Rating rationale

Scope Ratings today assigns Deutsche Lufthansa AG a Corporate Issuer Credit Rating (CICR) of BBB- and an S-2 short-term rating. The Outlook on the CICR is Stable. The senior unsecured debt issued by Lufthansa has been rated at BBB-. These reflect Scope’s view of i) Lufthansa’s global network coverage and diversified route network, ii) membership in global airline alliances, iii) diversification in various aviation-related services, and iv) Scope’s expectation for a continuation of free cash flow generation, including its view of management’s commitment to maintain a cautious financial policy.

The business risk profile is supported by Lufthansa’s global network coverage and diversified route network, its membership in global airline alliances, high share of business travellers, and benefits from diversification in various aviation-related services. The business risk profile is restrained by the marked cyclicality of the airline industry, including risks of material fluctuations of operating profits that may result from swings of demand for either passenger or cargo traffic. Lufthansa’s profitability is currently below its peers’ and is supported by low fuel costs, a benefit that will be short-lived in Scope’s view, given the intense market competition and likelihood that lower fuel prices will eventually be passed to customers through lower fares. Lufthansa has agreed collective-bargaining agreements with ground staff and flight attendants, which should help reduce unit costs in the future. The fleet-renewal programme may lower operating expenses, although Scope is concerned that some cost benefits may not be retained but may instead be ’competed away’. The recently announced Air Berlin transaction is neutral for the rating.

The outlook for global air traffic remains positive. Over the past two decades, global air traffic has grown by about 4-5% annually. The global expansion of air traffic is mainly driven by the lower cost of air travel and rising living standards in emerging markets such as India, China, Indonesia and Brazil. Scope believes the global demand for air traffic will continue to grow faster than global GDP growth. For 2016, Scope expects the global growth in air traffic to be about 7%, supported by lower oil prices that also result in lower air fares. This is in line with the forecast issued by the International Air Transport Association. The airline industry in Europe remains fairly fragmented. As long as consolidation among the players does not occur, Scope does not see great chances for a structural increase of profits in the industry.

Scope views the financial risk profile of Lufthansa as slightly more favourable than the business risk profile. Scope’s forecasts for 2016 point to a Scope-adjusted debt/EBITDA of 2.6x and FFO/Scope-adjusted debt (SaD) of 31%, followed by gradual improvements of both ratios, given its forecast that free operating cash flows are expected to exceed projected dividend payments. This forecast considers effects from the collective-bargaining agreement concluded with the flight attendants’ union, but excludes those from the agreement likely to be reached soon with the pilots’ union.

Lufthansa’s liquidity is solid. Financial obligations in the medium term are covered by cash, committed credit lines and the expected excess of free operating cash flows over dividend payments. Further financial flexibility also results from the high share of unencumbered aircraft in the fleet. In Scope’s view, Lufthansa pursues a cautious financial policy and is prepared to balance debtholder interests with shareholder interests, as was the case in 2009 and 2011 when dividend payments were cut due to weaker earnings.

Key rating drivers

The rating is driven positively by the following:

Scale of operations, including diversified worldwide route network and geographical reach, with strong positions at hubs in Frankfurt, Munich, Zurich, and Vienna
Globally diversified operations with various well-known brands
Diversified operations (MRO/Catering) with strong market positions mitigating cyclicality risks in passenger and cargo traffic
Multi-hub strategy giving customers a broad range of travel options; leading position in home market of Germany; competitive advantage in premium market for long-haul traffic
Alliances with various international airlines, notably Star Alliance, supporting an increased flight frequency
However, the following aspects limit the rating:

An exposure to cyclical changes of discretionary travel (business and leisure) and event risks, such as natural disasters, contagious diseases and strikes, that negatively affect passenger volumes
Intensely competitive environment, including yield pressures from low-cost airlines and other network airlines
Risk of material fluctuations of operating profits in passenger airline division due to the risk of volatile passenger and cargo traffic, and high operating leverage
Outlook

The Outlook is Stable and incorporates Scope’s expectation that Lufthansa should achieve debt-protection measures, such as SaD/EBITDA, of 2.0x-2.5x in the medium term. The key premise behind Scope’s expectation is that cash generated from ongoing operations is likely to exceed projected dividend payments.

Scope would consider a negative rating action if SaD/EBITDA or FFO/SaD were to respectively deteriorate to about 3.0x and 25%. Lufthansa has some headroom to accommodate minor deteriorations in trading conditions, including lower operating earnings (EBITDA). Scope estimates, all other things being equal, that negative rating pressure could result if the reported EBITDA margin were to deteriorate to about 8.5% (versus 10.2% reported for 2015 and 10% expected for 2016F, adjusting for the expected one-time gain resulting from the agreement with the flight attendants’ union).

A higher rating could be warranted if SaD/EBITDA were to decline to sustainably under 2.0×.

The full rating report, which includes the rating rationale and analytical details, is available to download here.