European Airlines: A Gradual Ascent

Due to demand and better oil prices, S&P says the major airlines are coming back from the disruption caused by the August terrorist plots

European Airlines: A Gradual Ascent

Due to demand and better oil prices, S&P says the major airlines are coming back from the disruption caused by the August terrorist plots

European airlines should continue to benefit from rising passenger numbers, generally stable or rising yields, and a moderation in crude-oil prices in recent months to record strong improvement in operating profits in 2006. Credit quality in the sector should continue to gradually strengthen but is unlikely to improve materially given underlying cost pressures.

Disruption at London Heathrow airport related to the failed terrorist attack in August, 2006, primarily affected British Airways, which incurred greater losses than originally expected of about £100 million. Some weakening in the group's forward bookings has also been evident, as more stringent security measures have softened the strong recovery shown in premium and business traffic.

However, Standard & Poor's does not consider that delays and disruptions during August have translated into widespread traffic losses and believes that easing fuel prices should allow British Airways to offset additional costs related to the summer disruption.

Underlying market conditions are good, supported by rising demand for air travel, and impressive revenue increases are expected in the passenger operations of the main network carriers. Strong premium-traffic growth has raised network airline yields in the first nine months of 2006.

Competition From U.S.

A market recovery has firmly materialized in Europe, supported by strong growth in passenger traffic over the past two years, despite the imposition of fuel surcharges. Passenger traffic growth for European network airlines reached peak levels of about 7% in 2005. Increases are expected to remain attractive but have weakened slightly in the nine months to June, 2006. Further moderation, expected through the remainder of the year, will reduce the annual passenger growth rate to about 5%, which is still a respectable level of performance.

All carriers remain subject to competitive price pressure, particularly from low-cost carriers in short-haul markets, which is expected to intensify over the winter period. Transatlantic long-haul markets are, nonetheless, growing increasingly competitive as a number of U.S. carriers, such as Delta Air Lines (DALRQ) and Continental Airlines (CAL), step up international programs by flying directly to a number of European cities.

Despite recent improvements, the global airline industry is vulnerable. It remains cyclical and, due to geopolitical and security concerns, it can also be subject, at times, to steadily rising costs and volatile demand patterns. The industry is characterized by intense competition, overcapacity, and high fixed costs, including the need to invest substantially in aircraft. Event risk is substantial, unpredictable, and can have a material adverse effect on company credit profiles.

Here is Standard & Poor's current outlook for rated European carriers:

British Airways (BAB)

Credit rating/outlook: BB+/Positive

Results for the second quarter ended Sept. 30, 2006, were significantly affected by the August terror alerts at London Heathrow and subsequent flight cancelations. Incurred additional costs are estimated to have had a financial impact of £100 million, resulting in an 8% decline in operating profit in the quarter.

BA and the trustees of its main pension scheme have agreed in principle to a 10-year funding plan to tackle its £2.1 billion deficit. Consultations with trade unions, aimed at gaining acceptance from staff for future benefit changes, are ongoing and will have to be concluded to finalize the future funding strategy. A reduction in pension-adjusted leverage, and evidence of recovering premium traffic, will provide strong momentum to regain investment-grade status.

Deutsche Lufthansa (DLAKY)

Credit rating/outlook: BBB/Stable

The outlook was revised to stable from negative on Oct. 30, reflecting the group's improving trading prospects and progress made in turning around underperforming operations. In the seasonally strongest third quarter ended Sept. 30, 2006, operating profit improved by 80% to €394 million and the group's full-year earnings outlook was raised by 30% to €750 million.

We expect Lufthansa's financial performance to benefit from the uplift in profitability provided by its core passenger operations, improvements to the cost base across the portfolio, and profit contribution of the previously loss-making Swiss International Airlines and catering. Despite challenging industry conditions, the group should maintain a stable credit profile with funds from operations (FFO) to adjusted debt of about 30%.