Rating rationale

Scope Ratings today assigns Deutsche Lufthansa AG a Corporate Issuer Credit Rating (CICR) of BBB- and an S-2 short-term rating. The Outlook on the CICR is Stable. The senior unsecured debt issued by Lufthansa has been rated at BBB-. These reflect Scope’s view of i) Lufthansa’s global network coverage and diversified route network, ii) membership in global airline alliances, iii) diversification in various aviation-related services, and iv) Scope’s expectation for a continuation of free cash flow generation, including its view of management’s commitment to maintain a cautious financial policy.

The business risk profile is supported by Lufthansa’s global network coverage and diversified route network, its membership in global airline alliances, high share of business travellers, and benefits from diversification in various aviation-related services. The business risk profile is restrained by the marked cyclicality of the airline industry, including risks of material fluctuations of operating profits that may result from swings of demand for either passenger or cargo traffic. Lufthansa’s profitability is currently below its peers’ and is supported by low fuel costs, a benefit that will be short-lived in Scope’s view, given the intense market competition and likelihood that lower fuel prices will eventually be passed to customers through lower fares. Lufthansa has agreed collective-bargaining agreements with ground staff and flight attendants, which should help reduce unit costs in the future. The fleet-renewal programme may lower operating expenses, although Scope is concerned that some cost benefits may not be retained but may instead be ’competed away’. The recently announced Air Berlin transaction is neutral for the rating.

The outlook for global air traffic remains positive. Over the past two decades, global air traffic has grown by about 4-5% annually. The global expansion of air traffic is mainly driven by the lower cost of air travel and rising living standards in emerging markets such as India, China, Indonesia and Brazil. Scope believes the global demand for air traffic will continue to grow faster than global GDP growth. For 2016, Scope expects the global growth in air traffic to be about 7%, supported by lower oil prices that also result in lower air fares. This is in line with the forecast issued by the International Air Transport Association. The airline industry in Europe remains fairly fragmented. As long as consolidation among the players does not occur, Scope does not see great chances for a structural increase of profits in the industry.

Scope views the financial risk profile of Lufthansa as slightly more favourable than the business risk profile. Scope’s forecasts for 2016 point to a Scope-adjusted debt/EBITDA of 2.6x and FFO/Scope-adjusted debt (SaD) of 31%, followed by gradual improvements of both ratios, given its forecast that free operating cash flows are expected to exceed projected dividend payments. This forecast considers effects from the collective-bargaining agreement concluded with the flight attendants’ union, but excludes those from the agreement likely to be reached soon with the pilots’ union.

Lufthansa’s liquidity is solid. Financial obligations in the medium term are covered by cash, committed credit lines and the expected excess of free operating cash flows over dividend payments. Further financial flexibility also results from the high share of unencumbered aircraft in the fleet. In Scope’s view, Lufthansa pursues a cautious financial policy and is prepared to balance debtholder interests with shareholder interests, as was the case in 2009 and 2011 when dividend payments were cut due to weaker earnings.

Key rating drivers

The rating is driven positively by the following:

• Scale of operations, including diversified worldwide route network and geographical reach, with strong positions at hubs in Frankfurt, Munich, Zurich, and Vienna
• Globally diversified operations with various well-known brands
• Diversified operations (MRO/Catering) with strong market positions mitigating cyclicality risks in passenger and cargo traffic
• Multi-hub strategy giving customers a broad range of travel options; leading position in home market of Germany; competitive advantage in premium market for long-haul traffic
• Alliances with various international airlines, notably Star Alliance, supporting an increased flight frequency

However, the following aspects limit the rating:

• An exposure to cyclical changes of discretionary travel (business and leisure) and event risks, such as natural disasters, contagious diseases and strikes, that negatively affect passenger volumes
• Intensely competitive environment, including yield pressures from low-cost airlines and other network airlines
• Risk of material fluctuations of operating profits in passenger airline division due to the risk of volatile passenger and cargo traffic, and high operating leverage

Outlook

The Outlook is Stable and incorporates Scope’s expectation that Lufthansa should achieve debt-protection measures, such as SaD/EBITDA, of 2.0x-2.5x in the medium term. The key premise behind Scope’s expectation is that cash generated from ongoing operations is likely to exceed projected dividend payments.

