october 2011
Methodology
Rating Companies in the Airline Industry
CONTACT INFORMATION
Kam Hon
Managing Director, Corporate
+1 416 597 7543
[email protected]
Kent Wideman
Chief Credit Of?cer
+1 416 597 7535
[email protected]
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Rating Companies in the Airline Industry
October 2011
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Rating Companies in the Airline Industry
TABLE OF CONTENTS
Introduction to DBRS Methodologies 4
Business and Financial Risk Overview 4
Stage 1: Industry Business Risk Rating for the Airline Industry 6
De?nition of the Industry 6
Business Risk Rating 6
Industry Pro?tability and Cash Flow 6
Industry Competitive Landscape 7
Industry Stability 7
Industry Regulation 7
Other Inherent Industry Considerations 7
Stage 2: Issuer Rating 8
Business Risk Pro?le 8
Financial Risk Pro?le 8
Company-Speci?c Business Risk Factors 9
Primary Factors 10
Diversi?cation and Market Share 10
Operating Cost Structure (Including Labour and Seasonality) 10
Fleet 11
Route Network 11
Customer Service/Reputation 11
Additional Factors 11
Fuel Hedging 11
Regulation 11
Currency Sensitivity 11
Common Business Considerations 12
Country Risk 12
Corporate Governance 12
Company-Speci?c Financial Risk Factors 13
Key Metrics 13
Overall Considerations in Evaluating a Company’s Financial Risk Pro?le 14
Earnings 14
Cash Flow and Coverage 14
Balance-Sheet and Financial Flexibility Considerations 15
Stage 3: Rating the Security 15
Appendix 16
Industry Business Risk Ratings 16
Industry Pro?tability and Cash Flow 16
Industry Competitive Landscape 17
Industry Stability 17
Industry Regulation 17
Other Inherent Industry Considerations 17
Industry Business Risk Rating De?nitions 18
Interrelationship between Financial and Business Risk 19
De?nition of Issuer Rating 19
Short-Term and Long-Term Ratings 19
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Introduction to DBRS Methodologies
• In general terms, DBRS ratings are opinions that re?ect the creditworthiness of an issuer, a security or
an obligation. They are opinions based on an analysis of historic trends and forward-looking measure-
ments that assess an issuer’s ability and willingness to make timely payments on outstanding obligations
(whether principal, interest, dividend or distributions) with respect to the terms of an obligation.
• DBRS rating methodologies include consideration of general business and ?nancial risk factors appli-
cable to most industries in the corporate sector as well as industry-speci?c issues and more subjective
factors, nuances and intangible considerations. Our approach is not based solely on statistical analysis
but includes a combination of both quantitative and qualitative considerations.
• The considerations outlined in DBRS methodologies are not intended to be exhaustive. In certain cases,
a major strength can compensate for a weakness and, conversely, there are cases where one weakness is
so critical that it overrides the fact that the company may be strong in most other areas.
• DBRS rating methodologies are underpinned by a stable rating philosophy, which means that in order
to minimize the rating changes due primarily to economic changes, DBRS strives to factor the impact
of a cyclical economic environment into its rating as applicable. Rating revisions do occur, however,
when it is clear that a structural change, either positive or negative, has transpired or appears likely to
transpire in the near future.
• As a framework, DBRS rating methodologies consist of several components that together form the basis
of the ultimate ratings assigned to individual securities. Assessments typically include the industry’s
business risk pro?le, the company’s general business risk pro?le, the company’s ?nancial risk pro?le and
considerations related to the speci?c security.
• To some extent, the business risk and ?nancial risk pro?les are interrelated. The ?nancial risk for
a company must be considered along with the business risks that it faces. In most cases, an entity’s
business risk will carry more weight in the ?nal issuer rating than will its ?nancial risk.
Business and Financial Risk Overview
• On a high-level macro basis, DBRS has a consistent approach to determining the issuer rating of an
entity that is common across many industries. (See the appendix for the de?nition of “issuer rating.”)
Our high-level approach can be broken into three stages, as shown on the opposite page.
• Where applicable, DBRS uses the concept of business risk ratings (BRRs) as a tool in assessing the
business strength of both industries and individual companies within many methodologies across the
corporate ?nance area. DBRS typically assesses ?ve areas to establish the overall BRR for an industry:
– Pro?tability and cash ?ow.
– Competitive landscape.
– Stability.
– Regulation.
– Other inherent industry considerations.
• Although there is an overlap in some instances (to some degree, in the long term, all ?ve factors tend to
relate to pro?tability and stability), DBRS has found that considering these ?ve measures in a separate
fashion is a useful way of approaching this analysis.
• Using the same factors across different industries provides a common base with which to compare the
business risks of various industries, even when they are distinctly different. In all cases, DBRS uses
historic performance and our experience to determine an opinion on the future, which is the primary
focus. For additional discussion on industry BRRs, please refer to the Industry Business Risk Ratings
and Industry Business Risk Rating De?nitions sections in the appendix.
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• It is important to note that the ratings for company-speci?c business and ?nancial risks as provided
under Stage 2 of this document should not be taken as ?nal issuer ratings. For example, an individual
company may ?t into the “A” range with respect to the analysis of its business risk, but its ?nancial
metrics could be more in the BB category. It would be incorrect to believe that the ?nal issuer rating in
this case would be either “A” or BB. In determining the ?nal issuer rating, both of these two major areas
must be considered. For additional discussion on this topic, please refer to the Interrelationship between
Business and Financial Risk section in the appendix.
Industry Business
Risk Rating
Rating on the Security
Company
Business Risk
Company
Financial Risk
Issuer Rating
+
Stage 1: Industry Business Risk Rating
Consider the overall business risk rating (BRR) for the industry.
Stage 3: Rating the Security
Consider covenant and ranking issues that exist for specific securities, using the issuer rating
to determine specific security ratings.
Level of collateral
and ranking of collateral
and recovery methodology
Holding company debt
versus operating company
debt and notching principles
The short-term rating stresses financial
risk as well as business risk, but places
more emphasis on financial risk and
liquidity than the long-term rating does.
=
Stage 2: Issuer Rating
Consider the strength of the individual issuer:
(a) First assessing how the company’s BRR compares with the industry BRR.
(b) Then assessing the company’s financial risk.
Taken together, these factors will determine the company’s issuer rating.
The long-term rating puts more
emphasis on business risk than
the short-term rating does.
Three Stages of DBRS Rating Analysis
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Stage 1: Industry Business Risk Rating
for the Airline Industry
DEFINITION OF THE INDUSTRY
• The airline industry encompasses global companies principally engaged in the transportation of pas-
sengers by plane. These companies may also engage in the transportation of cargo, but this is usually
on a much smaller scale.
• The methodology is broadly applied to both scheduled and chartered airlines and covers all segments
such as legacy, budget, feeder and regional airlines.
• While primarily focused on global companies, this methodology is also applicable to smaller operators,
which may be able to offset some scale and diversi?cation challenges through meaningful presence in
important niche markets.
BUSINESS RISK RATING
The business risk rating of the airline industry is BB (low) and recognizes the fact that the industry is one
of the most dif?cult industries in our economy in which to operate.
• Pro?tability of the industry is often weak because it is (a) labour intensive, (b) capital intensive, (c)
energy intensive, (d) sensitive to the state of the economy and (e) highly seasonal, with stronger results
in the third quarter and weaker results in the ?rst and fourth quarters.
• Barriers to entry into the industry are often low, helped by the ability to lease aircraft and outsource
most other support services.
• Stability of income is low because of the ?xed nature of costs and ?uctuating passenger loads.
• Regulation is high, and rather than reducing competition, regulation (especially related to security
matters) increases costs and reduces ?exibility of operations.
• Safety and reputation are key issues, and any airline that has an accident is hurt severely in lawsuit
settlement costs, reputation loss and future insurance rates.
• Therefore, the business risk rating of the airline industry is relatively low. Having said this, DBRS recog-
nizes that there are companies that are able to deal with these challenges and obtain investment-grade
ratings.
INDUSTRY PROFITABILITY AND CASH FLOW
• Pro?tability of the industry is generally weak, although, with high levels of depreciation and amortiza-
tion, cash ?ow levels tend to be stronger and help stabilize the balance sheet.
• While ?nancial ratios are covered separately in this methodology, the industry in general tends to have
high levels of adjusted debt because of the use of operating leases. This adds an element of costs that are
largely ?xed and, over the longer term, are sensitive to interest rate movement at the time of renewal.
• The airline industry is highly labour intensive, from pilots and ?ight attendants to personnel responsible
for baggage handling, ticketing and loading. These labour costs are mostly ?xed and restrict ?exibility
in adjusting the expense structure when needed. Moreover, most of the labour force is unionized, which
further limits operational ?exibility.
• Aircraft use high levels of fuels and are energy intensive, with operating pro?ts materially in?uenced by
fuel cost volatility.
• Interest rate levels have signi?cant in?uence on borrowing costs and leasing costs, which indirectly
affect pro?tability.
• Load factors are key, so the state of the economy is important to the airline industry. With a high
proportion of ?xed costs, a slowdown in the volume of passengers quickly translates into lower pro?t-
ability and makes earnings volatile.
• Operations are highly seasonal, with stronger results in the third quarter of the year, while the ?rst and
fourth quarters are usually weaker. Therefore, earnings through the year are highly volatile.
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INDUSTRY COMPETITIVE LANDSCAPE
• Barriers to entry into the industry are low because of the ability of the industry to lease aircraft at rela-
tively low rates, particularly older or surplus aircraft.
• Interest rates today are relatively low and this reduces the interest cost of leases.
• In recent years, a number of new airlines have engaged in niche segments, such as special charters,
vacation destinations, etc. These new entrants have a non-union labour force (which increases ?exibility
and lowers labour costs) and focus on selective routes that are high-volume destinations and give these
airlines critical mass to serve those destinations. These new entrants, with less in legacy costs and more
route ?exibility, often have a competitive advantage over the larger legacy airlines.
• The formation of an alliance among airlines (e.g. the Star Alliance) provides member airlines a com-
petitive advantage of scale and ?exibility by pooling resources from all members. The alliance allows
members to code share and leverage each other’s services, leading to increased coverage, better connec-
tions and higher capacity utilization.
INDUSTRY STABILITY
• Airlines are extremely sensitive to volume of traf?c (load factor) and pro?tability quickly falls off as
load factor declines.
• Costs are largely ?xed in the short term. (Fuel usage and costs are affected by load and ?ying conditions,
but the incremental impact is modest.) The industry is highly seasonal, with revenue usually peaking in
the third quarter but weak in the ?rst and fourth quarters.
