October 31, 2008
Fitch Affirms Delta’s IDR at ‘B’ After Close of Northwest Merger
Fitch Ratings has affirmed the Issuer Default Rating (IDR) and outstanding debt ratings of Delta Air Lines, Inc. (NYSE:DAL) following the closing of Delta's merger with Northwest Airlines (NWA) as follows:
-- IDR at 'B';
-- First-lien senior secured credit facilities at 'BB/RR1';
-- Second-lien secured credit facility (Term Loan B) at 'B/RR4'.
In addition, Fitch is assigning the following ratings for Northwest Airlines, Inc., now a wholly-owned subsidiary of Delta:
-- IDR at 'B';
-- Secured Bank Credit Facilities - 'BB/RR1'.
The ratings apply to $2.5 billion of funded secured debt (including the drawn $1 billion revolving credit facility) at Delta and approximately $1.4 billion of committed credit facilities (including $500 million of new revolving credit lines) at Northwest. The Rating Outlook for both issuing entities, now analyzed by Fitch on a consolidated basis, is Negative.
The 'B' rating reflects Fitch's view that the merged carrier's heavy debt and lease load, sizable fixed financing obligations and ongoing vulnerability to fuel price and air travel demand shocks keep its overall credit profile weak. While the rapid decline in jet fuel prices over the last three months has improved the new Delta's near-term free cash flow prospects markedly, the worsening global economic picture may well force Delta and the other large U.S. carriers to re-visit 2009 available seat mile (ASM) capacity growth plans in response to a softening air travel demand outlook. However, if fuel prices remain at or near current levels in 2009, Delta's free cash flow margins should improve, making some reduction in lease-adjusted leverage possible even if passenger unit revenue growth comes in weaker than expected.
Delta and its major airline competitors have begun to see strong unit revenue comparisons this fall as a result of the substantial cuts in domestic scheduled capacity that went into effect in September. Delta's international network continues to grow, however, and international revenue per ASM trends may begin to weaken noticeably if a global recession undermines demand moving into 2009. Delta management noted earlier this month that it would continue to monitor international demand closely and was prepared to trim schedules as necessary.
The impact of the recent fuel price collapse on consolidated DAL-NWA cash flow has been dramatic. Fitch estimates that a 10-cent change in the price of jet fuel drives approximately $350 million of annual cash flow for the new airline. Importantly, however, Delta's ability to participate in the fuel price decline has been limited by fuel derivative positions layered on in the first half of the year that will, in the near term, force DAL to post substantial amounts of cash collateral to counterparties as contracts are marked to market. With many swap and collar derivatives significantly out of the money at current energy prices, Fitch is concerned that the amount of cash posted in the current quarter could drive year-end unrestricted cash and investments well below the targeted $6 billion level. Over time, as hedge contracts are settled, liquidity pressures linked to derivatives will abate. However, the near-term liquidity trend requires close monitoring.
Merger-related integration risks have been reduced by the successful negotiation of a joint DAL-NWA pilot contract and the expected resolution of pilot seniority integration issues (either through a negotiated agreement or binding arbitration). Labor cost increases driven by the new agreements, together with cash transition costs estimated at $600 million by management, may pressure unit costs somewhat in 2009. Longer-term revenue synergies, tied in particular to fleet optimization and the creation of a diversified and deep global network, appear broadly achievable. Still, near-term improvements in revenue per ASM will be driven more directly by the large domestic capacity cuts already completed by both stand-alone carriers. The consolidated fleet is fragmented and diverse, limiting opportunities for big fleet-related cost savings. However, the opportunity to better match aircraft to market throughout the Delta system puts the carrier in a position to drive unit revenue growth that is better than the U.S. industry as a whole over the next several years.
Delta's post-reorganization capital structure was streamlined as a result of pre-petition debt and lease rejection in Chapter 11. Recovery expectations for the first-lien revolver and term loan are superior to those of the second-lien term loan. Recovery expectations for first-lien lenders are excellent, reflecting a deep collateral pool consisting of aircraft, engines, spare parts and other assets, as well as a tight covenant package protecting lenders via fixed charge coverage, minimum liquidity and collateral coverage tests. Similar covenants are included in NWA's secured bank credit facility, which is secured by their Pacific route authorities.
Taking into account the credit facilities, aircraft-backed EETC obligations and private mortgage agreements, Delta has few unencumbered assets remaining to support additional borrowing if liquidity conditions tighten further. However, the carrier may be able to raise cash through a potential credit card transaction with its affinity card partner. Similar deals have been completed by other U.S. airlines in 2008. Backstop financing commitments for scheduled aircraft deliveries through 2010 are in place, mitigating the risk of a further tightening of credit market conditions over the next two years.
A downgrade to 'B-' could follow if a steep decline in global air travel demand, combined with renewed fuel cost pressure, undermines free cash flow generation prospects for 2009. Negative rating actions could also result from impaired liquidity (exacerbated by larger than expected cash collateral deposits to fuel hedge counterparties) coupled with a weakening of operating margins and more serious constraints on access to aircraft capital markets. A revision of the Rating Outlook to Stable would likely follow in a scenario where much lower average fuel costs next year, together with steady growth in system revenue per ASM, drives large improvements in Delta's free cash flow generation.