Fitch Upgrades Continental Airlines' IDR to 'B-'; Outlook Stable
Fitch Ratings has upgraded the debt ratings of Continental Airlines, Inc. as follows:
-- Issuer Default Rating (IDR) to 'B-' from 'CCC';
-- Senior Unsecured Debt to 'CCC/RR6' from 'CC/RR6'.
Continental's Rating Outlook is Stable.
The upgrade reflects Continental's improved operating results during 2006, a brightening free cash flow generation outlook for 2007 and a balance sheet that has grown stronger this year through debt reduction and steadily improving liquidity. Continental ended the third quarter with $2.5 billion of unrestricted cash and short-term investments, compared with $2 billion at year-end (YE) 2005.
Taking into account the airline's strengthened cash position and operating cash flow, Fitch believes that the risk of an event-driven liquidity crisis -- linked to future air travel demand and/or fuel price shocks -- has been reduced dramatically. Despite heavy fixed cash obligations related to scheduled debt principal payments and required pension contributions, the airline is in a position to fund 2007 debt and pension obligations without pressuring its cash position significantly over the next several quarters.
While the risk of significant liquidity pressure has diminished, the 'B-' IDR captures the high degree of financial risk linked to Continental's very heavy debt and lease loads, substantial near-term cash obligations, as well as the U.S. airline industry's unique vulnerability to external shocks. Fitch believes that Continental's balance sheet can now absorb air travel demand and/or fuel price shocks more effectively than at any time since the onset of the industry financial crisis in 2001. Although the carrier remains committed to average annual available seat mile (ASM) growth rates of 5 to 7% annually over the next several years, management appears focused on the need to reduce debt while maintaining a strong cash position.
Much stronger operating results in the second and third quarters reflected the impact of an excellent demand and pricing environment during the peak travel period, despite the fact that surging energy prices continue to pressure Continental's cost per available seat mile (CASM) position. Improving yields, linked to fare increases and a better revenue mix, have been driven by constrained industry ASM growth this year. Continental and other U.S. airlines have indicated that increased security measures related to the Aug. 10 London bomb plot had a material impact on bookings in August and September -- particularly in trans-Atlantic markets. However, any related softening in demand does not appear to be carrying over into the fourth quarter. For the third quarter, Continental reported a 7.4% increase in revenue per ASM (RASM) on a 9.1% increase in consolidated capacity. As in previous quarters, most of the RASM increase was driven by improvements in yields. Despite $155 million of fuel cost pressure in the third quarter, operating income improved by $83 million year-over-year to $192 million.
Continental's growth in international markets, particularly secondary European cities served from its Newark hub, has been rapid again in 2006. Despite Delta's reinforced commitment to expanded international service, and factoring in the impact of the Aug. 10 security measures, Continental's trans-Atlantic RASM increased by 1.4% in the third quarter on a 15% increase in seat-mile capacity. Latin American unit revenue improved by 10% on a 13% increase in ASMs. The sensitivity of fares in these international markets to changes in capacity will be a critical factor in determining whether Continental's strong revenue performance can be extended into 2007.
High jet fuel costs continue to represent a significant drag on Continental's earnings and cash flow. The 20% pull-back in crude oil and refined product prices over the past two months provides additional support for margin improvement moving into 2007 -- even if RASM growth rates moderate next year. Continental now forecasts an average jet fuel price of $2.05 per gallon for the fourth quarter, but current jet fuel spot prices are now at approximately $1.80 per gallon. Continental's fuel hedging strategy is based on the idea that forward hedge positions should generally correlate with the level of advance bookings for future periods.
The passage of pension funding reform legislation by Congress in August represented an important step forward for Continental in managing the level of future cash contributions to its under-funded defined benefit pension plans. Special provisions for airlines in the bill will allow Continental to meet its under-funded liability over a ten-year period. This removes the risk of sharply higher required cash contributions under the old funding rules. Although Continental faces an additional pension funding burden relative to United and US Airways (both of which have terminated their defined benefit plans through Chapter 11), the new funding rules should allow Continental to keep required cash funding levels at or near accrued pension expense levels in 2007 and 2008. The carrier's under-funded pension liability totaled $1.2 billion on a projected benefit obligation (PBO) basis at YE 2005. Continental has funded its plans aggressively in 2006, with total cash contributions reaching $246 million year to date.
Fitch's Recovery Ratings (RR), introduced in 2005, are a relative indicator of creditor recovery on a given obligation in the event of a default. A broad overview of Fitch's RR methodology as it relates to specific sectors, including a Case Study webcast, can be found at www.fitchratings.com/recovery.
Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
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