Lufthansa Upgraded To 'BBB/A-2' On Solid Financial Performance; Outlook Stable

  • German airline Lufthansa continues to report strong operating performance, despite various operational headwinds and competitive challenges over the past two years.
  • We believe Lufthansa will stabilize EBITDA at €4.5 billion-€5.0 billion, sustain its reduced net debt position, and generate sufficient free operating cash flow (FOCF) to improve its resilience against the next potential industry downturn, while keeping adjusted funds from operations (FFO) to debt above our 30% threshold for a 'BBB' rating.
  • We are raising our issuer credit ratings on Lufthansa to 'BBB/A-2' from 'BBB-/A-3', our senior unsecured issue rating to 'BBB' from 'BBB-', and our junior subordinated issue rating to 'BB+' from 'BB'.
  • The stable outlook reflects our view that Lufthansa will benefit from consistent passenger traffic growth, make capacity adjustments and nonfuel cost savings, and financially turn around Eurowings to counterbalance lower yields and higher fuel expenses.
FRANKFURT (S&P Global Ratings) April 15, 2019--S&P Global Ratings today took the rating actions listed above.
We upgraded Lufthansa because of its continued strong operating performance, despite various operational headwinds and competitive challenges over the past two years. Lufthansa's solid reported EBITDA of about €5 billion in 2018 matches its highest EBITDA on record in 2017, resulting in credit metrics that are commensurate with our BBB rating.
Moreover, the airline was able to counterbalance the impact of higher fuel costs, nonrecurring expenses to integrate parts of former Air Berlin, the cost burden from irregularities and disruptions in flight operations, and overcapacity in the European short-haul network, thanks to its profitable growth (underpinned by solid demand for air travel), strongly performing long-haul network, and structural cost efficiencies.
Given Lufthansa's solid financial performance, our adjusted ratio of FFO to debt reached about 46% in 2018, compared with 47% in 2017, enhancing the airline's financial flexibility to tackle the next potential industry downturn.
Although the airline industry is tied to cyclical demand and supply conditions, and Lufthansa may not always be able to achieve the EBITDA generation it posted in 2017 and 2018, we believe that the company has the capacity to stabilize its EBITDA strength into lasting value of at least €4.5 billion-€5.0 billion in 2019-2020. In this way, Lufthansa will generate sufficient FOCF to fund capital expenditure (capex), including purchasing new planes, and maintain its reported net debt position at an average of €3.5 billion over 2019-2020. Such a financial performance should provide ample financial leeway for future external growth and accommodate potential fluctuations in pension liabilities, while allowing the airline to operate above our adjusted FFO-to-debt threshold for a 'BBB' rating of 30% over the next two years.
Our upgrade also takes into account the company's ability to continue lowering unit cost, as a measure to support its competitive position and help counterbalance industry volatility. This while protecting its strategic position in the profitable premium traffic and typically less-cyclical nonpassenger businesses: notably maintenance, repair, and overhaul (MRO), and catering.
Furthermore, given the inherent volatility of the airline industry and associated swings in earnings and cash flow, we consider that maintaining a continued prudent financial policy is a key credit factor. We believe that Lufthansa's financial discipline will support consistent and rating-commensurate financial leverage under normal operating and financial conditions. This means that the company will unlikely embark on any significant debt-financed external expansion and hold on to predictable shareholder distributions.
The company's policy is to ensure the adjusted net debt-to-EBITDA ratio remains below 3.5x (1.8x achieved in 2018) and a dividend payout of 10%-25% of EBIT while it continues to evaluate growth opportunities. This compares to our base case of adjusted debt to EBITDA for the company of below 2x over the next two years, incorporating our assumption for regular and annual dividend distribution, and the leverage guideline for the 'BBB' rating of below 3x. Accordingly, our forecast points to ample debt capacity headroom under the rating.
We forecast that Lufthansa's core credit measures, namely FFO to debt and debt to EBITDA, will continue performing better than our current intermediate financial profile assessment. That said, we expect that the airline's consistently high capex (8%-10% of revenue) over the next few years to modernize its aircraft fleet, which is essential to remain competitive, will weigh on its cash flow (as reflected in a relatively weak weighted-average ratio of adjusted FOCF to debt of 10%-11% in 2019-2020) and its overall creditworthiness.
