OREANDA-NEWS. Fitch Ratings has downgraded Public Joint Stock Company Aeroflot - Russian Airlines' (Aeroflot) Long-term foreign currency Issuer Default Rating (IDR) to 'B+' from 'BB-' and placed it on Rating Watch Negative (RWN). A full list of rating actions is available at the end of this commentary.

Aeroflot's rating downgrade reflects our expectations of weakening credit metrics over 2015-2017, principally due to rouble devaluation and lower yields. The RWN reflects the expected negative impact of Aeroflot's announced acquisition of a majority stake in OJSC Transaero Airlines on its already stretched financial profile, at least in the short-term. In resolving the RWN Fitch will assess Aeroflot's ability to restructure Transaero's debt and operations.

Aeroflot's business profile is supported by the company's fairly diversified route network, favourable hub position, competitive cost structure and its strong market position on the domestic market. The 'B+' rating incorporates a single-notch uplift for state support.

KEY RATING DRIVERS
FX Drives Financials Deterioration
Aeroflot's credit metrics significantly deteriorated in 2014 and we expect its financial profile to remain weak over 2015-2017, breaching Fitch's negative rating guidelines, despite a forecast gradual improvement over 2015-2017. Funds from operations (FFO) adjusted gross leverage rose to 7.5x in 2014 from 5x in 2013 and we expect it to slowly decline to below 7x by 2017 (excluding the impact of the planned acquisition). FFO fixed charge cover dropped to 1.8x in 2014 from 2.2x in 2013 and we forecast that it will remain below 1.5x until 2017.

The worsening credit metrics are driven by the sharp rouble devaluation contributing to a rise in debt levels, and pressure on yields due to economic decline and currency devaluation. We also expect additional financing to be incurred in 2015 to cover the company's cash obligations under its fuel and FX hedging contracts. Our forecast small improvement in Aeroflot's FFO gross leverage over 2015-2017 reflects capacity expansion, deployment of new, more cost-efficient aircraft, more favourable oil prices and expected slow recovery in yields from 2016.

Transaero's Acquisition Negative in Short-term
The RWN primarily reflects Aeroflot's planned acquisition of 75% + one share in financially troubled Transaero. We expect this transaction to have an immediate negative impact on Aeroflot's financial profile because Transaero is highly leveraged and has lower yields than Aeroflot. Aeroflot expects to acquire the majority stake in Transaero for a symbolic RUB1. However, we estimate that the consolidation of Transaero's debt, which stood at RUB107bn at end-2014, will add about 0.75x-1x to Aeroflot's FFO adjusted gross leverage.

The RWN resolution is dependent on Aeroflot's treatment of Transaero's debt - for example whether the debt will be restructured as part of the acquisition or fully consolidated by Aeroflot - and plans for operational restructuring of Transaero. The latter may involve cancelling overlapping and/or loss-making routes, Transaero continuing to operate as a standalone subsidiary within Aeroflot Group or being fully integrated into Aeroflot's operations, including being absorbed into the Aeroflot brand. While Aeroflot has some track record of successful integration of acquired assets, the execution risk in this transaction is high due to the relatively large size of Transaero and its high indebtedness. The acquisition of Transaero will increase Aeroflot's market share to 43% based on 2014 data for passenger traffic but further benefits and synergies are uncertain.

Yields and Margins under Pressure
We forecast Aeroflot will continue to see a decline in yields in 2015 by 26% yoy in dollar terms, which reflects the full-year effect of the currency devaluation and Russia's economic downturn, making passengers more price-sensitive. This follows a 15% drop in yields in 2014. In 2014 yields measured in dollar terms fell on both domestic and international destinations with the largest decline observed on European and Middle Eastern and African destinations.

Yields are likely to continue to fall sharply in 2015 on the international destinations but we expect some rebound on the domestic and CIS destinations in rouble terms. We expect a gradual increase from 2016 with the yields in dollar terms returning to 2014 levels by 2019.

High FX Exposure
Almost all of Aeroflot's debt (93% at end-1H15) is denominated in USD, as a large portion of its debt (82% at end-1H15) represents finance leases for aircraft purchases. In contrast only 33.6% of its revenue in 2014 was earned in USD or EUR (based on Aeroflot Airline's statistics). While an additional 30.2% of revenue was linked to EUR, ticket prices were set in RUB and their increase remained significantly short of mitigating the impact of the rouble devaluation. In addition, over 50% of operating costs are denominated in USD or EUR, further contributing to the currency mismatch and, consequently, weaker financials.

Domestic Passengers Drive Traffic
We expect Aeroflot's revenue-passenger-kilometres (RPK) in 2015 to maintain the rate of growth attained in 2014, driven primarily by expected continued strong domestic passenger traffic growth. While we expect a moderate increase in international scheduled flights, this will be offset by a forecast further drop in passenger traffic on charter flights and the CIS destinations. We expect the increase in RPK to accelerate from 2016 and project a 8.8% CAGR over 2014-2019, which is well below the 2010-2014 growth rates, reflecting the planned capacity expansion and sluggish economic growth.

