Air Canada upgraded to ‘BB’ from ‘BB-’ on lower sustained debt

• Ongoing debt reduction through 2024 facilitated by strong discretionary cash flow generation combined with a more favorable outlook for travel demand, contribute to Air Canada's credit measures that are trending better than we previously expected.

• We now estimate the company's adjusted funds from operations (FFO) to debt (S&P Global ratings adjusted) in the low-40% area through 2025, well exceeding our previous forecast and our upside threshold about 30%.

• As a result, S&P Global Ratings raised its issuer credit rating on Air Canada by one notch to 'BB' from 'BB-'.

• At the same time, we raised our issue-level rating on the company's secured debt by one notch to 'BBB-' from 'BB+', stemming from the upgrade on Air Canada.

• We also raised our issue-level ratings on many of Air Canada's enhanced equipment trust certificates (EETCs) reflecting our upgrade on the company.

• The stable outlook reflects our view that Air Canada will sustain credit measures that we view as commensurate for our issuer credit rating, including adjusted FFO to debt above 30%.

S&P Global Ratings today took the rating actions listed above. Our upgrade primarily reflects our expectation for adjusted debt to remain lower than we previously anticipated. Adjusted debt for Air Canada at the end of 2023 was about 20% lower than we previously anticipated owing primarily to strong discretionary cash flow generation in the fourth quarter, which led to more cash on the balance sheet that we net against debt. When compared to our previous estimates, working capital inflows, interest income, and EBITDA came in higher while lease liabilities were lower. The lower debt levels we now assume is a key contributor for the improvement in the adjusted credit measures we expect over the next few years. These include adjusted FFO to debt of about 40% through 2025 and in the mid-30% area in 2026, roughly 10% higher than we had expected in November.

We still assume adjusted EBITDA will be down about 15% in 2024 as higher operating costs and lower passenger revenue per available seat miles (PRASM) more than offset capacity growth. We assume Air Canada's costs per available seat mile (CASM), excluding fuel will increase about 4% this year, which is at the higher end of management's 2.5%-4.5% guidance and higher than we had previously assumed. A potential new contract with its pilots later this year is a key contributor to these higher costs. Bargaining talks began early last year after the Air Canada's 10-year agreement reached in 2014 came to an end. We assume a new contract is likely to be announced later this year and could include pay increases that are higher than those that WestJet pilots were awarded last summer (a 24% increase in hourly wages by 2026). Other contributors to the higher CASM we assume include new Air Passenger Protection Rules (APPR) that relate to compensating customers for delays and cancelations, additional airport fees, and general cost inflation. Beyond 2024, we assume CASM, excluding fuel will be relatively flat to down modestly as cost inflation is offset by the benefit of additional capacity to leverage its fixed costs. Still, we expect costs to remain well above pre-pandemic levels and an adjusted EBITDA margin of about 15% (compared to 19% in 2019).

We assume that the strong PRASM growth over the past couple of years will partially reverse as additional capacity is added and pent-up demand fades, reflecting pressure on yields and load factors. Our demand outlook incorporates our view that interest rate increases over the past couple of years have yet to have their full effect on discretionary spending in Canada. That said, we assume only a modest decline in PRASM of about 2.5% this year and 3% in 2025 as demand for air travel on Air Canada's Atlantic routes remain robust through most of this year and traffic continues to recover on Air Canada's pacific routes.

We expect new aircraft investments to contribute to negative FOCF generation and increased debt levels over the next few years. We expect Air Canada's capital expenditures (capex) will step up considerably in 2025 and 2026 to about C$3.2 billion and C$5.1 billion, respectively, as the company takes delivery of new aircraft. These investments contribute to our assumption that Air Canada's capacity will increase by about 30% by 2028 and lead to a younger and more fuel-efficient fleet. The incoming aircraft include a mix of narrowbody and widebody planes. The narrowbody planes include A220s, A321XLRs, and B737-8x, which we expect will be primarily used on Air Canada's Atlantic routes to support its strategy to target sixth-freedom travelers from the U.S. on route to Europe through Montreal and Toronto. The widebody planes primarily increase B787-10s, a portion of which could be used to replace some of Air Canada's existing B777-300 ER and/or A330-300 fleet. This additional future capacity appears to be targeting travel demand spurred by growth in Canada's immigration over the past few years, particularly to destinations in Southeast Asia, India, China, North Africa, and the Middle East. In our opinion, this expansion strategy provides Air Canada with the opportunity to expand its premium international traffic and could lead to stronger returns than if it were to add capacity in what is shaping up to be an increasingly crowded domestic market. However, this strategy is not without its risks. For instance, we expect the elevated capex over the next few years will contribute to negative FOCF generation beyond 2024, higher debt levels, weaker credit measures, and could leave Air Canada with less financial flexibility if market conditions deteriorate. That said, we also note there could be delays in the timing of these deliveries, either due to manufacturing delays at Boeing or if weaker air travel demand leads Air Canada to renegotiate its delivery schedule.

The stable outlook reflects our view that Air Canada will sustain credit measures that we view as commensurate for our issuer credit rating, including adjusted FFO to debt above 30% despite our expectation of slowing air travel demand, higher costs, and increased capital expenditures.

We could downgrade Air Canada within the next 12 months if we expect Air Canada to generate FFO to debt below 30% over the next couple of years. This might occur from higher-than-expected costs and the effects of a weaker North American economy, prolonged geo-political escalations, or competitive pressures that reduce Air Canada's traffic, revenues, and margins.

We could raise our rating within the next 12 months if we see sustained improvement in traffic and we continue to expect Air Canada will generate and maintain FFO to debt above 45%. In this scenario, we would expect the company to generate stronger EBITDA and lower FOCF deficits than our current estimates. Greater clarity regarding the potential impact of increased capacity, cost inflation, and weaker macroeconomic conditions on Air Canada's passenger traffic and margins is likely required for us to better assess the sustainability of our forecast credit measures.