Standard & Poor’s on airline credit ratings January 2007

S&P explains credit ratings

hy exactly are airlines such as Qantas and BA considered less risky, as indicated by their superior corporate credit ratings, than the likes of American and JAL? A recent comparative analysis by Standard & Poor's* identifies the main differentiating credit factors for the world's top airlines. The rating agency looked at both what it called "business risk" (industry characteristics, competitive position, etc) and "financial risk" (debt leverage, cash flow, liquidity, etc). The comparison, carried out in mid-December 2006 and based on statistics from 2005 or 2005/2006 financial years, plus qualitative analysis, included two airlines each from North America, Europe and Asia-Pacific: AMR, UAL, BA, Lufthansa, JAL and Qantas. S&P concluded that the six airlines had broadly similar industry risk characteristics and that all had "quite good" market positions. The variation in business risk scores — BA, Lufthansa and Qantas were rated "satisfactory" while AMR, JAL and UAL were judged "weak" — was mainly due to differences in 2005 operating profitability (after adjustments for depreciation, operating leases and retiree expenses). But the analysis found dramatic differences in cash flow generation and debt burdens between the six airlines. As a result, the financial risk scores ranged from Qantas' and Lufthansa's "intermediate" (or solid by airline standards), to BA's "aggressive" and AMR's, JAL's and UAL's "highly leveraged".

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Industry risk/market position

The report contained some interesting observations about regional differences in the regulatory environment, degree of competition and other factors. S&P considers the "highly concentrated" Japanese and Australian domestic markets and the many rapidly growing Asian markets the least risky. JAL and Qantas are well-positioned in that respect, since they earn 53% and 73% of their revenues domestically (the latter figure includes New Zealand). The US and Canadian domestic markets are clearly the riskiest, due to competition and relatively low barriers to entry. AMR and UAL are heavily exposed since they generate more than 60% of their revenues in the US domestic market.

European markets fall between the two extremes, though S&P noted that both BA and Lufthansa earn the bulk of their revenues (81% and 51%, respectively) from intercontinental operations, which are generally less risky than intra-European operations. The report suggested that Lufthansa, JAL and United have the most regionally diversified route networks. BA and JAL have the best home hubs (London Heathrow and Tokyo Narita). But S&P felt that Lufthansa's and Qantas' home hubs (Frankfurt and Sydney), which serve smaller metropolitan areas, may lose some connecting business traffic with the increasing use of medium-sized, longrange aircraft such as the 787. S&P rated Qantas' home market position the strongest among the six global carriers, despite the fact that its main competitor is an LCC. While JAL, BA and Qantas are the largest single operators from their home countries, those airlines (and Lufthansa) account for less than 50% of total traffic at their main hubs because those airports are served by a large number of international carriers. By contrast, American and United dominate most of their major hubs, which handle large numbers of domestic passengers. They have large shares of each local market, which tends to generate higher-yield traffic, but they also face intense competition from LCCs either at the hubs or nearby airports. The US-Europe unit passenger revenue differentials seem as wide as ever. AMR and UAL achieved less than 6 US cents per ASK in 2005, reflecting both low fares in the competitive US domestic market and a lesser reliance on international premium-fare passengers. BA and Lufthansa, which have mostly international operations and devote more space to premium classes, had unit revenues of 9.4 and 9.7 cents, respectively. Qantas and JAL were in the middle, with RASK of 8.4 cents and 7.7 cents, respectively — JAL's has declined because, following its 2002 acquisition of Japan Air System, it has a more equal blend of domestic and international flying. (The analysis did not include cargo and ancillary revenues, which can be significant contributors.) The US airlines also had the lowest unit costs around 6.5 cents per ASK (excluding restructuring costs) in 2005, compared to Lufthansa's 9.6, BA's

Jan/Feb 2007

HOW THE AIRLINES COMPARE

Airline Qantas Lufthansa BA JAL Rating BBB+/Watch Neg BBB/Stable BB+/Positive B=/Negative Business Risk Score Satisfactory Satisfactory Satisfactory Weak Financial Risk Score Intermediate Intermediate Aggressive Highly leveraged Revenues* Fully adjusted debt/capital ratio** Fully adjusted net debt/revenues** $9.9bn 48.7% 21% $22.4bn 73.5% 37% $14.8bn 78.8% 51% $18.7bn 91.1% 90% AMR B/Stable Weak Highly leveraged $20.7bn 109.8% 110% UAL B/Stable Weak Highly leveraged $17.4bn 90%*** 100%