Diversified Network and Well-Developed Hub
Aeroflot's business profile is commensurate with the 'BB' rating category due to its fairly diversified route network, high frequency of international flights, favourable hub position and its position as Russia's largest airline and flagship carrier and a medium-sized airline among European peers. The implementation of the multi-brand strategy within Aeroflot Group in co-operation with regional subsidiaries provides the group with greater operational flexibility without diluting Aeroflot's brand and enables the group to target multiple customer and geographic segments, adapt more quickly to customer demands and utilise feeder traffic from regional airline subsidiaries.

Rating Uplift for State Support
Aeroflot's rating of 'B+' continues to incorporate a single-notch uplift to its standalone 'B' rating for state support. Fitch considers the strategic, operational and, to a lesser extent, legal ties between Aeroflot and its parent, the Russian Federation (51.2% direct ownership and 7.8% indirect ownership) as fairly strong under the agency's parent and subsidiary rating linkage methodology.

There are no formal legal ties, such as guarantees or cross default provisions, but Aeroflot remains on the list of Russia's strategic enterprises. Its operational and financial strategies are overseen by the government and it is viewed as a means of promoting and developing Russia's aviation market. To date, there has been little evidence of tangible financial support, except for royalties, which include bilateral pool agreements with other airlines as well as intergovernmental agreements.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Russian GDP decline of 3.5% in 2015 and growth of 1% in 2016
- Capex in line with the company's forecast
- RPK growth at a 8.8% CAGR over 2014-2019, reflecting capacity expansion
- Drop of yields in dollar terms in 2015 by 26% yoy and a slow recovery from 2016
- Estimated cash payments under the FX and fuel hedging contacts of RUB33.1bn in 2015 and RUB2.9bn in 2016, funded by additional borrowings

RATING SENSITIVITIES
We will review the ratings once we have more details on the Transaero acquisition.
Negative: Future developments that could lead to negative rating action include:
-Further material deterioration of the credit metrics (eg FFO adjusted gross leverage well above 6.0x and FFO fixed charge cover below 1.25x on a sustained basis) due to Transaero acquisition, further rouble devaluation, protracted downturn in the Russian economy, drop in yields or overly ambitious fleet expansion.
-Weakening of state support.

Positive: Future developments that could lead to positive rating action include:
-Evidence of stronger state support.
-Improvement of the financial profile (eg FFO adjusted gross leverage below 5.0x and FFO fixed charge cover above 1.5x on a sustained basis) due to acquisition of Transaero without its debt, yield recovery, successful integration of the acquired assets, moderation of investments in the fleet and/or drop in fuel prices.

LIQUIDITY AND DEBT STRUCTURE
Adequate Liquidity
We view Aeroflot's liquidity as adequate. Its cash of RUB47.9bn at end-1H15 and available credit lines of RUB23.1bn were sufficient to cover short-term debt obligations of RUB43bn at end-H115. The company's debt repayment schedule is fairly well balanced. Some RUB5bn domestic bonds fall due in 2016.

We expect Aeroflot to generate negative free cash flow (FCF) over 2015-2016 due to its high capex (including finance leases). About a third of Aeroflot's cash position at end-2014 was held in USD and EUR and most of the cash was held at Sberbank (BBB-/Negative) and Bank BFA.

Weak Transaero's Liquidity
Transaero's short-term debt stood at RUB40.4bn against cash of RUB0.5bn at end-2014. If Transaero's debt is not restructured and fully consolidated by Aeroflot, it will put significant pressure on the latter's liquidity position.

Hedging Losses
To mitigate its exposure to volatile fuel prices and FX risk, Aeroflot undertook several fuel and FX hedging contracts with Russian banks, primarily VTB and Sberbank. As a result of oil price drop and currency devaluation, the company has to make cash payments under its hedging contracts estimated at RUB33.1bn for 2015 and RUB2.9bn for 2016.

Aeroflot hedged 55% of group's fuel consumption for 2015 and 0% for 2016. As part of the restructuring of the hedging contracts agreed with the banks, the company procured credit lines from the banks sufficient to cover its cash obligations under the hedging agreements over 2015-2016. This further exacerbates Aeroflot's already stretched credit metrics, but improves liquidity.

FULL LIST OF RATING ACTIONS
Long-term foreign currency IDR: downgraded to 'B+' from 'BB-'; placed on RWN
Long-term local currency IDR: downgraded to 'B+' from 'BB-'; placed on RWN
National Long-term rating; downgraded to 'A-(rus)' from 'A+(rus)'; placed on RWN
Short-term foreign currency IDR: affirmed at 'B'
Short-term local currency IDR: affirmed at 'B'
National Short-term rating: downgraded to 'F2(rus)' from 'F1(rus)'; placed on RWN
Foreign and local currency senior unsecured rating: downgraded to 'B+/RR4' from 'BB-'; placed on RWN
National senior unsecured rating: downgraded to 'A-(rus)' from 'A+(rus)'; placed on RWN