S&P Global Ratings has tempered its outlook for the North American airline sector following underwhelming year-to-date financial results and issuer guidance for the rest of 2024. Passenger growth is normalizing--more than we previously anticipated--following recent reports of domestic overcapacity in North America.

We now expect a slower rate of revenue growth this year will likely weigh on cash flow generation and credit protection, notably as issuers incur a full year of structurally higher labor costs and elevated maintenance expenses.

Table 1

We are closely monitoring the potential downside to airline ticket prices. We estimate that a small decline in unit revenues relative to our generally stable year-over-year (Table 2) assumptions could have a significant impact on the industry earnings profile. This sensitivity is now beyond what we previously considered due to our more subdued expectations for available seat mile and revenue growth this year, given the high operating leverage inherent in the industry.

The response by certain airlines to reduce their previously planned pace of expansion is encouraging. In our view, capacity restraint should lend support to average realized fares. For the larger North American airlines, we continue to estimate that earnings and cash flow will strengthen beyond this year.

However, discipline across the airline industry is not assured, particularly from participants that may face heightened losses and liquidity constraints. Increased pressure on balance sheets and liquidity the rest of this year could carry forward and limit (or derail) the pace of improvement in credit measures that we assume for most issuers next year.

Difference In Altitude Year To Year

Positive rating actions were pronounced globally in 2023 and reflected a sharp recovery in cash flow related to surging passenger travel demand following the height of the COVID-19 pandemic and balance sheet repair (Table 1). We upgraded each of the Big 3 U.S. airlines--Delta Air Lines Inc., United Airlines Inc., American Airlines Inc.--as well as Air Canada. However, 2024 has been a marked contrast.

We have already taken several negative rating actions since the start of the year. In our view, North American airlines will be hard-pressed to improve upon last year's earnings and operating cash flow, and the near-term outlook bias is negative (Charts 1 and 2).

Chart 1

Chart 2

Industry conditions can change quickly for airlines and contribute to often volatile forecasts. To be clear, we continue to assume revenues will increase this year (driven primarily by additional capacity), but at a more modest (and moderating) rate. The slowing improvement affects earnings estimates for 2024 due mainly to meaningfully higher overall costs that adds pressure to margins. Elevated operating expenses this year are unlikely to ease any time soon. In addition, fuel prices--the second-largest expense component after labor--remain high (albeit, well below 2022 peaks) and are unpredictable.

Declining year-over-year earnings also reduce the near-term benefits of moderating capital expenditure (mainly related to new aircraft deliveries) on free cash flow and balance sheets. As a result, we believe prospective credit profile stability (or improvement) becomes more dependent on stronger operating results next year.

Not All Ratings Are Under Pressure

We are not sounding the alarm for all issuer ratings. Delta, United, and Air Canada stand out as profitability leaders through June 30, 2024. The credit measures of these companies are also firmly commensurate (or strong) for our ratings. These airlines have meaningful exposure to higher-margin premium and loyalty program sales, whose growth has outpaced economy seating and other revenue segments. Material sales for international passenger travel also (for the most part) help alleviate domestic market pressure that has emerged.

These issuers should also benefit from a seemingly steady recovery in business travel that has lagged the growth in overall passenger volumes since the lows of the pandemic. We therefore assume Delta and United will maintain the most room to absorb a scenario of weaker than expected market conditions through next year.

Chart 3

On the other hand, Air Canada recently highlighted increased competition and lower passenger revenue per available seat mile (PRASM) on its trans-Atlantic routes. This is in contrast to what U.S. network carriers reported during second-quarter 2024 earnings commentary. We also believe rating pressure is increasing for a meaningful remaining share of the North American airline sector.

Our outlooks are negative on 33% of issuers, skewed toward historically low-cost carriers that have a preponderance of main cabin seating and leisure travel focus. These issuers no longer enjoy a labor cost advantage, a key pillar of the low-cost/ultra low-cost carrier business model (which disrupted the airline industry several years ago). In addition, changing consumer preferences, particularly toward premium seating and loyalty programs, have weakened margin profiles and competitive positioning, notably relative to the Big 3 early adopters.

Lastly, historically low-cost airlines have also faced outsize exposure to well-documented new aircraft delivery delays (i.e., the Boeing 737 Max) and engine reliability issues (i.e., the Pratt & Whitney PW1100G geared turbofan) that can disrupt operations and weigh on profitability. Furthermore, adjusted debt outside of the Big 3 has trended upward (Chart 4) and is an increasing risk as free cash flow losses continue.

Chart 4

Since the start of 2024, we lowered our ratings on Spirit Airlines Inc. and JetBlue Airways Corp. and revised our outlooks on Southwest Airlines Co. and Allegiant Travel Co. to negative from stable (Table 1). In most of these instances, near-term pressure on earnings and credit measures has been a common theme. JetBlue, Spirit, and Southwest have recently announced plans to enter the premium market (including domestic first class at JetBlue). We view this positively, though not to an extent that affects ratings due to the uncertain business benefits.