• The advent of travel websites and other travel distribution channels has led to a substantial increase in
discounted and promotional fares.
• The volume of business class is highly sensitive to economic conditions. The variability of the more
pro?table business class passenger would have an exaggerated impact on pro?tability.
INDUSTRY REGULATION
• The industry is heavily regulated in areas such as safety issues, maintenance policies, hours of operation
per month for personnel and route selection.
• Bilateral agreements with other countries restrict the number of ?ights between these countries.
• Generally, cabotage can restrict foreign airlines from picking up passengers in a country and ?ying them
to another location in that or any other country.
OTHER INHERENT INDUSTRY CONSIDERATIONS
• Safety and reputation issues are key for any airline, which must maintain a favourable track record.
• Airlines are vulnerable to security risks related to terrorism, war, political unrest, epidemics, etc.
• Airline operations are susceptible to disruptions from weather and natural disasters.
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Stage 2: Issuer Rating
To move from the generic industry BRR toward the issuer rating for a speci?c company, two tasks must be per-
formed. Speci?cally, we must determine the business risk and the ?nancial risk for the individual company.
BUSINESS RISK PROFILE
• The business risk pro?le of the issuer may be better or worse than the industry average due to the
presence of unique attributes or challenges that exist at the issuing entity. While not exhaustive, the list
of critical factors outlined in the previous section could result in a speci?c issuer rating being different
from the industry BRR.
• This methodology also provides some guidance on which factors are considered the most critical for the
industry in question. Issuers may also have meaningful business lines in addition to the base business that
extend beyond their most prominent industry, which could add signi?cant attributes or challenges.
FINANCIAL RISK PROFILE
• The graphic below is a visual display of the key ?nancial risk pro?le considerations that are discussed
in the Company-Speci?c Financial Risk Factors section of this methodology, although even the detail
provided there is not meant to be exhaustive.
• The discussion will note that DBRS often makes calculation adjustments in key ratios for risks related to a
variety of areas. In some cases, a relationship with a parent or associated company will also be important.
Earnings
Company
Financial Risk
? Gross margin
? Return on equity
? Return on capital
? EBIT and EBITDA
margins
Cash Flow and Coverage
Balance-Sheet and
Financial Flexibility
? Short-term balance-
sheet ratios
? All debt-related ratios
? Asset coverage
? Liquidity, including bank
lines and access to
capital markets
? Cash flow ratios
? Coverage ratios
? Capex considerations
? Dividends and/or
repurchase programs
Key Financial Risk Metrics
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Company-Speci?c Business Risk Factors
• We now consider if an individual company in the airline industry would be better, worse or the same
as the industry BRR. Our focus here is on the critical business risk factors that relate to this industry in
particular. The ?ve critical factors used to determine the industry BRR are applied by DBRS to compare
numerous industries and are thus more general in nature.
• By analyzing these key drivers (which will vary on an industry-by-industry basis), the essential strengths
and challenges of each industry are captured in an accurate fashion, and transparency is provided. The
analysis below is connected to the industry BRR in that the industry BRR establishes where an average
company would be considered to score on the matrix. For example, an industry with a BRR of BBB would
mean that the following matrix describes the scoring of an average company within the BBB column.
Company-Speci?c Business Risks – Critical Factors
Rating BBB BB B or below
Business Strength Adequate Weak Poor
Diversi?cation
and Market Share
• Highly diversi?ed across
several continents and
regions. Well-balanced
mixed of domestic and
intercontinental ?ights.
• Among market share leaders
in a signi?cant number of key
markets.
• A key member of a strong
international airline alliance,
with lots of code-sharing
opportunities. Meaningful
revenue from non-passenger
services.
• Well diversi?ed, with no
continent producing the
majority of revenue.
• Well-balanced mix of domestic
and intercontinental ?ights.
• Among market share leaders
in some key markets.
• A member of a strong
international airline
alliance. with code-sharing
opportunities.
• Some revenue from non-
passenger services.
• Majority of revenue from one
type of traf?c and vulnerable
to competition.
• Not typically among the
leaders in terms of market
share or only among market
share leaders on a very
narrow niche basis.
• A member of an international
airline alliance, with code-
sharing opportunities.
Operating Cost
Structure (Including
Labour and
Seasonality)
• Low-cost operating structure,
with strong ability to control
variable non-fuel costs.
• Ability to levy fuel surcharge
without adverse effect on
demand.
• Labour relations are good and
strikes are rare.
• If they exist, unions are
generally cooperative.
• Modest legacy cost burden.
• Track record of consistent
high-load factor.
• Ability to use ?eet for sun
destinations in winter often
adds another method of
using planes when there are
excesses in other regions.
• Strong ?nancial resources to
implement ?nancial hedges to
mitigate currency and fuel cost
risks.
• Operating cost structure is
better than average, with
some ?exibility to control
variable non-fuel costs.
• Some ?exibility in levying fuel
surcharges without material
impact on demand.
• Acceptable load factors.
• Labour relations are
reasonable.
• Strikes are minor, although
some labour disruptions may
occur.
• Moderately high legacy cost
burden.
• Some ?exibility in redirecting
?eet in winter to sun
destinations.
• Ability to implement ?nancial
hedges to mitigate currency
and fuel-cost risks.
• Average to high cost structure.
• Limited ?exibility to control
variable non-fuel costs.
• Below-average load factor and
moderate to high variability in
load factor.
• Material legacy cost burden.
• Labour relations are poor.
• Work disruptions are common.
• Seniority issues among
unionized workforce
an obstacle in contract
negotiations.
• Limited ability to levy fuel
surcharge.
• Low ?exibility in cutting planes
or costs.
• Limited ability to implement
?nancial hedges to mitigate
currency and fuel-cost risks.
Rating Companies in the Airline Industry
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Company-Speci?c Business Risks – Critical Factors
Rating BBB BB B or below
Business Strength Adequate Weak Poor
Fleet • Company has owned and
leased aircraft, including
leases on a long-term basis,
with some ?exibility.
• Company operates modern,
ef?cient ?eet.
• Fleet age well below industry
average.
• Fleet mix compatible with
route network.
• Company has a high
proportion of leased planes,
with leases that tend to
be middle term and have
moderate ?exibility.
• Company has a mixed ?eet of
old and new planes.
• Fleet age near industry
average.
• Fleet mix reasonable for route
network.
• High proportion of leased
planes, with long-term leases
and limited ?exibility in lease
terms.
• Company has a lot of older
and fuel-inef?cient planes.
• Plane size is not appropriately
matched to routes.
• Fleet age above industry
average.
Route Network • Highly pro?table routes, with
high proportion of business
travel.
• Traf?c routes have high
growth potential.
• Access to all key cities of
markets served.
• High ?ight frequency at
favourable time slots.
• Large number of landing
slots at key airports to
accommodate growth.
• Pro?table routes, with
reasonable share of business
travel.
• Traf?c routes have good
growth potential.
• Access to some key cities of
markets served.
• Frequent ?ights at favourable
time slots.
• Adequate landing slots at
key airports to accommodate
near-term growth.
• Network primarily covering
regional traf?c and/or serving
as feeder to other airlines.
• Focus on vacation
destinations and chartered
?ights at lower margins.
• Suf?cient landing slots at key
airports to handle existing
traf?c volume but limited
growth capacity.
Customer Service/
Reputation
• Very strong brand recognition.
• Strong reputation for quality
service.
• Strong customer loyalty.
• A highly popular loyalty
program.
• Strong brand recognition.
• Good reputation for quality
service.
• A highly popular loyalty
program.
• Acceptable reputation for
service.
• Some form of loyalty program.
• Inconsistent service quality
and frequent ?ight disruptions.
PRIMARY FACTORS
Diversi?cation and Market Share
• Diverse geographical coverage can add protection from adverse regional economic conditions.
• Strong market position usually bestows the carrier with economies of scale and pricing leadership.
• Serving attractive markets, such as ones with a high proportion of business travel and good growth
potential, provides good opportunities for revenue growth.
• Being a member of a strong global airline alliance adds to competitive advantage by offering improved
services to customers, such as increased ?ight choices and ef?cient connections and transfers.
• Meaningful revenue from other sources, such as transporting cargo, selling vacation packages or pro-
viding chartered services, reduces dependence on volatile passenger travel and revenue volatility,
Operating Cost Structure (Including Labour and Seasonality)
In an industry that has challenges with intensity across a full gamut of labour, capital, energy, economic and
seasonal considerations, companies that lead in cost control will have a signi?cant advantage. Flexibility
to adjust to changing market conditions is also important. In assessing cost control and ?exibility, DBRS
reviews the following areas:
• Track record on labour relations, the frequency of job actions and the duration of disruptions. A union-
ized labour force with highly restrictive work rules and hiring practices can be a major issue.
• Legacy cost burdens, such as high-cost pension and bene?ts plans.
Rating Companies in the Airline Industry
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• Capacity utilization and load factors s. Cost ef?ciency is dif?cult without strength in these key cost drivers.
• Pricing power and ability to levy fuel surcharges enable a carrier to pass on high costs to maintain pro?t.
Fleet
Key attributes assessed to determine the strength of an operators ?eet include the following:
• Suitability of planes to service the route network in terms of range and cost of operations.
• Average Age of Fleet: Younger planes tend to be more fuel ef?cient and require lower maintenance.
• Fleet Mix: Deploying planes from a large number of different manufacturers and a diverse mix of
models increases training costs, investment in parts and overall operating and maintenance costs.
• Fleet Ownership (Owned or Leased): Some portion of leases in the ?eet mix is acceptable and expected,
but leases can be problematic when they are short term or in?exible.
Route Network
A strong route network will provide the operator with a solid underlying base of pro?tability and future
growth potential. In assessing this factor, DBRS views the following as key attributes:
• Access to and adequate coverage of all key cities and regions.
• Routes that have high growth potential and above-average yield (e.g., with a higher proportion of
business travel).
• Frequent ?ights in favourable time slots.
• Adequate landing slots in key airports to service existing traf?c and for growth.
Customer Service/Reputation
Strength in customer service and reputation can be advantageous in attracting customers and charging
higher prices. In this respect, the following factors are assessed:
• Brand recognition.
• Reputation on quality of service.
• Customer loyalty.
• Availability of frequent-?yer or loyalty programs.
ADDITIONAL FACTORS
Fuel Hedging
• Given the energy intensiveness of the industry, hedging for fuel pricing is positive in that it reduces
earnings volatility.
