Credit Rating Lowered, Forecast Ugly

Fitch Ratings has assigned a 'B' rating to the $300 million in senior unsecured notes issued by Northwest Airlines. The notes carry a coupon rate of 10% and mature in 2009. The Rating Outlook for Northwest is Negative.

The unsecured rating and the negative rating outlook reflect Northwest's heavy debt load, high level of cash obligations over the next few years and the lack of progress toward the achievement of lower contract pay rates for unionized employees that would bring the carrier's unit labor costs in line with its restructured network carrier rivals. If competitive deals on amendable labor contracts are reached, Northwest should be in a position to deliver unit operating expenses at the low end of the network airline peer group. However, progress toward this goal has been slow. As a result, Northwest faces another year of marginal profitability and cash flow results in spite of an improving industry revenue environment.

Northwest continues to struggle with unit operating expenses that remain above the new competitive cost benchmark being established by the restructured network carriers--American and United. Although management reiterated its hope on Jan. 23 that the airline's unit labor cost premium could ultimately be erased, there is no expectation that new collective bargaining agreements with the pilots or ground workers can be reached quickly. Negotiations with the Air Line Pilots Association (ALPA) have been underway since last summer, when the pilot agreement became amendable, and the company has been in talks with its ground employees' union (the International Association of Machinists and Aerospace Workers) since late 2002.

Liquidity remains a source of relative credit strength, given the airline industry's ongoing exposure to external demand and fuel price shocks. A year-end 2003 unrestricted cash balance of $2.8 billion allowed Northwest to retain the strongest ratio of unrestricted cash to annual revenues among the U.S. network carriers. The strong cash balance was supported by asset sales completed in 2003 (including stakes in computer reservations company Worldspan and online travel companies Orbitz and Hotwire). An IPO of Northwest's Pinnacle regional airline unit provided liquidity for Northwest's defined benefit pension plans, which were funded in part during 2003 through a contribution of Pinnacle stock.

A solid liquidity buffer will remain critical in light of the cash flow pressures that Northwest faces in 2004 and 2005. Scheduled debt maturities total more than $600 million this year and $1.4 billion (including $975 million of secured credit facilities) in 2005. Cash pension funding will also represent a major drain on operating cash flow, but some required funding may be deferred if Congress acts quickly to cut so-called deficit reduction contributions (DRC) made to underfunded airline pension plans. The Senate voted yesterday to approve a deferral of most airline DRC payments in 2004 and 2005. Northwest management on Jan. 23 noted that 2004 cash funding of pension plans would not exceed the accrued pension expense on the income statement of $450 million.

Following Northwest's recent asset sales, few unencumbered assets are available to generate cash. Northwest has now issued debt on an unsecured basis (including $300 million in convertible bonds issued last fall) on three separate occasions over the past year. Continued access to the capital markets is allowing Northwest to counter the cash flow pressures posed by debt maturities and required cash pension funding this year. Some of the liquidity benefits, however, are being offset by the high coupon rate for the current offering, which will drive higher interest expense.

In addition to strong cash balances, Northwest's credit position is supported by better revenue fundamentals than those seen by the other network carriers. Passenger unit revenue (revenue per available seat mile) grew by 12% in the fourth quarter--outpacing the rest of the industry by a comfortable margin. The unit revenue improvement derived not only from strong load factors (up 3 points system-wide versus the prior-year period), but also from better pricing.

Passenger yields improved by 7% in the fourth quarter, in part reflecting Northwest's discipline in adding back scheduled capacity more slowly than the rest of the industry. The carrier's unit revenue premium to the rest of the industry widened year-over-year, reflecting more limited exposure to rapidly growing low-cost carriers in the Heartland markets where Northwest maintains a strong unit revenue position. Strengthening trans-Pacific, trans-Atlantic and cargo demand has also supported Northwest's relatively strong unit revenue performance.

Besides the risk of slow progress on the labor front, Northwest and the entire U.S. industry face a high level of fuel price risk this year that could undermine operating results and offset some of the expected revenue improvement. Northwest has no fuel hedges in place, and forecasts a full-year 2004 jet fuel price of 85 to 95 cents per gallon.

FMI: www.nwa.com