Microscope On Airline Fares

Our earnings and cash flow estimates are highly sensitive to relatively small changes in average PRASM, which we use as a rough proxy for airline fares. This is especially pronounced for lower-rated issuers struggling to generate positive earnings, but the largest North American airlines are not immune to potential downside.

We acknowledge there are myriad factors that could influence airline fares. Visibility is also very low because of the relatively short average traveler booking window. At this point, we are most concerned with the risk of lower fares amid current domestic overcapacity in the U.S. In our view, a slowing pace of passenger travel and heightened cost pressure exacerbates the impact of softer than expected PRASM on estimated credit measures.

In Europe, mixed sentiment regarding ticket price trends has some airlines suggesting that travelers have become more price sensitive as post-pandemic savings erode. Low-cost carrier Ryanair Holdings PLC reported average fares down 15% quarter on quarter in its first-quarter results for fiscal 2025 (to June 30), albeit from highs. easyJet PLC suggested more stable pricing trends in its third-quarter trading update (ended June 30), with revenue per seat marginally up quarter on quarter.

Table 2

We estimate that a 2% (200 basis points) drop in estimated annual PRASM (all else being equal, which assumes no offsetting cost-cutting measures) has a material impact on airline credit measures, which includes the larger rated airlines shown in Table 2. Such a decline is small in the context of historical fluctuations. It is important to note that any potential rating action would include a comprehensive review of business operations, the industry environment, and financial policies and not be solely based on estimated credit measures.

Key observations from our sensitivity analysis:

• Southwest's funds from operations (FFO) to debt drops below what we view as commensurate for our rating. The high sensitivity reflects our subdued earnings estimates in 2024 that contributes to a free cash flow deficit and adjusted debt position (from net cash in recent years).
• American's FFO to debt falls below our 12% (sustained) rating threshold, which reflects its weak estimated credit measures for 2024 (which we assume will improve in 2025).
• Air Canada, United, and Delta have sufficient capacity to withstand a modest PRASM decline without potentially affecting our ratings (particularly on the latter two).

For reference, the FFO-to-debt ratio is the primary measure we reference in our rating thresholds for airlines, followed by adjusted debt to EBITDA. Of note, FFO is essentially EBITDA minus cash interest and cash taxes; or most airlines, adjusted debt calculations include leases and are net of accessible cash (though we will generally not deduct cash if a company has a business risk profile lower than fair).

Prices Have Not Kept Up With Fuel Costs

We are also somewhat surprised that the average domestic price of passenger air travel has not increased since 2022 (Chart 5). Yes, a lot of capacity has been added to the market, but U.S. passenger traffic has also continued to expand and fully recovered above pre-pandemic levels alongside above-trend real GDP growth (Chart 6). The industry has also endured unprecedented supply constraints (beyond just new aircraft delivery delays and engine reliability issues) over this period. U.S. domestic airfares adjusted for inflation are below those of mid-2019.

Chart 5

Chart 6

Airlines have historically been relatively successful at passing on higher fuel costs to customers (with a lag), and PRASM (which includes ancillary revenues) has increased across the sector. However, jet fuel prices remain well above average U.S. domestic fares on a relative basis (indexed to mid-2019). In our view, a pronounced supply response beyond that disclosed by airlines may be required for sustained appreciation in average airfares, especially if U.S. real GDP expansion slows in line with our economists' forecasts to 1.7% next year (from 2.5% in 2023 and 2.5% expected this year).

Some Final Thoughts

Our subdued outlook for most North American airlines over the near term includes increasing downside pressure for certain ratings. Several issuers have highlighted the potential for weaker near-term pricing, which we view as a key risk to estimated credit measures across the industry. At the same time, industry fundamentals can quickly change, and we expect to take a relatively measured approach to rating actions over the near term. The Big 3, Southwest, and Air Canada account for most North American airline revenues. Among these issuers, the credit profiles of Southwest and American have higher relative exposures to weaker market conditions.

We continue to assume year-over-year improvement in earnings and cash flow in 2025. In our view, the recalibration of growth planned for the rest of this year by much of the industry should lend support to prices. However, this cannot be assured, and weaker-than-expected operating results in 2024 or 2025 could constrain prospective credit measures from more debt and/or less cash.

From a demand perspective, there are many reasons to believe passenger volumes will continue to increase annually, barring a pronounced recession or another black swan event such as the pandemic. There is a well-established positive correlation between U.S. airline revenues and real GDP (though this has recently lagged somewhat), and air travel is expanding globally. In our view, the shift in consumer preferences for experiences (instead of goods) further supports demand for air travel.

We also see merit in the assertion by certain airlines that customers remain focused on the value proposition of flying. The network airlines are likely to be key beneficiaries of premium and loyalty revenue growth. But recent strategic pivots by Southwest and JetBlue, for example, could introduce pockets of market disruption.