• Financial capacity to support ?nancial derivatives gives a carrier ?exibility to mitigate currency and
fuel-cost risks.
• For meaningful credit, companies would be expected to hedge major portions within a year and some
beyond.
Regulation
• While regulation is heavy for all participants, some companies have better processes and strength in
dealing with safety issues, maintenance policies and hours of operation.
Currency Sensitivity
• Some companies are sensitive to currency and choices with respect to hedging can have an impact on
stability.
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COMMON BUSINESS CONSIDERATIONS
• There are two major considerations that were not included with the prior analysis but can have a mean-
ingful impact on an individual company in any industry: country risk and corporate governance (which
includes management). These areas tend to be regarded more as potential negative issues that could result
in a lower rating than otherwise would be the case, although DBRS would certainly consider exceptional
strength in corporate governance as a rating attribute.
• In most cases, our focus on the two areas is to ensure that the company in question does not have any
meaningful challenges that are not readily identi?able when reviewing the other business risk consider-
ations and ?nancial metrics outlined in this methodology.
Country Risk
• Governments often intervene in their economies and occasionally make substantial changes that can
signi?cantly affect a company’s ability to meet its ?nancial obligations; therefore, considerations include
the company’s main location or country of operation, the extent of government intervention and support
and the degree of economic and political stability.
• As such, the sovereign rating itself may in some cases become a limiting factor in an entity’s rating, par-
ticularly when the sovereign has a lower rating and the entity does not have meaningful diversi?cation
outside its domestic economy.
Corporate Governance
• Effective corporate governance requires a healthy tension between management, the board of directors
and the public. There is no single approach that will be optimal for all companies.
• A good board will have a profound impact on a company, particularly when there are signi?cant
changes, challenges or major decisions facing the company. DBRS will typically assess factors such as
the appropriateness of board composition and structure, opportunities for management self-interest,
the extent of ?nancial and non-?nancial disclosure and the strength or weakness of control functions.
For more detail on this subject, please refer to the DBRS criteria Evaluating Corporate Governance.
• With respect to the pivotal area of management, an objective pro?le can be obtained by assessing the
following: the appropriateness of core strategies; the rigour of key policies, processes and practices; man-
agement’s reaction to problem situations; the integrity of company business and regulatory dealings; the
entity’s appetite for growth, either organically by adding new segments or through acquisition; its ability
to smoothly integrate acquisitions without business disruption; and its track record in achieving ?nancial
results. Retention strategies and succession planning for senior roles can also be considerations.
Rating Companies in the Airline Industry
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Company-Speci?c Financial Risk Factors
KEY METRICS
• Recognizing that any analysis of ?nancial metrics may be prone to misplaced precision, we have limited
our key metrics to a small universe of critical ratios. For each of these ratios, DBRS provides a range
within which the issuer’s ?nancial strength would be considered as supportive for the same level of
business risk as the airline industry. For example, a company where the outlook for both business risk
and ?nancial risk metrics falls within the BBB category would, all else being equal, be expected to have
an issuer rating in the BBB range.
• To be clear, the ratings in the matrix below should not be understood as the ?nal rating for an entity
with matching metrics. This would only be the case to the extent that the business risk of the company
and a wide range of other ?nancial metrics were also supportive. The ?nal rating is a blend of both the
business risk and ?nancial risk considerations in their entirety.
Airline Industry Financial Metrics
Key Ratio BBB BB B
Percentage debt in the capital structure < 45% 45% to 60% > 60%
EBIT coverage > 3.0x 1.5x to 3.0x < 1.5x
Cash ?ow-to-debt > 20% 10% to 20% < 10%
EBITDA-to-interest > 4.0x 2.0x to 4.0x < 2.0x
Debt-to-EBITDA < 3.5x 3.5x to 5.0x > 5.0x
Return on equity > 7% 5% to 7% < 5%
• While the data in the above table are recognized as key factors, they should not be expected to be fully
adequate to provide a ?nal ?nancial risk rating for any company. The nature of credit analysis is such
that it must incorporate a broad range of ?nancial considerations, and this cannot be limited to a ?nite
number of metrics, regardless of how critical these may be.
• DBRS ratings are based heavily on future performance expectations, so while past metrics are impor-
tant, any ?nal rating will incorporate DBRS’s opinion on future metrics, a subjective but critical
consideration.
• It is also not uncommon for a company’s key ratios to move in and out of the ranges noted in the ratio
matrix above, particularly for cyclical industries. In the application of this matrix, however, DBRS is
typically focusing on multi-year ratio averages.
• Notwithstanding these potential limitations, the key ratios are very useful in providing a good starting
point in assessing a company’s ?nancial risk.
• It is important to note that ?nancial ratios for an entity can and will be in?uenced by both account-
ing and accounting choices. In Canada, this includes the current transition to International Financial
Reporting Standards (IFRS). DBRS notes that the differences between accounting choices will have an
impact on the ?nancial metrics of the companies that it covers. Historically in Canada, the ?nancial
risk factors included ratios based on Canadian Generally Accepted Accounting Principles (GAAP) and
U.S. GAAP, for the most part. In those cases when a company’s ?nancial statements are based on other
accounting standards, including IFRS, the ratios and ranges may need to be rede?ned.
• Recognizing that the metrics in the table above do not represent the entire universe of considerations
that DBRS examines when evaluating the ?nancial risk pro?le of a company, the following provides a
general overview that encompasses a broader range of metrics and considerations that could be mean-
ingful in some cases.
Rating Companies in the Airline Industry
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Overall Considerations in Evaluating a Company’s
Financial Risk Pro?le
In addition to the information already provided with respect to key ?nancial metrics, the following ?nan-
cial considerations and ratios are typically part of the analysis for the airline industry. As it is not possible
to completely separate business and ?nancial risks, note that many of the following ratios will relate to
both areas.
EARNINGS
• DBRS earnings analysis focuses on core earnings or earnings before non-recurring items and in doing so
considers issues such as the sources, mix and quality of revenue; the volatility or stability of revenue; the
underlying cost base (e.g., the company is a low-cost producer); optimal product pricing; and potential
growth opportunities. Accordingly, earnings as presented in the ?nancial statements are often adjusted
for non-recurring items or items not considered part of ongoing operations.
• DBRS generally reviews company budgets and forecasts for future periods. Segmented breakdowns by
division are also typically part of DBRS analysis. Notwithstanding the focus on core earnings, note that
actual net earnings is also a consideration in our analysis given the direct impact that this has on the
capital structure.
Typical Earnings Ratios
• EBITDA interest coverage.
• EBIT interest coverage.
• EBITDA margin.
• EBIT margin.
• Net margin.
• Return on equity.
• Return on capital.
CASH FLOW AND COVERAGE
• DBRS cash ?ow analysis focuses on the core ability of the company to generate cash ?ow to service
current debt obligations and other cash requirements as well as on the future direction of cash ?ow.
From a credit analysis perspective, insuf?cient cash sources can create ?nancial ?exibility problems,
even though net income metrics may be favourable.
• DBRS evaluates the sustainability and quality of a company’s core cash ?ow by focusing on cash ?ow
from operations and free cash ?ow before and after working capital changes. Using core or normalized
earnings as a base, DBRS adjusts cash ?ow from operations for as many non-recurring items as relevant.
As with earnings, the impact that non-core factors have on cash ?ow may also be an important reality.
• In terms of outlook, DBRS focuses on the projected direction of free cash ?ow, the liquidity and coverage
ratios and the company’s ability to internally versus externally fund debt reduction, future capital expen-
ditures and dividend and/or stock repurchase programs, as applicable.
Typical Cash Flow Ratios
• Cash ?ow-to-debt.
• Adjusted cash ?ow-to-adjusted debt (DBRS-adjusted ratios for operating leases, which are capitalized
and included as debt).
• Cash ?ow-to-net debt.
• Adjusted cash ?ow-to-adjusted net debt (DBRS-adjusted ratios for operating leases, which are capital-
ized and included as debt).
Rating Companies in the Airline Industry
October 2011
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BALANCE-SHEET AND FINANCIAL FLEXIBILITY CONSIDERATIONS
• As part of determining the overall ?nancial risk pro?le, DBRS evaluates various other factors to
measure the strength and quality of the company’s assets and its ?nancial ?exibility. From a balance-
sheet perspective, DBRS focuses on the quality and composition of assets, including goodwill and other
intangibles; off-balance-sheet risk; and capital considerations such as the quality of capital, appropriate-
ness of leverage to asset quality and the ability to raise new capital.
• DBRS also reviews the company’s strategies for growth, including capital expenditures and plans for main-
tenance or expansion, and the expected source of funding for these requirements, including bank lines and
related covenants. Where the numbers are considered signi?cant and the adjustments would meaningfully
affect the credit analysis, DBRS adjusts certain ratios for items such as operating leases, derivatives, secu-
ritizations, hybrid issues, off-balance-sheet liabilities and various other accounting issues.
Typical Balance-Sheet Ratios
• Current ratio.
• Debt-to-EBITDA.
• Net debt-to-EBITDA.
• Adjusted debt-to-EBITDA (DBRS-adjusted ratios for operating leases, which are capitalized and
included as debt).
• Debt-to-capital.
• Net debt-to-capital.
• Adjusted debt-to-capital (DBRS-adjusted ratios for operating leases, which are capitalized and included
as debt).
Stage 3: Rating the Security
With respect to Stage 3, the following comments describe how the issuer rating is used to determine
ratings on individual securities:
• DBRS uses a hierarchy in rating long-term debt that affects issuers that have classes of debt that do not
rank equally. In most cases, lower-ranking classes would receive a lower DBRS rating. For more detail
on this subject, please refer to DBRS rating policy entitled “Underlying Principles.”
• In some cases, issued debt is secured by collateral. This is more typical in the non-investment-grade spectrum.
For more detail on this subject, please refer to DBRS Rating Methodology for Leveraged Finance.
• The existence of holding companies can have a meaningful impact on individual security ratings. For more
detail on this subject, please refer to the criteria Rating Parent/Holding Companies and Their Subsidiaries.
Rating Companies in the Airline Industry
October 2011
16
Appendix
INDUSTRY BUSINESS RISK RATINGS
• DBRS uses the concept of business risk ratings (BRRs) as a tool in assessing the business strength of
both industries and individual companies within many methodologies across the corporate ?nance area.
(DBRS does not typically use this approach for most ?nancial, government and public ?nance sectors,
where the industry is more challenging to de?ne and this approach is not as useful.)