Scope would consider a negative rating action if SaD/EBITDA or FFO/SaD were to respectively deteriorate to about 3.0x and 25%. Lufthansa has some headroom to accommodate minor deteriorations in trading conditions, including lower operating earnings (EBITDA). Scope estimates, all other things being equal, that negative rating pressure could result if the reported EBITDA margin were to deteriorate to about 8.5% (versus 10.2% reported for 2015 and 10% expected for 2016F, adjusting for the expected one-time gain resulting from the agreement with the flight attendants’ union).

A higher rating could be warranted if SaD/EBITDA were to decline to sustainably under 2.0x.

The full rating report, which includes the rating rationale and analytical details, is available to download here.

Regulatory disclosures

Important information
Information pursuant to Regulation (EC) No 1060/2009 on credit rating agencies, as amended by Regulations (EU) No. 513/2011 and (EU) No. 462/2013

Responsibility
The party responsible for the dissemination of the financial analysis is Scope Ratings AG, Berlin, District Court for Berlin (Charlottenburg) HRB 161306 B, Chief Executive Officer: Torsten Hinrichs, Dr Stefan Bund, Dr Sven Janssen.
Rating prepared by Werner Stäblein, Lead Analyst. 
Rating committee responsible for approval of the rating : Guillaume Jolivet, Committee Chair.
The rating concerns an entity, which was evaluated for the first time by Scope Ratings AG.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months. A rating change is, however, not automatically ensured.

Information on interests and conflicts of interest
The rating was prepared independently by Scope Ratings but for a fee based on a mandate of the rated entity.
As at the time of the analysis, neither Scope Ratings AG nor companies affiliated with it hold any interests in the rated entity or in companies directly or indirectly affiliated to it. Likewise, neither the rated entity nor companies directly or indirectly affiliated with it hold any interests in Scope Ratings AG or any companies affiliated to it. Neither the rating agency, the rating analysts who participated in this rating, nor any other persons who participated in the provision of the rating and/or its approval hold, either directly or indirectly, any shares in the rated entity or in third parties affiliated to it. Notwithstanding this, it is permitted for the above-mentioned persons to hold interests through shares in diversified undertakings for collective investment, including managed funds such as pension funds or life insurance companies, pursuant to EU Rating Regulation (EC) No 1060/2009. Neither Scope Ratings nor companies affiliated with it are involved in the brokering or distribution of capital investment products. In principle, there is a possibility that family relationships may exist between the personnel of Scope Ratings and that of the rated entity. However, no persons for whom a conflict of interests could exist due to family relationships or other close relationships will participate in the preparation or approval of a rating.

Key sources of information for the rating
- Website of the rated entity
- Detailed information provided on request
- Data provided by external data providers
- Current performance record
- External market reports
- Audited annual financial statements
- Press reports/other public information
Scope Ratings considers the quality of the available information on the evaluated company to be satisfactory. Scope ensured as far as possible that the sources are reliable before drawing upon them, but did not verify each item of information specified in the sources independently.

Methodology
The methodology applicable for this rating (Corporate Rating Methodology) is available on www.scoperatings.com. The historical default rates of Scope Ratings can be viewed on the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s default rating, definitions of rating notations and further information on the analysis components of a rating can be found in the documents on methodologies on the rating agency’s website.

Examination of the rating by the rated entity prior to publication
Prior to publication, the rated entity was given the opportunity to examine the rating and the rating drivers, including the principal grounds on which the credit rating or rating outlook is based. The rated entity was subsequently provided with at least one full working day, to point out any factual errors, or to appeal the rating decision and deliver additional material information. Following that examination, the rating was not modified.
 
Conditions of use/exclusion of liability
© 2016 Scope Corporation AG and all its subsidiaries including Scope Ratings AG, Scope Analysis, Scope Investor Services GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope cannot, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided “as is” without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or otherwise damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party, as opinions on relative credit risk and not as a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings AG at Lennéstraße 5 D-10785 Berlin.

Rating issued by
Scope Ratings AG, Lennéstraße 5, 10785 Berlin.