specific factors we analyze in our methodological framework, it is important to understand
how we view the relationship between business and financial risks. Table 1 displays this relationship and its
implications for a company's rating.

Table 1

Chart 1 summarizes the rating process.

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Chart 1

Part 1--Business Risk Analysis
Business risk is analyzed in four categories: country risk, industry risk, competitive position, and profitability. We
determine a score for the overall business risk based on the scale shown in table 2.

Table 2
 Business Risk Measures
 Description    Rating equivalent
 Excellent      AAA/AA
 Strong         A
 Satisfactory   BBB
 Weak           BB
 Vulnerable     B/CCC                                                                                       3
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Analysis of business risk factors is supported by factual data, including statistics, but ultimately involves a fair
amount of subjective judgment. Understanding business risk provides a context in which to judge financial risk,
which covers analysis of cash flow generation, capitalization, and liquidity. In all cases, the analysis uses historical
experience to make estimates of future performance and risk.

1. Country risk and macroeconomic factors (economic, political, and social environments)
Country risk plays a critical role in determining all ratings on companies in a given national domicile.
Sovereign-related stress can have an overwhelming effect on company creditworthiness, both directly and indirectly.

Sovereign credit ratings are suggestive of the general risk that local entities face, but the ratings may not fully
capture the risk applicable to the private sector. As a result, when rating corporate or infrastructure companies or
projects, we look beyond the sovereign rating to evaluate the specific economic or country risks that may affect the
entity's creditworthiness. Such risks pertain to the effect of government policies and other country risk factors on the
obligor's business and financial environments, and an entity's ability to insulate itself from these risks.

2. Industry business and credit risk characteristics
In establishing a view of the degree of credit risk in a given industry for rating purposes, it is useful to consider how
its risk profile compares to that of other industries. Although the industry risk characteristic categories are broadly
similar across industries, the effect of these factors on credit risk can vary markedly among industries. Chart 2 below
illustrates how the effects of these credit-risk factors vary among some major industries. The key industry factors are
scored as follows: High risk (H), medium/high risk (M/H), medium risk (M), low/medium risk (L/M), and low risk

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Chart 2

We believe the U.S. airline industry has weak industry risk characteristics compared to many other industries. Its
cyclical and competitive characteristics present specific challenges to attaining high ratings. Changing regulatory
regimes and market conditions work to the advantage of some air carriers and to the detriment of others. Most
airlines, particularly in the U.S., are rated well into speculative-grade territory.

The following major factors affect the airline industry globally and are important in understanding the industry's
competitive environment and prospects for growth and cash flow generation, as well as the industry's challenges and                                                                                     5
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Industry strengths:
•   Global economic and demographic trends favorable for long-term demand growth;
•   Readily financeable revenue assets (aircraft);
•   Availability of government credit to finance air travel infrastructure;
•   The service is vital to almost all national economies;
•   No effective competing modes of transportation on long routes; and
•   Low technological risk, as such changes are evolutionary.

Industry challenges/risks:
• Vulnerability to fuel price inflation/volatility;
• Sensitivity to the economic cycle;
• Demand fluctuations caused by actual or feared terrorism, war, and epidemics; much business and leisure travel
  becomes optional in times of crisis;
• Deregulation and material regulatory changes;
• Seasonal demand for leisure travel;
• Price competition, particularly for leisure travel;
• High barriers to exit, leading to overcapacity;
• Limited ability to add capacity because of dependence on government-provided air traffic control and airports;
• High operating leverage, leading to temptation to price at the modest marginal cost of filling a seat with a
• Capital-intense and heavy debt use;
• Principal asset (aircraft) and major input (fuel) are priced in a single currency (U.S. dollars), producing foreign
  exchange mismatches for many airlines; and
• Labor-intense, with labor usually organized and powerful because of service business vulnerability to work

3. Company competitive position (keys to competitive success)
In analyzing a company's competitive position, we consider the following factors:

•   Market position;
•   Operating efficiency;
•   Diversification;
•   Management; and
•   Ownership and governance.

Market position. Three aspects are industry-specific and critical to understanding an airline's market position:

• Route network, extent of competition, and barriers to entry;
• Position within markets served; and
• Passenger preference/customer service reputation and loyalty programs.

Market position is an important rating factor because it determines, to a large extent, the potential for revenue
generation. Mergers are one way to assemble a more comprehensive route network, particularly when there is little
overlap between the two airlines involved. Thus, for example, the combination of Delta Air Lines Inc. with

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Northwest Airlines Corp. will create a much broader route network than either airline had alone and greater access
to major business markets. Still, size alone is not sufficient for success, as seen by the fact that four of the six largest
U.S. airlines have filed for bankruptcy since 2001.