• The BRR is assessed independently of ?nancial risk, although in some cases there are subtle but impor-
tant links. As an example, the very low business risk pro?le of many regulated utilities has historically
allowed this sector to operate with debt levels that would not be acceptable for most other industry
sectors. Given this reality, it is dif?cult to consider the utility industry’s BRR without acknowledging
to some degree that the industry operates with sizable debt levels. This type of relationship exists with
many industries, although typically to a much lesser degree.
• When a BRR is applied to an industry, there is an acknowledgment that this is a general assessment
and there may in fact be a wide disbursement in the business strength of individual entities within the
industry. Nonetheless, this assessment is bene?cial to enabling DBRS to clearly delineate our industry
opinion and is a useful tool when comparing different industries. An industry BRR is de?ned as being
representative of those entities that the market would consider as “established,” meaning that the group
of companies being considered would have at least reasonable critical mass and track records. As such,
the BRR for an industry does not consider very small players, start-up operations or entities that have
unusual strengths or weaknesses relative to the base industry.
• DBRS methodologies note whether they apply to global industries or more speci?c countries or regions.
When analyzing individual credits, DBRS considers the degree to which regional considerations may differ
from the geographic area applicable within the industry methodology. Many entities have business units
that transcend industries and in these cases, more than one BRR would be considered, including the possible
bene?ts or challenges that may exist when all businesses are analyzed as part of a combined group.
• The BRR is a tool that provides additional clarity regarding the business risk of the industry overall, but
it should be viewed as just one aspect in the complex analysis of setting ratings and should by no means
be seen as either a ?oor or ceiling for issuers within a given industry. Although DBRS does not antici-
pate volatility in an industry’s BRR, changes are possible over time if there are meaningful structural
developments in the industry. When such a change does occur, DBRS will make this clear and note any
impact on related individual ratings within the industry as applicable.
• DBRS assesses ?ve areas to establish the overall BRR for an industry. Although there is an overlap
in some instances (to some degree, in the long term, all ?ve factors tend to relate to pro?tability and
stability), DBRS has found that considering these ?ve measures in a separate fashion is a useful way of
approaching its analysis. In all cases, DBRS uses historic performance and our experience to determine
an opinion on the future, which is the primary focus.
Industry Pro?tability and Cash Flow
• When ratios such as return on equity, return on capital and a variety of cash ?ow metrics are consid-
ered, some industries are simply more pro?table than others. While standard economics would suggest
a reversion to the mean through new competitors, this often occurs at a very slow pace over a long time
horizon and in some cases may not occur at all because of barriers to entry.
• The bene?ts from above-average pro?ts and/or cash ?ow are substantial and include internal capital
growth, easier access to external capital and an additional buffer to unexpected adversity from both
liquidity and capital perspectives.
• Some industries and their participants have challenges or strengths in areas such as research and devel-
opment (R&D), brand recognition, marketing, distribution, cost levels and a potentially wide variety of
other tangibles and intangibles that affect their ability in the area of pro?tability.
Rating Companies in the Airline Industry
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Industry Competitive Landscape
• The competitive landscape provides information regarding future pro?tability for the industry and
thus somewhat crosses over into the pro?tability and cash ?ow assessment, but competition is deemed
worthy of separate consideration because of its critical nature.
• Participants in industries that lack discipline, produce commodity-like products or services, have low
barriers to entry and exhibit ongoing pricing war strategies generally have dif?culty attaining high prof-
itability levels in the longer term. Certain industries bene?t from a monopoly or oligopoly situation,
which may relate to regulation.
Industry Stability
• This factor relates primarily to the degree of stability in cash ?ow and earnings, measuring the degree to
which the industry and its participants are affected by economic or industry cycles. Stability is consid-
ered critical as industries with high peaks and troughs have to deal with higher risk at the bottom of a
cycle. As such, to some degree, industries with lower but stable pro?tability are considered more highly
than industries with higher average pro?tability that is more cyclical.
• Some of the key factors in considering stability include the nature of the cost structure (?xed or variable),
diversi?cation that provides counter-cyclicality and the degree to which the industry interrelates with
the overall economy. Depending on the industry, economic factors could include in?ation or de?ation,
supply and demand, interest rates, currency swings and future demographics.
Industry Regulation
• Where applicable, regulation can provide support through stability and a barrier to entry, but it can also
cause challenges and change the risk pro?le of an industry and its participants in a negative way, includ-
ing the reality of additional costs and complications in enacting new strategies or other changes.
• As part of its analysis of regulation, DBRS also considers the likelihood of deregulation for a regulated
industry, noting the many examples where this transition has proven to be a major challenge in the past.
Other Inherent Industry Considerations
• Each industry has its own set of unique potential risks that, even if managed well, cannot be totally
eliminated. Speci?c risks, the ability to manage them and the range of potential outcomes vary industry
by industry. Two of the most common risks are changing technology and operational risks.
• Some of the other more common risks are in the areas of legal, product tampering, weather, natural
disasters, labour relations, currency, energy prices, emerging markets and pensions.
Rating Companies in the Airline Industry
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INDUSTRY BUSINESS RISK RATING DEFINITIONS
DBRS speci?es the BRR for an industry in terms of our Long-Term Obligations rating scale. When dis-
cussing industry BRRs for an industry, DBRS typically provides either one speci?c rating or a limited
range (such as BBB (high)/BBB). Using a range recognizes the fact that, by their nature, industry BRRs are
less precise than a speci?c corporate or security rating as they represent an overall industry. In addition
to relating to the industry level, these de?nitions also apply to the business risk of individual companies,
which will fall more often in the very high and low categories (AA/AAA and B) than would be the case
for an entire industry.
Industry Business Risk Ratings (BRRs)
Rating Business Strength Comment
AA/AAA Exceptional An industry BRR of AA/AAA is considered unusually strong, with no meaningful
weakness in any individual area. It may include pure monopolies that are deemed
essential (the primary case being regulated utilities, where the risk of deregulation
is believed to be very low). Common attributes include product differentiation, high
barriers to entry and meaningful cost advantages over other industries or entities.
These and other strengths provide exceptional stability and high pro?tability. It
would be quite rare for an industry to have a BRR in this category.
A Superior Industry BRRs at the “A” level are considered well above average in terms of
stability and pro?tability and typically have some barriers to entry related to capital,
technology or scale. Industries that have, by their nature, inherent challenges in
terms of cyclicality, a high degree of competition and technology risks would be
unlikely to attain this rating category.
BBB Adequate Industry BRRs at the BBB level include many cyclical industries where other
positive considerations are somewhat offset by challenges related to areas such
as commodity products, labour issues, low barriers to entry, high ?xed costs and
exposure to energy costs. This rating category is considered average and many
industries fall within it, with key considerations such as overall pro?tability and
stability typically considered as neither above or below average.
BB Weak An industry at the BB level has some meaningful challenges. In addition to high
cyclicality, challenges could include the existence of high technology or other risks.
Long-standing industries that may have lost their key strengths through factors
such as new competition, obsolescence or the inability to meet changing purchaser
demands may ?t here. The culmination of such factors results in an industry that
does not generally score well in terms of stability and pro?tability. For an entire
industry, this is typically the lowest BRR level.
B Poor While not common, there are cases where an industry can have a BRR of B. Such
industries would typically be characterized by below-average strength in all or
virtually all major areas.
Rating Companies in the Airline Industry
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INTERRELATIONSHIP BETWEEN FINANCIAL AND BUSINESS RISK
Having in mind the prior discussion on the typical importance that DBRS places on certain ?nancial
metrics and business strengths for the airline industry, we provide some guiding principles pertaining to
the application of DBRS methodologies, the ?rst one being that, in most cases, an entity’s business risk
will carry more weight in the ?nal rating than its ?nancial risk.
Based on this underlying concept, we provide the additional guidance for individual companies with
varying business risks:
• For an Entity with a Business Risk of AA (Exceptional): A company with a business risk of AA will almost
always be able to obtain an investment-grade issuer rating. When ?nancial metrics are in the BBB range,
an entity with a business risk of AA would typically be able to attain an “A”-range issuer rating.
• For an Entity with a Business Risk of “A” (Superior): Unless ?nancial strength fails to exceed the B
range, superior business strength will typically allow the ?nal issuer rating to be investment grade. Very
conservative ?nancial risk may in some cases allow the ?nal issuer rating to be within the AA range, but
this should not be considered the norm.
• For an Entity with a Business Risk of BBB (Adequate): At this average level of business risk, the level of
?nancial risk typically has the ability to result in a ?nal issuer rating from as high as “A” to as low as B.
• For an Entity with a Business Risk of BB (Weak): At this weak level of business risk, conservative ?nan-
cial risk can, in some cases, take the ?nal issuer rating into the BBB investment-grade range.
• For an Entity with a Business Risk of B (Poor): It is not typically possible for a company with a business
risk of B to achieve a ?nal investment-grade issuer rating.
DEFINITION OF ISSUER RATING
• DBRS Corporate rating analysis begins with an evaluation of the fundamental creditworthiness of the
issuer, which is re?ected in an “issuer rating”. Issuer ratings address the overall credit strength of the
issuer. Unlike ratings on individual securities or classes of securities, issuer ratings are based on the
entity itself and do not include consideration for security or ranking. Ratings that apply to actual securi-
ties (secured or unsecured) may be higher, lower or equal to the issuer rating for a given entity.
• Given the lack of impact from security or ranking considerations, issuer ratings generally provide an opinion
of default risk for all industry sectors. As such, issuer ratings in the banking sector relate to the ?nal credit
opinion on a bank that incorporates both the intrinsic rating and support considerations, if any.
• DBRS typically assigns issuer ratings on a long-term basis using its Long Term Obligations Rating Scale;
however, on occasion, DBRS may assign a “short-term issuer rating” using its Commercial Paper and Short
Term Debt Rating Scale to re?ect the issuer’s overall creditworthiness over a short-term time horizon.
SHORT-TERM AND LONG-TERM RATINGS
• For a discussion on the relationship between short- and long-term ratings and more detail on liquidity
factors, please refer to the DBRS policy entitled “Short-Term and Long-Term Rating Relationships” and
the criteria DBRS Commercial Paper Liquidity Support Criteria for Corporate Non-Bank Issuers.