Notes: * In 2005 or 2005/06 fiscal year, ** At the end of 2005 or 2005/06 fiscal year, ***=Upon emergence from Chapter 11 in early 2006 Source: Standard & Poor’s

8.9, Qantas' 8.2 and JAL's 7.9. The differences reflect a combination of actual cost competitiveness and traffic mix. The multibillion dollar cost cuts implemented by AMR and UAL in recent years have helped maintain their CASK lead.

Financial risk: vivid differences

The report noted that AMR, JAL and UAL carry significantly higher debt loads and have weaker financial ratios than the other three airlines, reflecting post-September 11 borrowings to maintain adequate liquidity and finance capital expenditures, as well as overall weaker profitability and cash flow generation. Qantas has the healthiest financial profile — so far. The report noted that its relatively light debt burden was one reason it caught the attention of private equity firms, which are looking to add considerable leverage. S&P cautioned that Qantas' debt burden was set to rise anyway due to substantial planned capital spending to modernise and expand its fleet, and that airlines generally are subject to a wide variety of potential stresses — reasons why a strong financial profile and ample liquidity are important. The fully-adjusted debt-to-capital ratios (the standard leverage measure) at the end of 2005 or 2005/06 financial years, ranged from Qantas' 49% to AMR's 110% (or UAL's negative 305%, though this improved to positive 90% when the company exited bankruptcy in early 2006). Lufthansa was the second-best with a ratio of 74%, followed by BA with 79% and JAL with 91%. In terms of fully-adjusted net debt as percentage of revenues, which measures solely an airline's debt burden relative to its size, the range was from Qantas' conservative 21% to AMR's elevated 110%. The figures for Lufthansa, BA, JAL and UAL were 37%, 51%, 90% and 100%. But why did UAL not get its debt-to-capital ratio below 90% despite all the Chapter 11 restructuring? Because, in S&P's words, "airlines, whose financial

obligations mostly take the form of secured debt and leases, have less scope to deliever in bankruptcy than does a typical industrial company". The report noted that each of the six airlines except JAL maintains a substantial unrestricted cash cushion. At the end of 2005 or 2005/06 financial years, BA's was the best at 29% of annual revenues, followed by Qantas' 21% and Lufthansa's 20%. AMR and UAL are now also in the 21% range, after significantly improving their cash reserves in 2006. Although JAL's equity offering in July 2006 more than tripled its cash reserves to US$1.6bn, this higher figure still amounted to only 9% of 2005 revenues. Regarding what S&P called the "final liquidity line of defence", Lufthansa and Qantas have mostly unencumbered fleets. BA has some unencumbered aircraft. UAL's, AMR's and JAL's fleets are almost entirely encumbered, but the latter two have some other assets, such as AMR's FFP, that could be monetised. Of the six airlines, Qantas has the highest credit rating with S&P — an investment-grade BBB+. However, the airline is on "creditwatch negative", meaning a downgrade is possible if the A$11.1bn takeover bid by a private equity consortium led by Macquarie Bank and Texas Pacific goes through, depending on how the transaction is financed. (According to the latest reports, the consortium has pledged to keep A$2bn of cash on Qantas' balance sheet to address airline industry risks, but that would be less than the A$2.9bn cash held at the end of June 2006.) Lufthansa has the next-best credit rating (BBB), followed by BA (BB+), JAL (B+) and AMR and UAL (B). BA is the only one in the group that could secure an upgrade from S&P in the near term, thanks to steadily improving earnings and a gradual reduction in debt. Although AMR's and UAL's earnings improved dramatically in 2006, their high debt burdens mean that near-term credit rating upgrades are unlikely.

* "For Global Airlines, Similar Market Positions But Widely Different Financial Profiles" by Philip Baggaley, Standard & Poor's (18 December 2006)

Jan/Feb 2007