Neither Ponzi nor Pyramid, but an End Game Nonetheless?

Liquidations and/or Use of the Failing Carrier Doctrine?

On the day when Bernie Madoff gets sentenced to 150 years for orchestrating the financial fleecing scheme that put its namesake, Charles Ponzi, to shame, I am pondering the balance sheets of airlines. And it comes down to this: some carriers have little room to maneuver. Investors (read: credit) are not lining up to provide new capital without demanding ransom in terms of collateral or sky-high coupon rates well above those paid in other industries.

Ponzi and pyramid schemes work by gathering proceeds from one group of investors to pay off earlier investors. It is no small irony, then, that much the same has been happening in the airline industry for years. The financial scams fall apart when they run out of money to pay new investors. In airlines, the end result is pretty much the same. Airlines continue to seek new capital even as previous investors fail to earn a respectable return on their investment. It’s not illegal, but neither is it sustainable. Indeed, it is fast becoming apparent that capital is quickly tiring of this industry and its inability to sustain profits, return its cost of capital and thus reinvest in itself at market rates.

In an industry that has succeeded mainly in destroying decades of capital, the end game for some airlines may be near. To inject new funds into its operation, United Airlines’ required collateral was reportedly three times the $175 million in cash it raised. More troubling yet -- the coupon rate on the new debt was 12.75 percent. Even with exorbitant collateral demands and above-market interest rates, new investors were willing to pay only 90 cents on the dollar for the security, which equates to an effective return to the investor closer to 17 percent.

At the same time, American announced it will sell $520.1 million in debt . American’s collateral requirements will be hefty, but slightly less than twice the amount it plans to raise. According to the Associated Press, American’s debt is investment grade based in part on the assets pledged as collateral. Therefore, American will pay significantly less for its capital than will United, even if the investor interest level is on par. But with corporations of this size, and of this importance to the US economy, “investment grade” ought to be the baseline, not the high bar. That’s not the case today. Earlier in the year, Southwest -- the industry’s only capital-worthy airline -- was forced to pay in excess of 10 percent on its loans. Wow. In other circumstances, that might be considered usury.

Data Points

Market perceptions, and cold, hard cash, demonstrate a new industry pecking order is emerging. Allegiant, AirTran, Alaska and SkyWest – airlines many Americans have never flown -- each today have a market capitalization greater than that of either United or US Airways.

In Spring 2009, Fitch’s Airline Credit Navigator outlined current liquidity and expected debt maturities for airlines over the next three years. It found “most of the biggest U.S. airlines ended the first quarter in "unfavorable liquidity positions.”

For three of the top seven carriers (US Airways, American and United), this liquidity ratio fell below 15 percent of trailing twelve month revenues - a benchmark commonly used to target an optimal amount of cash to be held on the balance sheet.

According to Fitch’s data, American, Continental, Delta, United, US Airways, Southwest and jetBlue held nearly $17 billion in liquidity at the end of the first quarter of 2009 (and with a market capitalization of $13.7 billion for the same group of carriers, the market says that a dollar today is not a dollar tomorrow). Southwest and Delta constitute two-thirds of the group’s market capitalization.

Assets are only one part of the disturbing picture the Fitch data paints. The other half is liabilities. Together, the carriers have debt obligations of nearly $12 billion due by the end of 2010. And these obligations come at a time where negative free cash flows are anticipated for the foreseeable future.

Take as one example Delta, which claimed title as the world’s largest airline following its merger with Northwest. While in the first quarter of this year Delta did not fall below Fitch’s relatively arbitrary liquidity rating. Fitch nonetheless downgraded the debt ratings of Delta and Northwest on June 25 to reflect “intense revenue pressure” and expected negative cash flows. As a result of its combined balance sheet with Northwest, Delta has a stronger absolute cash balance relative to the industry, but still faces nearly $5 billion of fixed debt obligations through 2011.

The shift of capacity by the U.S .legacy carriers to international markets has suffered from poor timing. For United, its exposure to once lucrative trans-Pacific markets is even more painful as the geographic region is closest to intensive care. By comparison, American and US Airways are fortunate to have little relative exposure in the Pacific. But the winner is likely the new Delta which, with lots of eggs in all international baskets. This diversification will certainly produce better results than either Northwest or Delta would have achieved individually.

