Fitch Ratings has downgraded Azul S.A.'s Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) to 'CCC-' from 'CCC+', and its National Scale Rating to 'CCC-(bra)' from 'B(bra)'.

Fitch has also downgraded Azul Investments LLP's unsecured notes to 'CCC-'/'RR4' from 'CCC+'/'RR4'.

The downgrades reflect Azul's high refinancing risks, operating cash flow pressure due to current and deferred leases payments, liquidity deterioration per Fitch's criteria, and the more restrictive local credit market due to Americanas' default. Fitch's view of a less friendly renegotiation backdrop with lessors and other main suppliers, despite their proven support during the pandemic, is also considered in this rating action.

Key Rating Drivers

High Refinancing Risks: Negative headwinds faced by Azul relate to credit tightening in the local market and uncertainties regarding the recovery of credit conditions, as the company seeks to refinance its leasing obligations and aircraft financing debt while investing to renew its fleet. These challenges coincide with capital market debt due in 2024 and 2026.

Azul's short-term maturities totaled BRL5.1 billion (BRL1.3 billion of financial debt and BRL3.8 billion of leasing obligations) as of Sept. 30, 2022. Azul's readily available cash, per Fitch's criteria, declined to BRL1.4 billion from BRL3.4 billion at end of December 2021. Total debt of BRL18.8 billion primarily consists of BRL14 4 billion of leasing obligations, BRL2.2 of cross-border senior notes due 2024 and BRL3.2 billion of senior notes due 2025).

Negative FCF: The increase in lease payments following their reduction/postponements during the Covid-19 pandemic crisis, in addition to elevated interest rates and still high fuel prices has led Fitch to project Azul's FCF will be negative by BRL2 billion in 2023, which is similar to our expectation for last year. Fitch estimates total leasing payments, including interest expense, of around BRL3.8 billion in 2022 and BRL3.3 billion in 2023, a significant increase from BRL1.4 billion in 2020 and BRL2.1billion in 2021..

Improved EBITDA: The benefits related to the elimination of PIS/Confins taxes, a reduction in fuel prices from extremely elevated levels and some improvement in the cost structured will improve the company's operating cash flow. Fitch expects Azul's EBITDA to reach around BRL5.3 billion in 2023 and BRL5.8 billion in 2024, an increase from a projected level of BRL3 billion in 2022. The performance during 2022 largely reflects the spike in fuel prices, which was partially offset by the substantial increase in yields.

During 1Q22, 2Q22 and 3Q22, Azul's average fuel price rose 57%, 81% and 85%, while yields increased 34%, 53% and 39%. The yield management strategy has been supported by pent-up demand following the pandemic and a strong rebound in corporate traffic demand. Brazilian domestic market demand has rebounded strongly, with the passenger traffic during 2022 only 7% lower than pre-pandemic (2019). The more rational behavior of the three largest players in the domestic market is likely to support healthy yields for a while.

Strong Domestic Market Position: Azul's credit profile benefits from its unique regional airline market position in Brazil, with a strong presence in underserved markets and limited route overlap with competitors, GOL Linhas Aereas Inteligentes S.A. and LATAM Airlines Group S.A. (D(cl)). Azul is the sole provider of services on 77% of its routes and is one of the two largest airline companies in Brazil, with a market share of around 29%, as measured by revenues/passenger/kilometer (RPK) in 2022. As Brazil is the company's key market, Azul's operating results are highly correlated to the Brazilian economy.

Derivation Summary

Azul's ratings rating reflects the continuation of ongoing refinancing risks. Azul's liquidity has deteriorated over the past quarters, and it used to be bright spot compare to most immediate peers. GOL's ratings also reflect high financial distress related to elevated refinancing risk.

Azul has a weaker position relative to global peers given its limited geographic diversification and relatively high operating leverage. Its strong position in the Brazilian regional market, high operating margins and track record of strong liquidity ratios have nevertheless been key rating drivers. These positive factors are tempered by the company's ongoing business growth and operational volatility related to its key market, Brazil.

Foreign exchange risk exposure is a negative credit factor for Azul considering its limited geographic diversification; the company implemented a currency hedge position that partially mitigates this risk.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer:

Fitch's base case during 2022 and 2023 includes an increase in RPK by 6% and 18%;

Load factors around 80% during 2022 and 2023;

Capex of BRL.8 billion in 2022 and BRL2,4 billion in 2023.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Material improvement in the company's debt-amortization profile, reducing refinancing risks, associated with the maintenance of sound liquidity position;

Maintenance of the solid rebound in the domestic air traffic in Brazil.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Continuous difficulties to access credit lines and/or to refinance its 2024 bonds by 3Q23.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Deterioration of Available Cash: The company's readily available cash, per Fitch's criteria, declined to BRL1.4 billion as of Sept. 30 2022, from BRL3.4 billion at end of December 2021. At the same period, short-term maturities totaled BRL5.1 billion (BRL1.3 billion of financial debt and BRL3.8 billion of leasing obligations). Total debt was BRL18.8 billion composed by BRL14 4billion of leasing obligations, BRL5.5 billion cross-border senior notes (BRL2.2 billion in 2024 and BRL3.2 billion in 2026).

The company considers it has other sources of liquidity such as accounts receivables (including subleases), security and maintenance deposits and the ability to use Tudo Azul (Azul's mileage program) as collateral for a secured debt issuance.

Issuer Profile

Azul is one of the largest local airlines in Brazil. The company has an important presence in the regional market and is the sole airline on 77% of its routes.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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