Operating efficiency. Evaluation of operating efficiency can be divided into:

• Revenue generation,
• Cost structure, and
• Fleet evaluation.

Revenue generation is usually measured by operating revenue per available seat mile (one seat flown one mile,
whether filled or not) or a subset of that, passenger revenue per available seat mile. This measure combines the
effects of capacity utilization and pricing. Similarly, costs are usually measured using operating cost per available
seat mile. Currently, all airlines, particularly those in the U.S., are facing steep increases in jet fuel prices, which now
represent about one-third of their total operating costs. Having already reduced labor costs in, or with the threat of,
bankruptcy, the airlines' main response has been to raise prices to offset the higher expenses. They did this
successfully in 2006 and 2007, but this will not be as easy in a weaker U.S. economy.

Diversification. If successfully developed, diversification can enhance credit quality. We look at the following areas
for airline credits:

•   Geographic,
•   Customer base served (leisure or business),
•   Nonpassenger airline business, and
•   Nonairline businesses.

Large airlines tend to benefit from geographic diversity. Thus, for example, large U.S. airlines have been able to shift
planes from the more competitive domestic market to various faster-growing international routes. Nonpassenger,
airline-related businesses, such as the sale of frequent flyer miles, can be quite profitable. Currently, the example of
ACE Aviation (parent of Air Canada) separating its loyalty program business and achieving a higher total stock
market capitalization has prompted some other large airlines to consider similar moves. Some large European and
Asian airlines operate significant air freight businesses, which are less vulnerable to event risk such as terrorism or

Management. Management is assessed on its ability to run and expand the business efficiently while mitigating
inherent business and financial risks. The airline industry has become an increasingly competitive business requiring
experienced and successful management teams to have a strong mix of the following disciplines:

•   Operating efficiency/cost control/strategy;
•   Labor relations track record;
•   Attitude toward business and operating risks;
•   Credibility of strategy, plans, and projections; and
•   Operating and financial track records.

We believe the quality of airline management has improved in the past several decades, as executives are more
focused on profitability, even at the expense of ceding some market share, and on understanding operating risks and
the need for adequate liquidity. Labor relations poses a particular challenge for airline managers, as unions are                                                                                          7
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well-organized and strong (particularly pilot unions), and a strike lasting a month or even less can bankrupt an

4. Profitability
Profit potential is a critical determinant of credit protection for airlines. A company that generates higher returns on
capital and operating margins also has a greater ability to generate equity capital internally, attract capital
externally, and withstand business adversity. Earnings power ultimately attests to the value of the company's assets
as well. In fact, a company's profit performance provides a litmus test of its fundamental health and competitive
position. Accordingly, the conclusions about profitability should confirm the assessment of business risk.
Profitability measures include the following ratios, which need to be compared with both those of other industry
participants and of rated entities in other industries:

• Operating income after depreciation expense divided by revenues,
• Lease-adjusted EBITDA margin (EBITDA expense divided by revenues), and
• Return on permanent capital (EBIT divided by average total debt, deferred taxes, minority interest, and
  shareholders' equity).

Airlines, like other transportation companies, report their margins after depreciation expense. We consider those
margins, but also lease-adjusted operating income before depreciation (consistent with our Corporate Ratings
Criteria). On the latter basis, airline margins, although volatile, tend to be fairly good. However, airlines have
substantial depreciation and rental expenses, and their high fixed costs make for high operating leverage. Return on
capital tends to be mediocre, given the huge investment in aircraft and the competition on pricing. We expect airline
earnings, after two fairly good years, to drop sharply in 2008 because of high fuel prices and a soft U.S. (and
potentially global) economy. Still, we do not expect to see a repeat of the huge losses incurred earlier this decade,
unless terrorism is renewed or the economic downturn is much worse than expected.

Part 2--Financial Risk Analysis
Having evaluated a company's business risk, the analysis proceeds to several financial categories. The company's
business risk profile determines the financial risk appropriate for any rating category. Financial risk is portrayed
largely through quantitative means, particularly by using financial ratios.

We analyze five risk categories: accounting characteristics; financial governance/policies and risk tolerance; cash
flow adequacy; capital structure, leverage, and asset protection; and liquidity/short-term factors. We then determine
a score for most of the financial risk categories using the following scale:

Table 3
 Financial Risk Measures
 Description     Rating equivalent
 Minimal         AAA/AA
 Modest          A
 Intermediate    BBB
 Aggressive      BB
 Highly leveraged B

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1. Accounting characteristics
Financial statements and related footnotes are the primary source of information about a company's financial
condition and performance. The analysis begins with a review of accounting characteristics to determine whether
ratios and statistics derived from the statements adequately measure a company's performance and position relative
to those of both its direct peer group and the universe of industrial companies. This assessment is important in
providing a common frame of reference and in helping the analyst determine the quality of disclosure and the
reliability of the reported numbers.

