(Note: This article uses a sample of the Mexican air transportation segment, represented by the four major Mexican airlines: Aeromexico, Volaris, Interjet, and VivaAerobus.)

The Pandemic Intensified Existing Industry Weaknesses

The abrupt decline in passenger traffic in 2020 as the COVID-19 pandemic unfolded has caused unprecedented financial damage to Mexico's airline industry. Given the social distancing and travel restrictions imposed domestically and abroad, demand in the Mexican air transportation market--represented by our selected sample of airlines--dropped 50.8% in 2020 to 33.2 million passengers (from 67.5 million passengers in 2019).

Chart 1

As a result, Grupo Aeromexico S.A.B. de C.V. (Aeromexico; D/--) filed for bankruptcy under U.S. Chapter 11 proceedings on June 30, 2020. While the company hasn't halted operations, it's currently restricted from incurring additional debt (other than the court approved debtor-in-possession [DIP] financing of about $1 billion) to finance operations until exiting Chapter 11, which implies a more cautious operating strategy. Despite the company's efforts to reduce fixed costs, the closing of borders and quarantine measures damaged Aeromexico's cash generation and thus limited its capacity to repay financial obligations.

Another example of the weakened industry is Interjet (not rated), which has fully suspended its operations. Even before the pandemic, the company's leverage metrics deteriorated from about 5.8x in 2015 to 13.0x in 2019. In our view, a key factor that compromised Interjet's credit profile was its acquisition of 22 SSJ-100 (Superjet) aircraft that were grounded in late 2016 due to a mechanical failure. These aircraft represented 30% of the airline's total fleet. Second, the company opted to keep rolling over sizable short-term debt maturities, and at the same time, continued to increase debt amid low liquidity to cover operating and administrative costs. Finally, Interjet currently faces claims from the Mexican government for unpaid liabilities related to airspace usage and unpaid taxes from the Tax Administration Service (SAT). In our view, these claims make it harder for the company to receive any kind of financial aid from shareholders due to the size of its liabilities.

The sharp drop in passenger traffic has hurt Volaris and VivaAerobus' (both not rated) financial performance to a great extent, but they've also seen mitigating factors. Both airlines have fleets consist of various types of A320s, which specialize in medium-range routes, including all destinations within Mexico. Volaris and VivaAerobus have absorbed much of Interjet's passenger base and have taken market share from Aeromexico. Aeromexico had focused more on expanding international connectivity rather than on domestic services, so its market was hampered more by international border closures.

As of Dec. 31, 2020, the Mexican market share composition reflects that Volaris has the highest passenger traffic, displacing Aeromexico, which now has the second highest share.

How Did Mexican Airlines Get Here?

Aggressive fleet management required high debt levels in 2015-2017.   Mexican airlines' growth strategy focused on taking advantage of the country's favorable geographic location, with easy access to a transborder market and routes that connect a wide range of destinations across the Americas through a national hub. Therefore, most Mexican airlines prioritized the purchase of mid-range aircraft (such as A-320s or B-737s) that would allow them to travel an average distance of 3,350 nautical miles--roughly equivalent to a trip between Mexico City and New York City or Lima, Peru. In our view, proof of this strategy is the reported 29.7% increase in the number of international flights by Mexican airlines in 2017 versus 2015, and the 8.2% rise in domestic flights during the same period.

As a result, total debt--including lease liabilities--increased by about 33.0% in 2015 and about 50.0% in 2016. Between these two years, Mexican airlines received about MXN54 billion in debt proceeds to meet contracted advance payments for fleet add-ons and renewals, which lifted available seats per kilometers (ASKs) offered in 2017 to 96.8 billion (32.4%) from 73.1 billion in 2015.

Chart 2

However, high debt caused Mexican airlines' average debt to EBITDA to rise to 5.0x-6.0x by the end of 2017. Airlines expected this metric to improve with passenger traffic growth in the following years; however, 2018 and 2019 turned out to be challenging years. Lower passenger traffic growth versus ASK growth, high fixed operating costs, limited ability to increase prices to maintain market share, and high cost of debt were some of the crucial factors we think impaired the airlines' financial performance.

Significant debt increases in 2018-2019 slashed Mexican airlines' profitability.  After 2017, Mexican airlines' profitability wasn't strong enough to support the level of debt they had acquired while expanding and replacing their fleets. EBITDA margins dropped to about 15% in 2019 from about 20% in 2015. Many of airlines' major operating costs have low flexibility: aircraft maintenance, salaries, airspace use, and administrative expenses. Therefore, larger fleets represent higher maintenance costs, more operating workforce, and higher airspace use. This weakened the companies' liquidity capacity to meet debt and lease financing obligations.

In addition, the exchange rate volatility between 2017 and 2019 hit airlines hard. Since 2017, dollar-denominated debt made up an average of 80% of total debt for our sample of airlines. Most of this debt related to lease liabilities. Although we believe ticket prices are somewhat linked to the U.S. dollar fluctuations, the pass-through of foreign exchange rates wasn't enough to compensate for the high levels of dollar-denominated debt and interest payments.

