Fitch Ratings-Chicago-12 April 2017: Fitch Ratings has upgraded the Long-Term Issuer Default Rating (IDR) for Air Canada (AC) to ‘BB-’ from ‘B+’. The Rating Outlook is Stable. Fitch has also affirmed AC’s senior secured credit facility at ‘BB+/RR1’. In addition, Fitch has upgraded Air Canada’s senior unsecured debt to ‘BB-/RR4’ from ‘B+/RR4’. A full list of rating actions follows the end of this release.

KEY RATING DRIVERS
The rating action is supported by AC’s improved financial position including leverage that has declined from the high levels seen after the previous recession, prospects for leverage to move incrementally lower beginning in 2018, the elimination of the company’s pension deficit, and prospects for improving free cash flow (FCF) generation as AC moves past the peak of its heaviest period of capital spending. The upgrade is also supported by a strengthened overall North American aviation market, which has led to improved credit profiles for most industry participants.

Fitch’s primary concerns include the heavy capital spending that is still to occur in 2017, which will limit the company’s FCF generation, the still-soft unit revenue environment, and AC’s aggressive international expansion efforts. Other concerns are typical for the airline industry and include the possibility of rising fuel prices, cyclicality, high operating leverage, and exposure to exogenous shocks.

Stable Financial Performance:
AC’s financial results have shown positive momentum over the past several years as it worked to reduce its cost structure and expand internationally. Operating margins came down marginally in 2016 as new capacity, longer stage-lengths, and competition led to declining unit revenues. Nonetheless, the company continues to operate at levels of profitability that are much improved from the levels seen several years ago. Fitch’s base case forecast anticipates that operating margins will stay roughly flat or decline slightly over the intermediate term as higher fuel expenses are offset by declining non-fuel costs and better unit revenue performance compared to results seen in 2015 and 2016. Fitch expects that adjusted debt/EBITDAR could tick up to around 4.2x by year-end 2017 from 4x at year-end 2016 due to pressure on operating margins. We expect leverage to move below 4x in 2018 as operating margins stabilize or improve modestly, and as better FCF allows for some incremental debt reduction.

AC’s CASM ex-fuel was down by 2.9% in 2016 reflecting the benefits of the cost initiatives taken over the past several years. Fitch calculates that AC’s ex-fuel CASM for 2016 was down by nearly 11% compared to 2010 levels, at a time when much of the industry has been contending with labor and other cost pressures leading to broadly increasing unit costs. Unit cost results would have been better over the past three years were it not for the impacts of a weakening Canadian dollar, which has weakened by close to 20% compared to the U.S. dollar since the beginning of 2014.

The company is experiencing the benefit of flying its reconfigured, high-density 777s on long-haul routes, as well as the lower operating costs of its 787s. Fitch calculates that AC’s fuel efficiency as measured by ASM’s per gallon improved by 6.1% compared to full year 2015 levels, driven by its new efficient aircraft and by flying longer average stage lengths. AC expects to take delivery of another nine 787-9s in 2017, helping to reduce its dependence on its less efficient 767s. Fitch expects unit costs to continue to improve marginally in 2017. Part of the improvement is simply the result of increased capacity, as AC is expecting another year of meaningful growth in 2017. However, the company will also benefit from changes in fleet, including its 787 deliveries, and the continued shift of aircraft to Rouge, AC’s low-cost unit.

Above Average Capacity Growth
AC has grown at a rapid pace compared to industry peers over the last three years, and is set to add a material amount of new capacity again in 2017. The vast majority of AC’s growth centers on the international expansion plan that has been a central part of AC’s business strategy for the past several years. The company has managed its expansion well thus far, maintaining high load factors and expanding its margins even as capacity increased by more than a third since 2013. For comparison, the large U.S. network carriers (UAL, AAL, DAL) have kept capacity growth in the low single digits annually over the same time period.

Fitch views AC’s expansion efforts as carrying some risk in terms of potential for overcapacity and declining yields. However, these risks are mitigated by the company’s track record over the last several years and by the low-cost at which some capacity is being added (through dense seating configurations and growth at Rouge). Fitch also believes that AC has more flexibility to manage capacity than it did in the past as a result of having some aircraft that are now unencumbered by debt as well as some optionality around returning aircraft at the end of their operating leases.

LIQUIDITY
Fitch expects FCF to be minimal in 2017 and to be solidly positive in 2018, representing a meaningful change from the negative FCF figures that AC has produced in three of the last four years. AC’s financial flexibility is also supported by a solid liquidity balance, a growing base of unencumbered assets, and the fact that upcoming capital expenditures consist of highly financeable aircraft like the 787-9 and 737 MAX. At year end, the company had a cash and short-term investments balance of CAD$3.0 billion and an undrawn revolver of USD$300 million. Total liquidity is equal to 22% of latest 12 month (LTM) revenue.

Upcoming debt maturities are manageable given AC’s cash on hand and Fitch’s expectations for the company to generate meaningful cash from operations over the next several years. Debt maturities are around CAD$700 million in both 2017 and 2018. The company significantly reduced a maturity wall that it was facing in 2019 through the refinancing that it completed in the third quarter of 2016. AC used proceeds from a seven-year secured bond issuance, a new $800 million term loan and cash on hand to redeem its senior notes that were due in 2019 and 2020. As a result, 2019 maturities decreased from more than CAD$1.7 billion to CAD$560 million.

AC’s pension risk has dropped materially over the last several years. AC’s pension plans moved to an estimated surplus position of CAD$1.5 billion at the end of 2016 compared to a deficit of CAD$3.7 billion in 2012. AC’s pension status compares favorably to other North American competitors such as Delta and American that carry sizeable pension deficits ($10.6 billion and $7.2 billion respectively).

KEY ASSUMPTIONS
Fitch’s key assumptions within the rating case for AC include:
—Continued moderate growth in demand for air travel through the forecast period.
—Fuel prices increasing to by 30%-40% by the end of the forecast period compared to 2016 levels.
—AC’s capacity continues to grow in the high single digit range.

RATING SENSITIVITIES
Future actions that may individually or collectively cause Fitch to take a positive rating action include:

—Sustained adjusted debt/EBITDAR around 3.5×.
—Funds from operations (FFO) fixed charge coverage sustained above 3x-3.5×.
—EBITDAR margins sustained above 15%, EBIT margins above 10%.
—Neutral or positive FCF generation over the intermediate term.

Future actions that may individually or collectively cause Fitch to take a negative rating action include:

—Weaker than expected margin performance or higher than expected borrowing causing leverage to reach or exceed 4.5×.
—FFO fixed charge coverage around or below 2.5×.
—Weaker than expected financial performance causing FCF to be notably below Fitch’s expectations.
—A decline in the company’s EBIT margin to the low single digits, EBITDAR margins into the high single digits.

FULL LIST OF RATING ACTIONS

Fitch has taken the following rating actions:

Air Canada
-Long-Term IDR upgraded to ’BB’ from ‘B+’;
-Senior secured term loan B affirmed at ‘BB+/RR1’;
—Senior secured revolving credit facility affirmed at ‘BB+/RR1’;
—Senior secured notes affirmed at ‘BB+/RR1’;
—Senior unsecured debt upgraded to ’BB/RR4’ from ‘B+/RR4’.

The Rating Outlook is Stable.