OREANDA-NEWS. Fitch Ratings says sharp rouble devaluation and drop in yields due to the economic downturn in Russia have hit the Russian airlines' credit metrics, prompting further consolidation in the sector. State-owned Aeroflot is well placed to benefit from the current weakness of its domestic competitors by strengthening its market position but likely at the expense of weaker financials.

High FX exposure has left many Russian air carriers vulnerable to severe currency devaluation, which along with a decline in yields, has led to a material deterioration of their credit metrics and liquidity position. Their leverage ratios increased by at least 1.5x-2.5x in 2014 compared with 2013 and we expect their financial performance to remain under pressure in 2015-2016. As a result, we downgraded Aeroflot's rating to 'B+' from 'BB-' on 7 September. UTair had to restructure some of its financial indebtedness and Transaero received a state guarantee for one of its loans from VTB but the company's request for recapitalisation was not supported by the state. The Russian government's inter-governmental commission on air transport industry approved instead the acquisition of Transaero by Aeroflot in early September.

We expect Aeroflot to benefit from its domestic and international rivals cutting capacity and exposure to the Russian market due to Aeroflot's already strong market position, well-developed hub and the launch of low-cost carrier Pobeda, which targets price-conscious customers. The Russian airlines cut capacity by 6% yoy during 5M15; Transaero and UTair contributed the bulk of the cuts at 24% and 17%, respectively. This allowed Aeroflot to increase its total market share (including international players) to 31.1% in 2014 from 30.3% in 2013 and its market share among domestic players to 45% in 5M15 from 38.7% in 5M14.

However, we expect the Transaero transaction to have an immediate negative impact on Aeroflot's financial profile because Transaero is highly leveraged and has lower yields than Aeroflot. Aeroflot expects to acquire the majority stake in Transaero for a symbolic RUB1. We estimate that the consolidation of Transaero's debt, which stood at RUB107bn at end-2014, will add about 0.75x-1x to Aeroflot's funds from operations (FFO) adjusted gross leverage. As a result, we have placed Aeroflot's ratings on RWN.

While further consolidation of the already concentrated domestic market (five largest airlines account for 65% of the Russian passenger air transportation market) should enable better pricing discipline, this is likely to take place over the medium-term. In the short-term we expect the companies to continue focusing on load factors rather than yields. In contrast to the US airline industry, where consolidation among the legacy carriers and capacity constraints have led to an improved risk profile and firmer profitability for the industry as a whole, we do not expect the consolidation of the Russian air travel market to render similar benefits even over the medium-term. This is due to Russia's weak economy limiting the mobility of the population, its less developed airport infrastructure and competition from rail.

We forecast Russian airlines will continue to see a decline in yields in 2015 in dollar terms, which reflects the full year effect of the currency devaluation and Russia's economic downturn making passengers more price-sensitive. The significant reduction in yields is likely to continue on international destinations but we expect some rebound on domestic and CIS destinations in rouble terms.

We consider the slowdown of the Russian air travel market in 1H15 as temporary and continue to assess its medium-term potential as fairly strong due to the still low level of penetration with 0.7 trips per capita per year compared with 1.5 in Europe and 2.6 in the US and rising switch of long haul passengers from rail to air travel.