Copyright © 2011, DBRS Limited, DBRS, Inc. and DBRS Ratings Limited (collectively, DBRS). All rights reserved. The information upon which DBRS ratings and reports are based is
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doc_441436681.pdf
Methodology
Rating Companies in the Airline Industry
CONTACT INFORMATION
Kam Hon
Managing Director, Corporate
+1 416 597 7543
[email protected]
Kent Wideman
Chief Credit Of?cer
+1 416 597 7535
[email protected]
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Rating Companies in the Airline Industry
October 2011
3
Rating Companies in the Airline Industry
TABLE OF CONTENTS
Introduction to DBRS Methodologies 4
Business and Financial Risk Overview 4
Stage 1: Industry Business Risk Rating for the Airline Industry 6
De?nition of the Industry 6
Business Risk Rating 6
Industry Pro?tability and Cash Flow 6
Industry Competitive Landscape 7
Industry Stability 7
Industry Regulation 7
Other Inherent Industry Considerations 7
Stage 2: Issuer Rating 8
Business Risk Pro?le 8
Financial Risk Pro?le 8
Company-Speci?c Business Risk Factors 9
Primary Factors 10
Diversi?cation and Market Share 10
Operating Cost Structure (Including Labour and Seasonality) 10
Fleet 11
Route Network 11
Customer Service/Reputation 11
Additional Factors 11
Fuel Hedging 11
Regulation 11
Currency Sensitivity 11
Common Business Considerations 12
Country Risk 12
Corporate Governance 12
Company-Speci?c Financial Risk Factors 13
Key Metrics 13
Overall Considerations in Evaluating a Company’s Financial Risk Pro?le 14
Earnings 14
Cash Flow and Coverage 14
Balance-Sheet and Financial Flexibility Considerations 15
Stage 3: Rating the Security 15
Appendix 16
Industry Business Risk Ratings 16
Industry Pro?tability and Cash Flow 16
Industry Competitive Landscape 17
Industry Stability 17
Industry Regulation 17
Other Inherent Industry Considerations 17
Industry Business Risk Rating De?nitions 18
Interrelationship between Financial and Business Risk 19
De?nition of Issuer Rating 19
Short-Term and Long-Term Ratings 19
Rating Companies in the Airline Industry
October 2011
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Introduction to DBRS Methodologies
• In general terms, DBRS ratings are opinions that re?ect the creditworthiness of an issuer, a security or
an obligation. They are opinions based on an analysis of historic trends and forward-looking measure-
ments that assess an issuer’s ability and willingness to make timely payments on outstanding obligations
(whether principal, interest, dividend or distributions) with respect to the terms of an obligation.
• DBRS rating methodologies include consideration of general business and ?nancial risk factors appli-
cable to most industries in the corporate sector as well as industry-speci?c issues and more subjective
factors, nuances and intangible considerations. Our approach is not based solely on statistical analysis
but includes a combination of both quantitative and qualitative considerations.
• The considerations outlined in DBRS methodologies are not intended to be exhaustive. In certain cases,
a major strength can compensate for a weakness and, conversely, there are cases where one weakness is
so critical that it overrides the fact that the company may be strong in most other areas.
• DBRS rating methodologies are underpinned by a stable rating philosophy, which means that in order
to minimize the rating changes due primarily to economic changes, DBRS strives to factor the impact
of a cyclical economic environment into its rating as applicable. Rating revisions do occur, however,
when it is clear that a structural change, either positive or negative, has transpired or appears likely to
transpire in the near future.
• As a framework, DBRS rating methodologies consist of several components that together form the basis
of the ultimate ratings assigned to individual securities. Assessments typically include the industry’s
business risk pro?le, the company’s general business risk pro?le, the company’s ?nancial risk pro?le and
considerations related to the speci?c security.
• To some extent, the business risk and ?nancial risk pro?les are interrelated. The ?nancial risk for
a company must be considered along with the business risks that it faces. In most cases, an entity’s
business risk will carry more weight in the ?nal issuer rating than will its ?nancial risk.
Business and Financial Risk Overview
• On a high-level macro basis, DBRS has a consistent approach to determining the issuer rating of an
entity that is common across many industries. (See the appendix for the de?nition of “issuer rating.”)
Our high-level approach can be broken into three stages, as shown on the opposite page.
• Where applicable, DBRS uses the concept of business risk ratings (BRRs) as a tool in assessing the
business strength of both industries and individual companies within many methodologies across the
corporate ?nance area. DBRS typically assesses ?ve areas to establish the overall BRR for an industry:
– Pro?tability and cash ?ow.
– Competitive landscape.
– Stability.
– Regulation.
– Other inherent industry considerations.
• Although there is an overlap in some instances (to some degree, in the long term, all ?ve factors tend to
relate to pro?tability and stability), DBRS has found that considering these ?ve measures in a separate
fashion is a useful way of approaching this analysis.
• Using the same factors across different industries provides a common base with which to compare the
business risks of various industries, even when they are distinctly different. In all cases, DBRS uses
historic performance and our experience to determine an opinion on the future, which is the primary
focus. For additional discussion on industry BRRs, please refer to the Industry Business Risk Ratings
and Industry Business Risk Rating De?nitions sections in the appendix.
Rating Companies in the Airline Industry
October 2011
5
• It is important to note that the ratings for company-speci?c business and ?nancial risks as provided
under Stage 2 of this document should not be taken as ?nal issuer ratings. For example, an individual
company may ?t into the “A” range with respect to the analysis of its business risk, but its ?nancial
metrics could be more in the BB category. It would be incorrect to believe that the ?nal issuer rating in
this case would be either “A” or BB. In determining the ?nal issuer rating, both of these two major areas
must be considered. For additional discussion on this topic, please refer to the Interrelationship between
Business and Financial Risk section in the appendix.
Industry Business
Risk Rating
Rating on the Security
Company
Business Risk
Company
Financial Risk
Issuer Rating
+
Stage 1: Industry Business Risk Rating
Consider the overall business risk rating (BRR) for the industry.
Stage 3: Rating the Security
Consider covenant and ranking issues that exist for specific securities, using the issuer rating
to determine specific security ratings.
Level of collateral
and ranking of collateral
and recovery methodology
Holding company debt
versus operating company
debt and notching principles
The short-term rating stresses financial
risk as well as business risk, but places
more emphasis on financial risk and
liquidity than the long-term rating does.
=
Stage 2: Issuer Rating
Consider the strength of the individual issuer:
(a) First assessing how the company’s BRR compares with the industry BRR.
(b) Then assessing the company’s financial risk.
Taken together, these factors will determine the company’s issuer rating.
The long-term rating puts more
emphasis on business risk than
the short-term rating does.
Three Stages of DBRS Rating Analysis
Rating Companies in the Airline Industry
October 2011
6
Stage 1: Industry Business Risk Rating
for the Airline Industry
DEFINITION OF THE INDUSTRY
• The airline industry encompasses global companies principally engaged in the transportation of pas-
sengers by plane. These companies may also engage in the transportation of cargo, but this is usually
on a much smaller scale.
• The methodology is broadly applied to both scheduled and chartered airlines and covers all segments
such as legacy, budget, feeder and regional airlines.
• While primarily focused on global companies, this methodology is also applicable to smaller operators,
which may be able to offset some scale and diversi?cation challenges through meaningful presence in
important niche markets.
BUSINESS RISK RATING
The business risk rating of the airline industry is BB (low) and recognizes the fact that the industry is one
of the most dif?cult industries in our economy in which to operate.
• Pro?tability of the industry is often weak because it is (a) labour intensive, (b) capital intensive, (c)
energy intensive, (d) sensitive to the state of the economy and (e) highly seasonal, with stronger results
in the third quarter and weaker results in the ?rst and fourth quarters.
• Barriers to entry into the industry are often low, helped by the ability to lease aircraft and outsource
most other support services.
• Stability of income is low because of the ?xed nature of costs and ?uctuating passenger loads.
• Regulation is high, and rather than reducing competition, regulation (especially related to security
matters) increases costs and reduces ?exibility of operations.
• Safety and reputation are key issues, and any airline that has an accident is hurt severely in lawsuit
settlement costs, reputation loss and future insurance rates.
• Therefore, the business risk rating of the airline industry is relatively low. Having said this, DBRS recog-
nizes that there are companies that are able to deal with these challenges and obtain investment-grade
ratings.
INDUSTRY PROFITABILITY AND CASH FLOW
• Pro?tability of the industry is generally weak, although, with high levels of depreciation and amortiza-
tion, cash ?ow levels tend to be stronger and help stabilize the balance sheet.
• While ?nancial ratios are covered separately in this methodology, the industry in general tends to have
high levels of adjusted debt because of the use of operating leases. This adds an element of costs that are
largely ?xed and, over the longer term, are sensitive to interest rate movement at the time of renewal.
• The airline industry is highly labour intensive, from pilots and ?ight attendants to personnel responsible
for baggage handling, ticketing and loading. These labour costs are mostly ?xed and restrict ?exibility
in adjusting the expense structure when needed. Moreover, most of the labour force is unionized, which
further limits operational ?exibility.
• Aircraft use high levels of fuels and are energy intensive, with operating pro?ts materially in?uenced by
fuel cost volatility.
• Interest rate levels have signi?cant in?uence on borrowing costs and leasing costs, which indirectly
affect pro?tability.
• Load factors are key, so the state of the economy is important to the airline industry. With a high
proportion of ?xed costs, a slowdown in the volume of passengers quickly translates into lower pro?t-
ability and makes earnings volatile.
• Operations are highly seasonal, with stronger results in the third quarter of the year, while the ?rst and
fourth quarters are usually weaker. Therefore, earnings through the year are highly volatile.
Rating Companies in the Airline Industry
October 2011
7
INDUSTRY COMPETITIVE LANDSCAPE
• Barriers to entry into the industry are low because of the ability of the industry to lease aircraft at rela-
tively low rates, particularly older or surplus aircraft.
• Interest rates today are relatively low and this reduces the interest cost of leases.
• In recent years, a number of new airlines have engaged in niche segments, such as special charters,
vacation destinations, etc. These new entrants have a non-union labour force (which increases ?exibility
and lowers labour costs) and focus on selective routes that are high-volume destinations and give these
airlines critical mass to serve those destinations. These new entrants, with less in legacy costs and more
route ?exibility, often have a competitive advantage over the larger legacy airlines.
• The formation of an alliance among airlines (e.g. the Star Alliance) provides member airlines a com-
petitive advantage of scale and ?exibility by pooling resources from all members. The alliance allows
members to code share and leverage each other’s services, leading to increased coverage, better connec-
tions and higher capacity utilization.
INDUSTRY STABILITY
• Airlines are extremely sensitive to volume of traf?c (load factor) and pro?tability quickly falls off as
load factor declines.
• Costs are largely ?xed in the short term. (Fuel usage and costs are affected by load and ?ying conditions,
but the incremental impact is modest.) The industry is highly seasonal, with revenue usually peaking in
the third quarter but weak in the ?rst and fourth quarters.