We continue to view Lufthansa's sizable (albeit structurally and significantly reduced in 2017) and volatile debt-like pension obligation, which makes up a substantial portion (about 35% at end-2018) of its total adjusted debt, as one of its main credit weakness. This is because an increase in net pension liabilities (if key assumptions around pension scheme change) would weigh on Lufthansa's financial leverage ratios. We understand that a 50-basis point change in the discount rate would equate to a net pension provision movement of about €1.8 billion as of Dec. 31, 2018. However, this assumes no change in the value of plan assets and/or inflation assumptions. We also acknowledge that the increase in the adjusted accounting pension provisions has no immediate material negative impact on the company's liquidity and cash flows, given the long-term nature of the obligations.
We view positively Lufthansa's proactive measures to lower the pension liability and the exposure to benchmark interest rates, and bolster the stability of its ratios. They included agreements with cabin crew and pilots on amendments to their pension arrangement realized in 2016-2017. These measures and the favorable performance of plan assets resulted in the company's pension deficit falling significantly to about €5.09 billion on Dec. 31, 2017, from about €8.35 billion a year earlier. This is marginally constrained by a fall in the long-term German- and corporate bond yields, which the company uses to measure its pension deficit under International Financial Reporting Standards (IFRS).
Lufthansa enjoys an excellent competitive position based on the leading positions it has at its main hubs in Frankfurt, Munich, Zurich, and Vienna, the continued strong demand from its economically strong outbound markets, the diversity in its operations, and its good exposure to high-yield premium traffic. Our view is somewhat tempered by the fundamental characteristics of the airline industry, such as Lufthansa's susceptibility to European and global economic cycles, oil price fluctuations, high capital intensity, and unforeseen geopolitical and security events, including global terrorism and disease outbreaks.
Good geographic diversification reduces Lufthansa's dependency on local economies and forms a buffer against localized event risks. Furthermore, the airline's leading market position in aircraft MRO as well as catering adds stability to group earnings through the lower and different-stage cyclicality of these operations. Lufthansa's cost position is a competitive disadvantage, however, which could lead to changes in our analysis if the company's positive trend in lowering its unit cost is interrupted.
The stable outlook reflects our view that Lufthansa will be able to maintain adjusted FFO to debt of more than 30% in 2019-2020. This is based on our expectation that 2019 and 2020 will likely be solid years for the airline's EBITDA thanks to consistent passenger traffic growth, timely capacity adjustments and nonfuel cost savings, and the financial turnaround of Eurowings. These will counterbalance the burden from lower yields and higher fuel expenses, in our view. Accordingly, we consider that the company will realize a sustained benefit from ongoing strategic and efficiency initiatives, while gradually reducing its unit cost and thereby protecting its profitability and business profile.
We would lower the rating if Lufthansa's earnings weakened, such that the ratio of adjusted FFO to debt deteriorated to less than 30%, with limited prospects of improvement in the next 12 to 18 months. This could occur due to, for example, lower growth in passenger volumes than we anticipate, a greater fall in ticket fares than in our base case, or a larger surge in fuel prices beyond what we factor into our forecast, which Lufthansa was unable to pass on via higher ticket fares or counterbalance by cost savings. A downgrade would also be likely if we noted any deviations in terms of financial policy decisions that would prevent credit measures remaining consistent with the 'BBB' rating.
Although unlikely in the next 12 months, we could raise the rating if we considered that Lufthansa would achieve and keep its reported EBITDA in excess of €5.5 billion (excluding the impact of IFRS 16). Such an improvement could stem from a combination of structurally improved competitive environment allowing for more timely and efficient pass through of fuel price inflation through higher ticket fares and continuing cost-cutting by Lufthansa. This earnings performance would need to be complemented by the airline's solid FOCF generation and reduced debt, such that adjusted FFO to debt improved and consistently stayed well above 50%. Furthermore, an upgrade would hinge on Lufthansa's commitment to aligning its financial policy to ensure that such a ratio is sustainable.
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