Air Canada's BB Corp Cred Rtg Afmd by S&P; Off Watch.

NEW YORK--(BUSINESS WIRE)--Standard & Poor's CreditWire 9/23/98-- Standard & Poor's today affirmed its double-'B' corporate credit and senior unsecured debt ratings on Air Canada, and removed them from CreditWatch. The ratings were placed on CreditWatch with negative implications Sept. 2, 1998. The CreditWatch placement followed a strike by Air Canada's pilots that grounded the main carrier's operations. The outlook is stable.

Air Canada and the Air Canada Pilots Association on Sept. 14, 1998 reached a two-year contract agreement that provides wage increases of 4% in the first year and 5% in the second year. While the strike and its aftermath are costly, the resulting contract is broadly in line with expectations and Air Canada's ratings continue to benefit from a solid competitive position as the nation's leading air carrier and improved operating results over the past several years. The strike lasted 13 days and the airline required another three days before full scheduled service was resumed. With the strike lasting over the busy Labor Day weekend, Air Canada is expected to have directly lost over C$220 million in revenue. In addition, lost bookings and current seat discounting will decrease the company's revenue per available seat mile over the next three months. A 5% drop in Air Canada's yield -- an industry measure of unit revenues -- during the fourth quarter of 1998 (from fourth quarter 1997 results) would cost the company an estimated C$50 million. In total, the direct and indirect costs related to the strike are expected to be about C$300 million, negatively impacting what was tracking to be a record operating profit. Including the effect of the strike, Air Canada's 1998 operating margin (after depreciation and rent) is expected to drop to less than 4%, with 1998 net income relatively marginal.

Over the last three years the company's productivity per employee has remained flat, while service improvements and capacity additions contributed to a recent increase in unit costs. Although direct comparison to U.S. carriers is skewed by the relatively large amount of nonpassenger operations (including cargo) at Air Canada, the company's costs are currently slightly higher than the industry average. In addition, the Canadian airline industry, albeit improved over recent years, has comparatively lower revenue yield than the U.S. This lower yield is due to competition fostered by concentrated key markets, few airport capacity constraints, route overlaps, and multiple competitors including charter airlines. The lower revenue/higher cost dynamic makes Air Canada relatively less profitable than many of its North American peers.

The Pilot Association's agreement will result in wage increases with the company's other unions, of which three main contract agreements -- with flight attendants, ticket agents and machinists -- are scheduled to be renegotiated over the next few months. Unionized employee wages are expected to increase by approximately C$80 to C$100 million in two years time. With wages and certain other factors, including a weakened Canadian dollar, putting upward pressure on costs the company will likely curb its expansion plans, and focus on maximizing current operations. Cost initiatives -- which may include the layoff of temporary employees, the outsourcing of maintenance, working more closely with alliance partners to negotiate supplier contracts, the sale or replacement of older aircraft, and the rationalization of routes -- will partially ameliorate other cost increases.

For fiscal 1998, while Air Canada is forecast to produce a positive cash flow from operations of over C$200 million, the airline will also receive over C$600 million of new aircraft. An increase to the company's lease adjusted debt levels is therefore expected. However, the impact to the balance sheet is relatively minor over the short term, and the company still retains significant cash and operating line availability.

Air Canada's rating remains the same based on its dominant position in the Canadian market, its superior Canadian route system and its membership in the "Star Alliance", the world's largest global airline alliance. The financial performance of Air Canada remains weak for the rating category, and the cash cost of the strike and future wage agreements will slow any improvement in financial protection measures. The 1998 lease-adjusted total debt to total capital is projected to be around the 80% level, while the strike impacted, lease adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) coverage of interest is expected to fall to about 2 times (x). On a normalized basis EBITDA coverage of interest is expected to be between 2.5x to 3 x. Both measures are mediocre in the context of strong industry performance.

OUTLOOK: STABLE

Over the next three years Air Canada plans almost C$2.2 billion in aircraft acquisitions and capital expenditures; a longer them wide-body fleet renewal program will further add to acquisition costs beyond 2000. However, the company does have some flexibility in its acquisition program and is expected to manage spending in line with the rating category. The recent Canadian dollar weakness impacting the company's U.S. dollar based expenses -- including financing -- is partially offset by non-Canadian dollar revenues and is not expected to directly impact margins. Air Canada's direct exposure to Asia is minimal, as the company's main domestic competitor has the majority of Canadian route rights to the region. However, the spill over effect of the Asian economic downturn, which includes more industry capacity switching to Atlantic routes and the general softening of the global economy, will constrain Air Canada's profitability. Even so, over the next few years Air Canada is expected to maintain its market position, generate material cash from operations, and gradually improve its financial profile, Standard & Poor's said. ---CreditWire