• The advent of travel websites and other travel distribution channels has led to a substantial increase in
discounted and promotional fares.
• The volume of business class is highly sensitive to economic conditions. The variability of the more
pro?table business class passenger would have an exaggerated impact on pro?tability.
INDUSTRY REGULATION
• The industry is heavily regulated in areas such as safety issues, maintenance policies, hours of operation
per month for personnel and route selection.
• Bilateral agreements with other countries restrict the number of ?ights between these countries.
• Generally, cabotage can restrict foreign airlines from picking up passengers in a country and ?ying them
to another location in that or any other country.
OTHER INHERENT INDUSTRY CONSIDERATIONS
• Safety and reputation issues are key for any airline, which must maintain a favourable track record.
• Airlines are vulnerable to security risks related to terrorism, war, political unrest, epidemics, etc.
• Airline operations are susceptible to disruptions from weather and natural disasters.
Rating Companies in the Airline Industry
October 2011
8
Stage 2: Issuer Rating
To move from the generic industry BRR toward the issuer rating for a speci?c company, two tasks must be per-
formed. Speci?cally, we must determine the business risk and the ?nancial risk for the individual company.
BUSINESS RISK PROFILE
• The business risk pro?le of the issuer may be better or worse than the industry average due to the
presence of unique attributes or challenges that exist at the issuing entity. While not exhaustive, the list
of critical factors outlined in the previous section could result in a speci?c issuer rating being different
from the industry BRR.
• This methodology also provides some guidance on which factors are considered the most critical for the
industry in question. Issuers may also have meaningful business lines in addition to the base business that
extend beyond their most prominent industry, which could add signi?cant attributes or challenges.
FINANCIAL RISK PROFILE
• The graphic below is a visual display of the key ?nancial risk pro?le considerations that are discussed
in the Company-Speci?c Financial Risk Factors section of this methodology, although even the detail
provided there is not meant to be exhaustive.
• The discussion will note that DBRS often makes calculation adjustments in key ratios for risks related to a
variety of areas. In some cases, a relationship with a parent or associated company will also be important.
Earnings
Company
Financial Risk
? Gross margin
? Return on equity
? Return on capital
? EBIT and EBITDA
margins
Cash Flow and Coverage
Balance-Sheet and
Financial Flexibility
? Short-term balance-
sheet ratios
? All debt-related ratios
? Asset coverage
? Liquidity, including bank
lines and access to
capital markets
? Cash flow ratios
? Coverage ratios
? Capex considerations
? Dividends and/or
repurchase programs
Key Financial Risk Metrics
Rating Companies in the Airline Industry
October 2011
9
Company-Speci?c Business Risk Factors
• We now consider if an individual company in the airline industry would be better, worse or the same
as the industry BRR. Our focus here is on the critical business risk factors that relate to this industry in
particular. The ?ve critical factors used to determine the industry BRR are applied by DBRS to compare
numerous industries and are thus more general in nature.
• By analyzing these key drivers (which will vary on an industry-by-industry basis), the essential strengths
and challenges of each industry are captured in an accurate fashion, and transparency is provided. The
analysis below is connected to the industry BRR in that the industry BRR establishes where an average
company would be considered to score on the matrix. For example, an industry with a BRR of BBB would
mean that the following matrix describes the scoring of an average company within the BBB column.
Company-Speci?c Business Risks – Critical Factors
Rating BBB BB B or below
Business Strength Adequate Weak Poor
Diversi?cation
and Market Share
• Highly diversi?ed across
several continents and
regions. Well-balanced
mixed of domestic and
intercontinental ?ights.
• Among market share leaders
in a signi?cant number of key
markets.
• A key member of a strong
international airline alliance,
with lots of code-sharing
opportunities. Meaningful
revenue from non-passenger
services.
• Well diversi?ed, with no
continent producing the
majority of revenue.
• Well-balanced mix of domestic
and intercontinental ?ights.
• Among market share leaders
in some key markets.
• A member of a strong
international airline
alliance. with code-sharing
opportunities.
• Some revenue from non-
passenger services.
• Majority of revenue from one
type of traf?c and vulnerable
to competition.
• Not typically among the
leaders in terms of market
share or only among market
share leaders on a very
narrow niche basis.
• A member of an international
airline alliance, with code-
sharing opportunities.
Operating Cost
Structure (Including
Labour and
Seasonality)
• Low-cost operating structure,
with strong ability to control
variable non-fuel costs.
• Ability to levy fuel surcharge
without adverse effect on
demand.
• Labour relations are good and
strikes are rare.
• If they exist, unions are
generally cooperative.
• Modest legacy cost burden.
• Track record of consistent
high-load factor.
• Ability to use ?eet for sun
destinations in winter often
adds another method of
using planes when there are
excesses in other regions.
• Strong ?nancial resources to
implement ?nancial hedges to
mitigate currency and fuel cost
risks.
• Operating cost structure is
better than average, with
some ?exibility to control
variable non-fuel costs.
• Some ?exibility in levying fuel
surcharges without material
impact on demand.
• Acceptable load factors.
• Labour relations are
reasonable.
• Strikes are minor, although
some labour disruptions may
occur.
• Moderately high legacy cost
burden.
• Some ?exibility in redirecting
?eet in winter to sun
destinations.
• Ability to implement ?nancial
hedges to mitigate currency
and fuel-cost risks.
• Average to high cost structure.
• Limited ?exibility to control
variable non-fuel costs.
• Below-average load factor and
moderate to high variability in
load factor.
• Material legacy cost burden.
• Labour relations are poor.
• Work disruptions are common.
• Seniority issues among
unionized workforce
an obstacle in contract
negotiations.
• Limited ability to levy fuel
surcharge.
• Low ?exibility in cutting planes
or costs.
• Limited ability to implement
?nancial hedges to mitigate
currency and fuel-cost risks.
Rating Companies in the Airline Industry
October 2011
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Company-Speci?c Business Risks – Critical Factors
Rating BBB BB B or below
Business Strength Adequate Weak Poor
Fleet • Company has owned and
leased aircraft, including
leases on a long-term basis,
with some ?exibility.
• Company operates modern,
ef?cient ?eet.
• Fleet age well below industry
average.
• Fleet mix compatible with
route network.
• Company has a high
proportion of leased planes,
with leases that tend to
be middle term and have
moderate ?exibility.
• Company has a mixed ?eet of
old and new planes.
• Fleet age near industry
average.
• Fleet mix reasonable for route
network.
• High proportion of leased
planes, with long-term leases
and limited ?exibility in lease
terms.
• Company has a lot of older
and fuel-inef?cient planes.
• Plane size is not appropriately
matched to routes.
• Fleet age above industry
average.
Route Network • Highly pro?table routes, with
high proportion of business
travel.
• Traf?c routes have high
growth potential.
• Access to all key cities of
markets served.
• High ?ight frequency at
favourable time slots.
• Large number of landing
slots at key airports to
accommodate growth.
• Pro?table routes, with
reasonable share of business
travel.
• Traf?c routes have good
growth potential.
• Access to some key cities of
markets served.
• Frequent ?ights at favourable
time slots.
• Adequate landing slots at
key airports to accommodate
near-term growth.
• Network primarily covering
regional traf?c and/or serving
as feeder to other airlines.
• Focus on vacation
destinations and chartered
?ights at lower margins.
• Suf?cient landing slots at key
airports to handle existing
traf?c volume but limited
growth capacity.
Customer Service/
Reputation
• Very strong brand recognition.
• Strong reputation for quality
service.
• Strong customer loyalty.
• A highly popular loyalty
program.
• Strong brand recognition.
• Good reputation for quality
service.
• A highly popular loyalty
program.
• Acceptable reputation for
service.
• Some form of loyalty program.
• Inconsistent service quality
and frequent ?ight disruptions.
PRIMARY FACTORS
Diversi?cation and Market Share
• Diverse geographical coverage can add protection from adverse regional economic conditions.
• Strong market position usually bestows the carrier with economies of scale and pricing leadership.
• Serving attractive markets, such as ones with a high proportion of business travel and good growth
potential, provides good opportunities for revenue growth.
• Being a member of a strong global airline alliance adds to competitive advantage by offering improved
services to customers, such as increased ?ight choices and ef?cient connections and transfers.
• Meaningful revenue from other sources, such as transporting cargo, selling vacation packages or pro-
viding chartered services, reduces dependence on volatile passenger travel and revenue volatility,
Operating Cost Structure (Including Labour and Seasonality)
In an industry that has challenges with intensity across a full gamut of labour, capital, energy, economic and
seasonal considerations, companies that lead in cost control will have a signi?cant advantage. Flexibility
to adjust to changing market conditions is also important. In assessing cost control and ?exibility, DBRS
reviews the following areas:
• Track record on labour relations, the frequency of job actions and the duration of disruptions. A union-
ized labour force with highly restrictive work rules and hiring practices can be a major issue.
• Legacy cost burdens, such as high-cost pension and bene?ts plans.
Rating Companies in the Airline Industry
October 2011
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• Capacity utilization and load factors s. Cost ef?ciency is dif?cult without strength in these key cost drivers.
• Pricing power and ability to levy fuel surcharges enable a carrier to pass on high costs to maintain pro?t.
Fleet
Key attributes assessed to determine the strength of an operators ?eet include the following:
• Suitability of planes to service the route network in terms of range and cost of operations.
• Average Age of Fleet: Younger planes tend to be more fuel ef?cient and require lower maintenance.
• Fleet Mix: Deploying planes from a large number of different manufacturers and a diverse mix of
models increases training costs, investment in parts and overall operating and maintenance costs.
• Fleet Ownership (Owned or Leased): Some portion of leases in the ?eet mix is acceptable and expected,
but leases can be problematic when they are short term or in?exible.
Route Network
A strong route network will provide the operator with a solid underlying base of pro?tability and future
growth potential. In assessing this factor, DBRS views the following as key attributes:
• Access to and adequate coverage of all key cities and regions.
• Routes that have high growth potential and above-average yield (e.g., with a higher proportion of
business travel).
• Frequent ?ights in favourable time slots.
• Adequate landing slots in key airports to service existing traf?c and for growth.
Customer Service/Reputation
Strength in customer service and reputation can be advantageous in attracting customers and charging
higher prices. In this respect, the following factors are assessed:
• Brand recognition.
• Reputation on quality of service.
• Customer loyalty.
• Availability of frequent-?yer or loyalty programs.