Comparing airlines (or any other companies) across borders presents a variety of accounting comparability
problems. These affect income statement and balance sheet items involving accrual accounting: depreciation,
amortization, equity, and other accounts. Beyond that, airlines use various depreciation lives for aircraft, which can
have a significant effect on comparability. Gains on sale-leaseback of aircraft are taken into income under U.K.
accounting, but are amortized under U.S. accounting. Many, though not all, of these problems can be addressed by
focusing on "cash" ratios, i.e., those focusing on EBITDA or related concepts.

Off-balance-sheet aircraft and facility leases form a large portion (sometimes the majority) of total fixed financial
obligations for airlines. We regard these as simply another form of secured debt (albeit a less onerous form) and use
a discounted present-value model to adjust credit ratios to reflect the added financial burden. All credit ratios can be
adjusted to take these leases into account, and the effect is often significant. Because these obligations are spread out
over many years, are often at borrowing rates much lower than what an airline could otherwise achieve, and can be
at least partly satisfied in many cases by returning the plane to a lessor, airlines may have better credit flexibility
than their weak credit measures (relative to those of other industrial issuers) would indicate.

2. Financial governance, policies, and risk tolerance
The robustness of management's financial and accounting strategies and related implementation processes is a key
element in credit-risk evaluation. We attach great importance to management's philosophies and policies involving
financial risk. Airlines have ready access to equipment financing, which sometimes tempts management to operate at
higher-than-prudent debt leverage or even highly leveraged positions. Pursuit of growth opportunities and the need
to modernize fleets are other factors that, albeit legitimate business considerations, can sometimes lead to aggressive
use of lease or debt financing. In some cases, fleet expansion or renewal programs are not clearly correct or
incorrect, but rather a trade-off between operating benefits and financial risk.

Other issues to consider when evaluating financial policy include share repurchases, funding of acquisitions and
capital expenditures, and target capital structure and concrete steps taken to achieve it. Companies' financial and
accounting strategies and track records are critical to understanding management's intent and risk appetite and can
be a material negative rating factor if over-aggressiveness and imprudence are evident.

Other risks include fuel price volatility, foreign currency mismatches, and interest rates. Fuel prices tend to be the
most serious issue, but most U.S. airlines (with the notable exception of Southwest Airlines Co.) have not
undertaken substantial hedging programs. This is partly because of their weak credit quality, which prompts
counterparties to hedge instruments to demand cash collateral.

3. Cash flow adequacy
For all corporate borrowers, cash flow analysis is the most critical element of all credit rating decisions. There
usually is a strong relationship between cash flow and profitability, but many transactions and accounting entries
affect one and not the other. Analysis of cash flow patterns can reveal debt-servicing capability that is stronger or                                                                                       9
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weaker than might be apparent from earnings.

For airlines, cash flow analysis assesses a carrier's ability to generate cash from internal sources relative to the claims
against that cash. Cash flow is defined variously as EBITDA, funds from operations (FFO; the sum of net income,
depreciation and amortization, and other noncash expenses or revenues), or cash from operations, which also takes
into account changes in the current accounts. Current assets and current liabilities are typically a relatively small
part of the balance sheet for airlines, so the difference between FFO and cash from operations is not great. We will
usually focus on FFO, which excludes seasonal variations that might affect receivables and payables.

Airline cash flow ratios. Ratios show the relationship of cash flow to debt and debt service, and to the company's
needs. Because there are calls on cash other than for repaying debt, it is important to know the extent to which those
requirements will allow cash to be used for debt service or lead to greater need for borrowing. The most important
cash flow ratios we look at for airlines are:

•   EBIT/interest;
•   EBITDA coverage*;
•   FFO*/debt*; and
•   FFO*/capital expenditures*.


Most North American airlines have generated improved cash flow ratios in the past several years because of better
earnings and/or reduced debt and pensions (often in bankruptcy). We expect that progress to halt or reverse
somewhat because of lower earnings and, at some airlines, higher capital expenditures. The large U.S. airlines have
mostly deferred modernizing their fleets and now face the need to spend billions of dollars to replace aging and less
fuel-efficient planes.

4. Capital structure, leverage, and asset protection
A company's assets and related cash flow mix are critical determinants of the appropriate leverage for a given rating
level. Assets/brands producing strong cash flow and having clear marketability justify a higher level of debt than
assets with weaker cash generation and market value characteristics.

In many respects, the financial factor over which management has the greatest control is how the carrier is financed
and, accordingly, how much financial risk it is willing to bear. As a general rule, the greater the use of debt and
leases relative to equity or to the size of the company, the higher the risk for all creditors. Debt leverage measures
are not as predictive of default as profitability and cash flow, but they do reflect on management's financial policy
and the depth of resources available to an airline if operating results falter.