Chart 3

Airlines opted for a greater market share over higher ticket prices.  Similar to operating strategy of airlines in other parts of the world, we believe that fleet expansion was tied to Mexican airlines' expectation of accelerated growth in passenger traffic and their ability to raise ticket prices without losing market share. For our sample of Mexican airlines, traffic increased 24.5% to 56.1 million passengers in 2017 from 45.1 million in 2015. Passenger traffic was positively correlated to ASK growth during that period. On the other hand, airlines reported a 3.9% growth in ticket prices denominated in Mexican pesos, but a 12.9% fall when converted into U.S. dollars, meaning that prices didn't increase in dollar terms between 2015 and 2017.

Chart 4 below illustrates that the growth in revenues is positively correlated with the volatility in the average peso/dollar exchange rate. This supports our view that Mexican airlines only passed on the negative effect of peso depreciation to fares without adding any direct increase. However, this wasn't enough to offset the weakening in revenue compared to the airlines' expectations.

Chart 4

The combination of both variables--ticket prices and passenger growth--resulted in revenue growth of 29.3% in 2017 versus 2015 (without ancillaries/cargo) for our sample of Mexican airlines, which was mainly due to higher passenger volume and less so to ticket prices. In our opinion, Mexican airlines opted to sacrifice profits rather than lose market share, betting on a better financial performance through higher passenger traffic. However, the path to passenger traffic growth hinged largely on maintaining affordable prices, and to a lesser extent, greater diversification in routes and frequencies.

Analyzing our sample's revenues (ticket sales and ancillaries), the industry reported 35.2% growth in 2017, totaling MXN109.8 billion (from MXN81.2 billion in 2015). We believe ancillary revenues partly compensated for low-cost fares. In connection with the above, ancillaries began to take on greater relevance given Mexican airlines' inability to raise base fares. As of 2017, revenue share of ancillaries rose to 15% of total revenue from 11% in 2015.

Chart 5

We Expect A Bumpy Recovery For Mexican Airlines

S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Economic and operational assumptions for Mexican airlines in 2021

We think there's still a high level of uncertainty about the pace of the Mexican airline industry's recovery in the next few years, particularly demand for air travel. The roll-out of the vaccines, the effects from possible variants of the virus, the reopening of borders, passengers' willingness to travel, and consumer purchasing power are some examples of these uncertain factors. Our current macroeconomic base-case scenario for Mexico assumes that GDP will grow 3.9% in 2021, which wouldn't offset the sharp contraction in 2020. Therefore, we consider that 2021 will still be a challenging year for Mexico's economy, especially for some of the sectors, such as airlines, that were hardest hit by measures to limit the pandemic.

Source: "Latin America’s Economic Recovery From The Pandemic Will Be Highly Vulnerable To Setbacks," Dec. 1, 2020.

We predict Mexican airlines will significantly raise prices

In our view, an improvement in the profitability of Mexican airlines would depend primarily on making significant operational changes, especially considering that the market will be 25%-30% smaller than in 2019. We also consider that the pandemic has severely curtailed demand for corporate travel, which we don't think will fully resume this year. In our opinion, adapting to the "new normal" of air travel will still take several months, if not years.

One of the main changes we expect in the industry is potentially higher ticket prices, even though this causes demand for air transportation services to decrease. We expect to see an industry to focus more on profitability that can cover high fixed costs without needing to resort to a higher level of debt. Among the pricing strategies that we could see would be an increase in the sale of ancillaries and higher tariff subdivisions (such as executive, classic, flexible, basic, etc.), as well as the rise in ticket fares not only just by the Mexican peso's depreciation against the dollar.

The Mexican airline industry's recent operating track record suggests that a low-cost model--a leveraged capital structure, high maintenance requirements, or considerable capex for growth--could significantly pressure cash flow during even a slight downturn in passenger traffic. Therefore, we expect airlines to either keep leverage low, moderate capex plans, or raise ticket prices.

Chart 6

A low-cost business model could come under strain if high leverage undermines profits and reduces financial flexibility. In our view, leverage will likely induce companies to raise average prices. Another important factor to consider is that while airlines have currently put fleet replacement on hold, at some point in the next few years they will need to start renewing their fleets, which could result in additional debt. In our view, a sustainable and cautious growth model, along with profitable operations, will be critical factors driving airlines' medium-term financing strategies.

Recovery will largely depend on vaccination programs

We think that there is still a long way to recovery for the transportation industry, especially air transportation. We believe that a recovery to pre-pandemic levels could occur in 2023; however, this will depend on immunization programs across the region and around the world to restore safer conditions for socializing and mass interactions (please see "COVID-19 Heat Map: Some Bright Spots In Recovery Amid Signs Of Stability," Feb. 17, 2021). We expect air traffic recovery to be slow because several countries have decided to close their borders to avoid vaccine shortages. Therefore, our expectations largely depend on the speed that medical laboratories can meet the demand for vaccine doses.

As of this report's date, our only active rating on a Mexican airline is on Aeromexico, which we expect to remain at 'D' until it completes a business and financial reorganization process under Chapter 11 proceedings in the U.S.