ADDITIONAL FACTORS
Fuel Hedging
• Given the energy intensiveness of the industry, hedging for fuel pricing is positive in that it reduces
earnings volatility.
• Financial capacity to support ?nancial derivatives gives a carrier ?exibility to mitigate currency and
fuel-cost risks.
• For meaningful credit, companies would be expected to hedge major portions within a year and some
beyond.
Regulation
• While regulation is heavy for all participants, some companies have better processes and strength in
dealing with safety issues, maintenance policies and hours of operation.
Currency Sensitivity
• Some companies are sensitive to currency and choices with respect to hedging can have an impact on
stability.
Rating Companies in the Airline Industry
October 2011
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COMMON BUSINESS CONSIDERATIONS
• There are two major considerations that were not included with the prior analysis but can have a mean-
ingful impact on an individual company in any industry: country risk and corporate governance (which
includes management). These areas tend to be regarded more as potential negative issues that could result
in a lower rating than otherwise would be the case, although DBRS would certainly consider exceptional
strength in corporate governance as a rating attribute.
• In most cases, our focus on the two areas is to ensure that the company in question does not have any
meaningful challenges that are not readily identi?able when reviewing the other business risk consider-
ations and ?nancial metrics outlined in this methodology.
Country Risk
• Governments often intervene in their economies and occasionally make substantial changes that can
signi?cantly affect a company’s ability to meet its ?nancial obligations; therefore, considerations include
the company’s main location or country of operation, the extent of government intervention and support
and the degree of economic and political stability.
• As such, the sovereign rating itself may in some cases become a limiting factor in an entity’s rating, par-
ticularly when the sovereign has a lower rating and the entity does not have meaningful diversi?cation
outside its domestic economy.
Corporate Governance
• Effective corporate governance requires a healthy tension between management, the board of directors
and the public. There is no single approach that will be optimal for all companies.
• A good board will have a profound impact on a company, particularly when there are signi?cant
changes, challenges or major decisions facing the company. DBRS will typically assess factors such as
the appropriateness of board composition and structure, opportunities for management self-interest,
the extent of ?nancial and non-?nancial disclosure and the strength or weakness of control functions.
For more detail on this subject, please refer to the DBRS criteria Evaluating Corporate Governance.
• With respect to the pivotal area of management, an objective pro?le can be obtained by assessing the
following: the appropriateness of core strategies; the rigour of key policies, processes and practices; man-
agement’s reaction to problem situations; the integrity of company business and regulatory dealings; the
entity’s appetite for growth, either organically by adding new segments or through acquisition; its ability
to smoothly integrate acquisitions without business disruption; and its track record in achieving ?nancial
results. Retention strategies and succession planning for senior roles can also be considerations.
Rating Companies in the Airline Industry
October 2011
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Company-Speci?c Financial Risk Factors
KEY METRICS
• Recognizing that any analysis of ?nancial metrics may be prone to misplaced precision, we have limited
our key metrics to a small universe of critical ratios. For each of these ratios, DBRS provides a range
within which the issuer’s ?nancial strength would be considered as supportive for the same level of
business risk as the airline industry. For example, a company where the outlook for both business risk
and ?nancial risk metrics falls within the BBB category would, all else being equal, be expected to have
an issuer rating in the BBB range.
• To be clear, the ratings in the matrix below should not be understood as the ?nal rating for an entity
with matching metrics. This would only be the case to the extent that the business risk of the company
and a wide range of other ?nancial metrics were also supportive. The ?nal rating is a blend of both the
business risk and ?nancial risk considerations in their entirety.
Airline Industry Financial Metrics
Key Ratio BBB BB B
Percentage debt in the capital structure < 45% 45% to 60% > 60%
EBIT coverage > 3.0x 1.5x to 3.0x < 1.5x
Cash ?ow-to-debt > 20% 10% to 20% < 10%
EBITDA-to-interest > 4.0x 2.0x to 4.0x < 2.0x
Debt-to-EBITDA < 3.5x 3.5x to 5.0x > 5.0x
Return on equity > 7% 5% to 7% < 5%
• While the data in the above table are recognized as key factors, they should not be expected to be fully
adequate to provide a ?nal ?nancial risk rating for any company. The nature of credit analysis is such
that it must incorporate a broad range of ?nancial considerations, and this cannot be limited to a ?nite
number of metrics, regardless of how critical these may be.
• DBRS ratings are based heavily on future performance expectations, so while past metrics are impor-
tant, any ?nal rating will incorporate DBRS’s opinion on future metrics, a subjective but critical
consideration.
• It is also not uncommon for a company’s key ratios to move in and out of the ranges noted in the ratio
matrix above, particularly for cyclical industries. In the application of this matrix, however, DBRS is
typically focusing on multi-year ratio averages.
• Notwithstanding these potential limitations, the key ratios are very useful in providing a good starting
point in assessing a company’s ?nancial risk.
• It is important to note that ?nancial ratios for an entity can and will be in?uenced by both account-
ing and accounting choices. In Canada, this includes the current transition to International Financial
Reporting Standards (IFRS). DBRS notes that the differences between accounting choices will have an
impact on the ?nancial metrics of the companies that it covers. Historically in Canada, the ?nancial
risk factors included ratios based on Canadian Generally Accepted Accounting Principles (GAAP) and
U.S. GAAP, for the most part. In those cases when a company’s ?nancial statements are based on other
accounting standards, including IFRS, the ratios and ranges may need to be rede?ned.
• Recognizing that the metrics in the table above do not represent the entire universe of considerations
that DBRS examines when evaluating the ?nancial risk pro?le of a company, the following provides a
general overview that encompasses a broader range of metrics and considerations that could be mean-
ingful in some cases.
Rating Companies in the Airline Industry
October 2011
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Overall Considerations in Evaluating a Company’s
Financial Risk Pro?le
In addition to the information already provided with respect to key ?nancial metrics, the following ?nan-
cial considerations and ratios are typically part of the analysis for the airline industry. As it is not possible
to completely separate business and ?nancial risks, note that many of the following ratios will relate to
both areas.
EARNINGS
• DBRS earnings analysis focuses on core earnings or earnings before non-recurring items and in doing so
considers issues such as the sources, mix and quality of revenue; the volatility or stability of revenue; the
underlying cost base (e.g., the company is a low-cost producer); optimal product pricing; and potential
growth opportunities. Accordingly, earnings as presented in the ?nancial statements are often adjusted
for non-recurring items or items not considered part of ongoing operations.
• DBRS generally reviews company budgets and forecasts for future periods. Segmented breakdowns by
division are also typically part of DBRS analysis. Notwithstanding the focus on core earnings, note that
actual net earnings is also a consideration in our analysis given the direct impact that this has on the
capital structure.
Typical Earnings Ratios
• EBITDA interest coverage.
• EBIT interest coverage.
• EBITDA margin.
• EBIT margin.
• Net margin.
• Return on equity.
• Return on capital.
CASH FLOW AND COVERAGE
• DBRS cash ?ow analysis focuses on the core ability of the company to generate cash ?ow to service
current debt obligations and other cash requirements as well as on the future direction of cash ?ow.
From a credit analysis perspective, insuf?cient cash sources can create ?nancial ?exibility problems,
even though net income metrics may be favourable.
• DBRS evaluates the sustainability and quality of a company’s core cash ?ow by focusing on cash ?ow
from operations and free cash ?ow before and after working capital changes. Using core or normalized
earnings as a base, DBRS adjusts cash ?ow from operations for as many non-recurring items as relevant.
As with earnings, the impact that non-core factors have on cash ?ow may also be an important reality.
• In terms of outlook, DBRS focuses on the projected direction of free cash ?ow, the liquidity and coverage
ratios and the company’s ability to internally versus externally fund debt reduction, future capital expen-
ditures and dividend and/or stock repurchase programs, as applicable.
Typical Cash Flow Ratios
• Cash ?ow-to-debt.
• Adjusted cash ?ow-to-adjusted debt (DBRS-adjusted ratios for operating leases, which are capitalized
and included as debt).
• Cash ?ow-to-net debt.
• Adjusted cash ?ow-to-adjusted net debt (DBRS-adjusted ratios for operating leases, which are capital-
ized and included as debt).
Rating Companies in the Airline Industry
October 2011
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BALANCE-SHEET AND FINANCIAL FLEXIBILITY CONSIDERATIONS
• As part of determining the overall ?nancial risk pro?le, DBRS evaluates various other factors to
measure the strength and quality of the company’s assets and its ?nancial ?exibility. From a balance-
sheet perspective, DBRS focuses on the quality and composition of assets, including goodwill and other
intangibles; off-balance-sheet risk; and capital considerations such as the quality of capital, appropriate-
ness of leverage to asset quality and the ability to raise new capital.
• DBRS also reviews the company’s strategies for growth, including capital expenditures and plans for main-
tenance or expansion, and the expected source of funding for these requirements, including bank lines and
related covenants. Where the numbers are considered signi?cant and the adjustments would meaningfully
affect the credit analysis, DBRS adjusts certain ratios for items such as operating leases, derivatives, secu-
ritizations, hybrid issues, off-balance-sheet liabilities and various other accounting issues.
Typical Balance-Sheet Ratios
• Current ratio.
• Debt-to-EBITDA.
• Net debt-to-EBITDA.
• Adjusted debt-to-EBITDA (DBRS-adjusted ratios for operating leases, which are capitalized and
included as debt).
• Debt-to-capital.
• Net debt-to-capital.
• Adjusted debt-to-capital (DBRS-adjusted ratios for operating leases, which are capitalized and included
as debt).
Stage 3: Rating the Security
With respect to Stage 3, the following comments describe how the issuer rating is used to determine
ratings on individual securities:
• DBRS uses a hierarchy in rating long-term debt that affects issuers that have classes of debt that do not
rank equally. In most cases, lower-ranking classes would receive a lower DBRS rating. For more detail
on this subject, please refer to DBRS rating policy entitled “Underlying Principles.”
• In some cases, issued debt is secured by collateral. This is more typical in the non-investment-grade spectrum.
For more detail on this subject, please refer to DBRS Rating Methodology for Leveraged Finance.
• The existence of holding companies can have a meaningful impact on individual security ratings. For more
detail on this subject, please refer to the criteria Rating Parent/Holding Companies and Their Subsidiaries.
Rating Companies in the Airline Industry
October 2011
16
Appendix
INDUSTRY BUSINESS RISK RATINGS
• DBRS uses the concept of business risk ratings (BRRs) as a tool in assessing the business strength of
both industries and individual companies within many methodologies across the corporate ?nance area.
