S&P Raises Outlook on Gol Linhas (GOL) to Stable; Cost-Control Initiatives Panning Out

Standard & Poor's Ratings Services said that it had revised its outlook on Gol Linhas Aereas Inteligentes S.A. (NYSE: GOL) to stable from negative. At the same time, we affirmed our global scale 'B' and national scale 'brBBB-' corporate credit ratings on GOL.

The outlook revision reflects GOL's improved operating results by cutting excess capacity and through cost control initiatives and additional sales efforts, coupled with less aggressive competition in Brazil. At the same time, GOL has been extending its debt maturity profile and lowering debt cost through refinancing, such as the tender offer for the prepayment of remainder of the 2017, 2020, and 2023 bonds. These factors partly counter the drag from the company's higher leverage than those of its industry peers, concentration of revenues in a single market, and significant exposure to currency variations because most of its cash is in Brazilian reais (R$), while part of its costs and most of its debt are denominated in dollars, thus causing greater volatility of cash flows and financial metrics. Also, the company is exposed to the intrinsic risks of the airline industry, which we view as "high" risk due to its cyclicality, intense competition, and exposure to fuel prices and economic cycles, resulting in volatile demand and credit metrics.

The ratings on GOL reflect our view of the company's "weak" business risk profile and "aggressive" financial risk profile.

We still view GOL's business risk profile as "weak," mainly due to its concentration of revenues in a single market and Brazil's sluggish economy. However, the partly mitigating factors are the company's improving operating efficiency and low-cost business model. GOL has maintained a significant presence in the Brazilian aviation market, despite cutting its capacity in recent years by returning excess aircraft and focusing on more profitable routes. Furthermore, the company's strong presence at the country's busiest airports and greater sales efforts improved its load factors to about 75% and increased passenger revenues per available seat-kilometer (PRASK). These factors, combined with efforts to reduce costs, strengthened operating and financial metrics, despite higher jet fuel prices and additional expenses for restructuring GOL's fleet and routes. We expect the company's strategy to improve its operating metrics, resulting in load factors of more than 75% by year-end 2014 and close to 80% in 2015, higher yields and PRASK and greater control on costs per available seat-kilometer (CASK) not including jet fuel costs. The company's EBITDA margins (adjusted by operating leases) were about 16% in the 12 months ended June 2014, up from about 9% in a year-earlier period.

We view GOL's financial risk profile as "aggressive", but with credit metrics currently more in line with that category. GOL's improved operations have reduced cash flow pressures and allowed the company to fund its cash needs internally. Furthermore, GOL's refinancing activities reduced its operating lease adjusted (OLA) debt to R$8.6 billion in June 2014 from R$8.78 billion in December 2013. This, combined with stronger EBITDA, significantly improved debt to EBITDA to 5.5x from 10.7x and funds from operations (FFO) to debt to 8.7% from 0.5%. Also, as part of GOL's efforts to reduce debt cost, the company plans to repay the outstanding amount on the 2017, 2020, and 2023 senior unsecured notes through a tender offer.

In our base-case scenario, we assume the company will continue to reduce capacity measured by available seat-kilometer (ASK), at a gradual pace during the next two years, while benefitting from more resilient air travel demand despite Brazil's sluggish economy. Our base-case scenario also includes the following assumptions:

• Brazil's GDP growth of about 1.2% in 2014 and 2015;
  
• A 1% decrease in GOL's ASK in 2014 and 0.6% in 2015;
  
• Load factor reaching 75% in 2014 and about 80% in 2015;
  
• Exchange rate fairly stable at around R$2.40 per $1.00 for 2014 and 2015;
  
• Growth in CASK (minus jet fuel) in line with Brazil's expected inflation rate of about 6% in 2014 and 2015;
  
• The fleet's reduction by four aircraft in 2014 and increase of three in 2015; and
  
• Fairly stable debt levels in 2014 and some decrease in 2015.

As a result, we project the company's RASK to increase slightly for the next two years, while controlling CASK, allowing for EBITDA margins to reach 17% by the end of 2014 and 18.5% in 2015. Also, debt to EBITDA should be 5.2x and close to 4.5x, respectively, and EBITDA interest coverage above 2.0x in the next two years. Furthermore, we expect cash generation to improve, resulting in FFO to debt close to 12% in 2014 and about 15% in 2015.

GOL's liquidity is "strong." The company continues to have significant cash position of R$2.8 billion as of June 2014, while short-term debt totals R$532 million. Also, we believe liquidity sources will exceed uses by more than 1.5x during the next 12 months. Our assumptions include:

• Sources of liquidity:

  -- Cash position of R$2.8 billion
  -- FFO of about R$1 billion in 2014
  -- R$540 million in freed-up resources due to the capital reduction at Smiles (GOL's frequent flyer program)
  -- R$600 million of new debt issued at Smiles to fund the capital reduction

  Uses of liquidity:

  -- Short-term debt of R$532 million,

  Expected capital expenditure of about R$300 million

  -- A drop of about R$1 billion in capital at Smiles

  GOL has also renegotiated the covenants to which the company is subject to under its current debentures issues. We now expect the company to fully comply with these covenants, with about 30% of headroom. GOL also has significant obligations for aircraft acquisitions due to orders with Boeing, with a smooth payment and delivery schedule. We also expect the company to continue financing aircraft acquisitions mainly through operating and financial leases.

  In our credit assessment, we have a "negative" score for GOL's capital structure modifier, because about 75% of its total debt is in dollars with little natural hedge from dollar-denominated revenues, which increases volatility of credit metrics and can weaken the interest coverage ratios if the Real depreciates. Therefore, we render a one-notch downward adjustment from GOL's anchor. The mitigating factor is GOL's high cash position, compared with the uses of cash, resulting in a one-notch upward adjustment. Finally, we believe GOL compares negatively to similarly rated companies, as it's still in middle of an aggressive restructuring of its operations, with exposure to a slowing economy, which exacerbates the intrinsic risks of the airline industry.

  The stable outlook reflects our expectations that GOL will continue to improve its profitability by reducing costs and increasing PRASK and load factors by focusing on profitable routes and business travelers, despite Brazil's stalled economy. Furthermore, we also expect the company to continue refinance its debt to extend its debt maturity profile and reduce debt costs. These factors will result in stronger credit metrics, such as total debt to EBITDA of about 5.0x by the end of 2014 and close to 4.5x in 2015.

  An upgrade is possible if the company can strengthen its operating metrics, due to more efficient cost control or higher-than-expected demand, leading to sustainably higher load factors and yields and debt to EBITDA of less than 4.0x and FFO to debt of 20%. We can also raise the ratings if GOL reduces its exposure to foreign currency exchange rates either by improving the natural hedge from its dollar-denominated revenues or by reducing dollar-denominated debt, resulting in more stable cash flows.

  We could downgrade GOL if its results weaken due to inefficiencies in its operations, or weaker-than-expected market conditions, resulting in debt to EBITDA of more than 5x and FFO to debt of less than 10%. Also, we could lower the ratings if the company's liquidity deteriorates due to weaker cash flows.

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