Fitch Affirms Northwest Airlines' Rating; Outlook Remains Negative.

CHICAGO -- Fitch Ratings has affirmed the senior unsecured debt rating of Northwest Airlines, Inc. at 'B'. The Rating Outlook for Northwest remains 'Negative'.

The 'B' rating reflects Northwest's highly levered balance sheet, continuing losses in a period of prolonged industry revenue underperformance, and high jet fuel costs, as well as heavy fixed financing obligations that must be funded through improved operating cash flow generation over the next few years. In particular, Northwest faces significant scheduled debt maturities and large cash contributions to its defined benefit pension plans (especially after 2005).

Although Northwest's credit profile remains weak, Fitch's affirmation of the rating during a period of persistently poor legacy carrier operating performance reflects growing confidence that a new round of collective bargaining agreements with unionized employee groups can be negotiated over the next several months. This would provide Northwest with an opportunity to drive its cost per available seat mile (CASM) below levels now being reported by legacy carrier competitors American and Continental. Recently reported movement in bargaining between management and the Air Line Pilots Association (ALPA) suggests that a competitive pilot contract could be ratified by this fall. Negotiations with ground employees, represented by the International Association of Machinists and Aerospace Workers (IAM) are also continuing. The ALPA contract has been amendable since the summer of 2003 and the IAM agreement has been open since late 2002.

Northwest's credit position is supported by better revenue fundamentals than those seen by the other network carriers. Passenger unit revenue (revenue per available seat mile) increased by 12% year-over-year in the first quarter, outpacing the rest of the industry by a comfortable margin. The unit revenue improvement derived not only from strong load factors (up 3 points systemwide versus the prior-year period) but also from better pricing. Passenger yields improved by 7% in the first quarter, in part reflecting Northwest's discipline in adding back scheduled capacity more slowly than the rest of the industry. The carrier's unit revenue premium to the rest of the industry widened year over year, reflecting more limited exposure to rapidly growing low-cost carriers in the Heartland markets where Northwest maintains a strong unit revenue position. Strengthening demand patterns in trans-Pacific, trans-Atlantic, and cargo markets have also supported Northwest's relatively strong unit revenue performance.

Future unit labor cost reductions tied to lower pay rates and improved productivity, coupled with Northwest's more competitive nonlabor cost position and revenue per CASM premium to the industry, should put the carrier in a position to return to profitability, even after factoring in persistently high jet fuel costs and weak industry pricing. Capital expenditures should peak at $1.7 billion in 2004, driven by the delivery of 10 Airbus A330 widebody aircraft and 38 Bombardier regional jets this year. Firm financing commitments are already in place for these and other scheduled aircraft deliveries. Following the completion of the mainline fleet modernization program, capital commitments should be reduced significantly in 2005 and 2006. Fitch estimates that 2005 capital expenditures will total approximately $800 million. Fitch therefore believes that new labor deals will make a return to positive free cash flow possibly as early as 2005. This would put Northwest in a position to fund heavy debt and capital lease maturities without undermining its relatively strong liquidity position.

The retention of the Negative Outlook reflects the risk that still-higher fuel costs and/or external demand shocks could further undermine Northwest's operating performance in 2004 and 2005. Should talks with the unions stall or if the fuel price situation worsens materially by year-end, a change in the rating could result.

Liquidity remains a source of relative credit strength given the airline industry's ongoing exposure to external demand and fuel price shocks. A March 31 unrestricted cash balance of $2.9 billion allowed Northwest to retain the strongest ratio of unrestricted cash to revenues among the U.S. network carriers. The strong cash balance was supported by asset sales completed in 2003 (including stakes in computer reservations company Worldspan and online travel companies Orbitz and Hotwire). An IPO of Northwest's Pinnacle regional airline unit provided liquidity for Northwest's defined benefit pension plans, which were funded in part during 2003 through a contribution of Pinnacle stock.

A solid liquidity buffer will remain critical in light of the cash flow pressures that Northwest faces in 2005 and 2006. Excluding Northwest's $975 million secured credit facility, which matures in September 2005, the airline must fund approximately $515 million in maturing debt and capital leases next year. Maturities for 2006 total $802 million. The secured credit facility, collateralized by Northwest's Pacific route authorities and a number of older generation aircraft and engines, may be refinanced. This would reduce liquidity concerns significantly in 2005, particularly if new labor deals are in place.

Northwest's defined benefit pension plans remain substantially underfunded. The gap between pension plan assets and the projected benefit obligation (PBO) stood at $3.75 billion as of Dec. 31, 2003. This liability must ultimately be funded through required cash payments, but near-term pension contributions for 2004 and 2005 have been largely deferred as a result of changes enacted by Congress through the Pension Funding Equity Act, passed in April. An increase in the applicable discount rate used to calculate pension liabilities, together with an allowed deferral of so-called deficit reduction contribution (DRC) payments, has made it possible for Northwest and the other U.S. legacy carriers to scale back required funding levels this year and next. Management has noted that cash funding in 2004 will total approximately $255 million, well below the $450 million pension expense number reported on the income statement. Fitch expects 2005 required cash contributions to be in the range of $400 million to $500 million. Substantially higher cash funding levels could drain operating cash flow in 2006 and beyond if plan asset returns fall short of assumed levels or if an extension of discount rate relief is not passed by Congress after the current two-year legislative relief period ends in early 2006.

Besides the risk of slow progress on the labor front, Northwest and the entire U.S. industry face a high level of fuel price risk this year that could undermine operating results further, offsetting some of the expected revenue improvement. Through April, Northwest had 28% of expected second quarter fuel exposure hedged via option collars ($34 to $39 crude oil prices). The company has stated that its full-year average fuel price forecast lies between $0.95 and $1.05 per gallon of jet fuel. A $0.10 change in the price of jet fuel impacts Northwest's annual mainline fuel expense by approximately $170 million.