(DBRS does not typically use this approach for most ?nancial, government and public ?nance sectors,
where the industry is more challenging to de?ne and this approach is not as useful.)
• The BRR is assessed independently of ?nancial risk, although in some cases there are subtle but impor-
tant links. As an example, the very low business risk pro?le of many regulated utilities has historically
allowed this sector to operate with debt levels that would not be acceptable for most other industry
sectors. Given this reality, it is dif?cult to consider the utility industry’s BRR without acknowledging
to some degree that the industry operates with sizable debt levels. This type of relationship exists with
many industries, although typically to a much lesser degree.
• When a BRR is applied to an industry, there is an acknowledgment that this is a general assessment
and there may in fact be a wide disbursement in the business strength of individual entities within the
industry. Nonetheless, this assessment is bene?cial to enabling DBRS to clearly delineate our industry
opinion and is a useful tool when comparing different industries. An industry BRR is de?ned as being
representative of those entities that the market would consider as “established,” meaning that the group
of companies being considered would have at least reasonable critical mass and track records. As such,
the BRR for an industry does not consider very small players, start-up operations or entities that have
unusual strengths or weaknesses relative to the base industry.
• DBRS methodologies note whether they apply to global industries or more speci?c countries or regions.
When analyzing individual credits, DBRS considers the degree to which regional considerations may differ
from the geographic area applicable within the industry methodology. Many entities have business units
that transcend industries and in these cases, more than one BRR would be considered, including the possible
bene?ts or challenges that may exist when all businesses are analyzed as part of a combined group.
• The BRR is a tool that provides additional clarity regarding the business risk of the industry overall, but
it should be viewed as just one aspect in the complex analysis of setting ratings and should by no means
be seen as either a ?oor or ceiling for issuers within a given industry. Although DBRS does not antici-
pate volatility in an industry’s BRR, changes are possible over time if there are meaningful structural
developments in the industry. When such a change does occur, DBRS will make this clear and note any
impact on related individual ratings within the industry as applicable.
• DBRS assesses ?ve areas to establish the overall BRR for an industry. Although there is an overlap
in some instances (to some degree, in the long term, all ?ve factors tend to relate to pro?tability and
stability), DBRS has found that considering these ?ve measures in a separate fashion is a useful way of
approaching its analysis. In all cases, DBRS uses historic performance and our experience to determine
an opinion on the future, which is the primary focus.
Industry Pro?tability and Cash Flow
• When ratios such as return on equity, return on capital and a variety of cash ?ow metrics are consid-
ered, some industries are simply more pro?table than others. While standard economics would suggest
a reversion to the mean through new competitors, this often occurs at a very slow pace over a long time
horizon and in some cases may not occur at all because of barriers to entry.
• The bene?ts from above-average pro?ts and/or cash ?ow are substantial and include internal capital
growth, easier access to external capital and an additional buffer to unexpected adversity from both
liquidity and capital perspectives.
• Some industries and their participants have challenges or strengths in areas such as research and devel-
opment (R&D), brand recognition, marketing, distribution, cost levels and a potentially wide variety of
other tangibles and intangibles that affect their ability in the area of pro?tability.
Rating Companies in the Airline Industry
October 2011
17
Industry Competitive Landscape
• The competitive landscape provides information regarding future pro?tability for the industry and
thus somewhat crosses over into the pro?tability and cash ?ow assessment, but competition is deemed
worthy of separate consideration because of its critical nature.
• Participants in industries that lack discipline, produce commodity-like products or services, have low
barriers to entry and exhibit ongoing pricing war strategies generally have dif?culty attaining high prof-
itability levels in the longer term. Certain industries bene?t from a monopoly or oligopoly situation,
which may relate to regulation.
Industry Stability
• This factor relates primarily to the degree of stability in cash ?ow and earnings, measuring the degree to
which the industry and its participants are affected by economic or industry cycles. Stability is consid-
ered critical as industries with high peaks and troughs have to deal with higher risk at the bottom of a
cycle. As such, to some degree, industries with lower but stable pro?tability are considered more highly
than industries with higher average pro?tability that is more cyclical.
• Some of the key factors in considering stability include the nature of the cost structure (?xed or variable),
diversi?cation that provides counter-cyclicality and the degree to which the industry interrelates with
the overall economy. Depending on the industry, economic factors could include in?ation or de?ation,
supply and demand, interest rates, currency swings and future demographics.
Industry Regulation
• Where applicable, regulation can provide support through stability and a barrier to entry, but it can also
cause challenges and change the risk pro?le of an industry and its participants in a negative way, includ-
ing the reality of additional costs and complications in enacting new strategies or other changes.
• As part of its analysis of regulation, DBRS also considers the likelihood of deregulation for a regulated
industry, noting the many examples where this transition has proven to be a major challenge in the past.
Other Inherent Industry Considerations
• Each industry has its own set of unique potential risks that, even if managed well, cannot be totally
eliminated. Speci?c risks, the ability to manage them and the range of potential outcomes vary industry
by industry. Two of the most common risks are changing technology and operational risks.
• Some of the other more common risks are in the areas of legal, product tampering, weather, natural
disasters, labour relations, currency, energy prices, emerging markets and pensions.
Rating Companies in the Airline Industry
October 2011
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INDUSTRY BUSINESS RISK RATING DEFINITIONS
DBRS speci?es the BRR for an industry in terms of our Long-Term Obligations rating scale. When dis-
cussing industry BRRs for an industry, DBRS typically provides either one speci?c rating or a limited
range (such as BBB (high)/BBB). Using a range recognizes the fact that, by their nature, industry BRRs are
less precise than a speci?c corporate or security rating as they represent an overall industry. In addition
to relating to the industry level, these de?nitions also apply to the business risk of individual companies,
which will fall more often in the very high and low categories (AA/AAA and B) than would be the case
for an entire industry.
Industry Business Risk Ratings (BRRs)
Rating Business Strength Comment
AA/AAA Exceptional An industry BRR of AA/AAA is considered unusually strong, with no meaningful
weakness in any individual area. It may include pure monopolies that are deemed
essential (the primary case being regulated utilities, where the risk of deregulation
is believed to be very low). Common attributes include product differentiation, high
barriers to entry and meaningful cost advantages over other industries or entities.
These and other strengths provide exceptional stability and high pro?tability. It
would be quite rare for an industry to have a BRR in this category.
A Superior Industry BRRs at the “A” level are considered well above average in terms of
stability and pro?tability and typically have some barriers to entry related to capital,
technology or scale. Industries that have, by their nature, inherent challenges in
terms of cyclicality, a high degree of competition and technology risks would be
unlikely to attain this rating category.
BBB Adequate Industry BRRs at the BBB level include many cyclical industries where other
positive considerations are somewhat offset by challenges related to areas such
as commodity products, labour issues, low barriers to entry, high ?xed costs and
exposure to energy costs. This rating category is considered average and many
industries fall within it, with key considerations such as overall pro?tability and
stability typically considered as neither above or below average.
BB Weak An industry at the BB level has some meaningful challenges. In addition to high
cyclicality, challenges could include the existence of high technology or other risks.
Long-standing industries that may have lost their key strengths through factors
such as new competition, obsolescence or the inability to meet changing purchaser
demands may ?t here. The culmination of such factors results in an industry that
does not generally score well in terms of stability and pro?tability. For an entire
industry, this is typically the lowest BRR level.
B Poor While not common, there are cases where an industry can have a BRR of B. Such
industries would typically be characterized by below-average strength in all or
virtually all major areas.
Rating Companies in the Airline Industry
October 2011
19
INTERRELATIONSHIP BETWEEN FINANCIAL AND BUSINESS RISK
Having in mind the prior discussion on the typical importance that DBRS places on certain ?nancial
metrics and business strengths for the airline industry, we provide some guiding principles pertaining to
the application of DBRS methodologies, the ?rst one being that, in most cases, an entity’s business risk
will carry more weight in the ?nal rating than its ?nancial risk.
Based on this underlying concept, we provide the additional guidance for individual companies with
varying business risks:
• For an Entity with a Business Risk of AA (Exceptional): A company with a business risk of AA will almost
always be able to obtain an investment-grade issuer rating. When ?nancial metrics are in the BBB range,
an entity with a business risk of AA would typically be able to attain an “A”-range issuer rating.
• For an Entity with a Business Risk of “A” (Superior): Unless ?nancial strength fails to exceed the B
range, superior business strength will typically allow the ?nal issuer rating to be investment grade. Very
conservative ?nancial risk may in some cases allow the ?nal issuer rating to be within the AA range, but
this should not be considered the norm.
• For an Entity with a Business Risk of BBB (Adequate): At this average level of business risk, the level of
?nancial risk typically has the ability to result in a ?nal issuer rating from as high as “A” to as low as B.
• For an Entity with a Business Risk of BB (Weak): At this weak level of business risk, conservative ?nan-
cial risk can, in some cases, take the ?nal issuer rating into the BBB investment-grade range.
• For an Entity with a Business Risk of B (Poor): It is not typically possible for a company with a business
risk of B to achieve a ?nal investment-grade issuer rating.
DEFINITION OF ISSUER RATING
• DBRS Corporate rating analysis begins with an evaluation of the fundamental creditworthiness of the
issuer, which is re?ected in an “issuer rating”. Issuer ratings address the overall credit strength of the
issuer. Unlike ratings on individual securities or classes of securities, issuer ratings are based on the
entity itself and do not include consideration for security or ranking. Ratings that apply to actual securi-
ties (secured or unsecured) may be higher, lower or equal to the issuer rating for a given entity.
• Given the lack of impact from security or ranking considerations, issuer ratings generally provide an opinion
of default risk for all industry sectors. As such, issuer ratings in the banking sector relate to the ?nal credit
opinion on a bank that incorporates both the intrinsic rating and support considerations, if any.
• DBRS typically assigns issuer ratings on a long-term basis using its Long Term Obligations Rating Scale;
however, on occasion, DBRS may assign a “short-term issuer rating” using its Commercial Paper and Short
Term Debt Rating Scale to re?ect the issuer’s overall creditworthiness over a short-term time horizon.
SHORT-TERM AND LONG-TERM RATINGS
• For a discussion on the relationship between short- and long-term ratings and more detail on liquidity
factors, please refer to the DBRS policy entitled “Short-Term and Long-Term Rating Relationships” and
the criteria DBRS Commercial Paper Liquidity Support Criteria for Corporate Non-Bank Issuers.
Copyright © 2011, DBRS Limited, DBRS, Inc. and DBRS Ratings Limited (collectively, DBRS). All rights reserved. The information upon which DBRS ratings and reports are based is
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