The following key ratios are useful indicators of leverage:

•   Total debt*/total debt + equity;
•   Total debt* + present value of operating leases/EBITDAR;
•   Total debt*/total debt* + market value of equity; and
•   Total debt*/revenues.


Airlines tend to have higher leverage than other comparably rated industrial companies. This reflects heavy debt and

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lease usage to finance their fleets, as well as historically weak profitability (and thus retained earnings). To some
extent, that higher leverage can be supported because aircraft can in most cases be financed (on delivery or as a
means of raising cash against existing assets), even if the airline itself is a weak credit. U.S. bankruptcy law provides
favorable rights to aircraft financiers to repossess collateral, and many other legal jurisdictions ensure that lessors
(although less often secured lenders) can have access to their collateral. The analyst should take care when
comparing debt to capital of airlines that have gone through bankruptcy with that of their nonbankrupt peers. The
former will usually have an intangible asset, either goodwill or "value in excess of amounts allocable to specific
assets" arising from revaluation of assets upon emergence from bankruptcy. For example, Delta Air Lines and
Northwest Airlines, which emerged from Chapter 11 bankruptcy during a period of strong airline earnings and
share prices, recorded large amounts of goodwill that caused their equity accounts to be overstated relative to those
of other airlines. In such cases, we would also review debt to market capitalization and debt to EBITDA. We also
review debt to revenue as a way of measuring how heavy a financial burden an airline carries relative to its size
(measured by revenue).

5. Liquidity/short-term factors
Our analysis of liquidity (and financial flexibility more generally) starts with operating cash flow and cash on hand,
then looks at other actual and contingent sources and uses of funds in the short term that could provide or drain
cash under given circumstances.

The quality and extent of a company's liquidity are products of its own cash flow and financial strength and its
access to external sources of funding. A general rule is that the stronger a company's internally generated
profitability, unencumbered short- and long-term assets, cash flow, and capital base, the better its access to external
capital and liquidity. This is because these operating and financial strengths make the company an attractive
"credit" and equity investment candidate. Conversely, when a company's operating results and cash flow
deteriorate, leading to a decline in liquidity, its need for access to external capital often increases. Yet, at such times
of stress, its access to external capital is often markedly reduced because it has become a less attractive borrowing
and investment candidate. Its financial flexibility is reduced.

Liquidity is often the leading short-term credit issue for most speculative-grade corporate issuers/borrowers. The
short-term horizon can be particularly critical in terms of liquidity, event risk, and susceptibility to changes in
business conditions, all of which can lead to precipitous declines in earnings, cash flow, and capital. For such
companies, it is important to understand which sources of liquidity and capital are available beyond internal cash
flow, the likely demands on those resources, and, where relevant, the availability of implicit or explicit government
support. This is particularly important for airlines because of the volatile nature of their operating and financial
performance, capitalization, and book equity.

Critical sources of external liquidity for companies with deteriorating internal liquidity include:

•   Committed bank lines,
•   Large cash and short-term investment holdings,
•   Unencumbered, financeable assets (e.g., aircraft),
•   Saleable, nonstrategic assets (e.g., non-airline subsidiaries, real estate),
•   Access to resources through a parent company or ownership by a government,
•   Support from aircraft manufacturers and lessors, and
•   Support from a government (e.g., flag carriers; see also discussion of this issue in the "Industry Business And                                                                                       11
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  Credit Risk Characteristics" section above).

Airlines have the added advantage over most industries in that their principal assets, aircraft, are readily financeable
(through leases or secured lending), and saleable, reflecting several factors:

• Aircraft can be easily transferred from one operator to another in an active, liquid, and global market;
• The value of aircraft does not decline substantially when the operating airline is in financial distress, although
  their price is, of course, affected by general industry conditions; and
• Lessors and secured creditors can, with varying degrees of difficulty, repossess aircraft if the airline does not
  continue rental or debt service payments.

Airlines often hold fairly large amounts of cash as a key source of liquidity. This reflects several factors: Some
airlines are too weak to arrange general credit facilities. All face potential threats to liquidity from industry
downturns, event risk (terrorism, epidemics), or strikes. Also, the credit card processors that handle most airline
ticket purchases and advance funds to an airline before the flight occurs will typically demand cash collateral if an
airline appears at risk of insolvency. Such processing agreements in the U.S. have financial covenants similar to those
in bank agreements. Prior to the Sept. 11, 2001, attacks, most large U.S. airlines had significant amounts of
unencumbered assets against which they subsequently borrowed to maintain liquidity (which nevertheless did not
prevent eventual bankruptcy for most). The U.S. airlines, with the notable exception of Southwest, now have
relatively few unencumbered assets, so cash liquidity is even more critical to their solvency.

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