Renewed Consolidation Focus Based on an Old Tool?

In prior eras, the airline industry has relied on the “failing carrier doctrine” to combine companies on the verge of collapse or unable to meet debt obligations. That doctrine might be dusted off and used again during the next 12 months. Precedent shows mergers and acquisitions are viewed more favorably – with fewer concerns about competition – when the economy is in a swoon and airlines are at greater risk of going under.

US Airways chief Doug Parker is not alone in making a case for consolidation. United’s Glenn Tilton is also in the chorus. Both carriers are on Fitch’s list of those in the “liquidity danger zone.” United and US Airways still have some room to maneuver, but recent attempts to raise capital have proven, in the airline industry particularly, money is getting increasingly expensive.

We may be entering a new era in which the “failing carrier doctrine” no longer applies. Instead, we are now facing the “failing industry doctrine.”

On Second Thought

One of the big issues related to mergers not discussed enough is the preservation of the tax loss carry forwards that each airline has accrued (accrued losses can be used to offset profits in future years). So in the short to medium term, the industry may resist the urge to merge because a change of control could or would have significant tax ramifications. If this is the case, why not apply the failing carrier doctrine to anti-trust immunity?

First, there is no doubt we will see additional capacity cuts, with the next round showing up in the schedules for fall of 2009. This industry is not shrinking because it wants to, but rather because it has to. By the time airlines cut further at the end of the summer travel season, the industry’s two decades of economics-be-damned growth may be nothing but a memory of bad decisions gone by. Then the U.S. airline industry can finally get down to the business of being a business. Or be resigned to failure.

As I have written time and again, in this economy, capital will determine the survivors. Access to capital is the lifeline airlines need now. Those who control that capital are sending a message to legacy carriers, and that is they will pay dearly for funding until they can demonstrate a sufficient return for investors.

Republic Airways Holdings, Inc.

Recognizing the importance of that lifeline might shape the airline industry of the future. Republic Airways CEO Bryan Bedford seems to already be moving that way. As a result of his purchase of Midwest, Bedford now has investment firm TPG on his board - - basically, capital now in is the role of decision maker.

Whether other carriers can accept that kind of change might very well decide the future of the industry and whether some airlines even survive. Right now, that future for many airlines and the hundreds of thousands of people they employ is anything but bright.

Keep in mind, the next industry shakeout is not reserved for the big players alone. Look for entities other than the five legacy carriers (American, Continental, Delta, United and US Airways) to have input into any new architectural renderings of network structure. And input will not only come from Alaska and from the so-called low cost carriers, (Southwest, jetBlue and AirTran) but also some regional carriers like SkyWest.

And I keep coming back to Republic.

Let’s Just Continue the War of Attrition

Considering the Concept of "Rent Sharing"

Maybe the best answer to US airline industry woes is the same path followed in the early 1990’s when iconic names like Pan Am and Eastern liquidated.

I understand Continental’s thinking, I think. They have many attributes that are viewed in previous consolidation periods as positives: youngish fleet; decent, if not good, labor relations; hubs/gateways in markets with strong underlying local demand; hubs/gateways in markets that have interest not only to those in the US but around the globe; and a respected management team that has not only devised a plan but has acted on it. But they still have a fragile balance sheet just like the rest of the US industry.

Kevin Crissey at UBS writes this morning on Continental’s attitude toward consolidation: “We believe CAL mgmt view consolidation as beneficial over the long run but much less so in the short run as labor would take a big cut of the synergies. With fuel and demand draining life from the sector, mgmt appears to be focusing on CAL's survival and likely views a merger as increasing bankruptcy risk”. Continuing to beat that fuel issue to death, my only question is what is the short-term and what is the long-term for the US industry? Is the short-term six months or is it two years?

Mr. Crissey was right to raise the labor situation and the negative impact on any short-term synergies that might be gained from the overall deal. In last week’s congressional hearings on the Delta-Northwest hearings, I believe that Dr. Clifford Winston of the Brookings Institute referred to the topic as “rent sharing”. The negative synergies in "rent sharing" between labor and the deal in the case of Continental and United are somewhere in the $300 – 400 million range, or double those in the Northwest – Delta case.

But rates of pay are only half of the story. Continental’s pilots are more productive than United’s pilots per month based on publically available data in 2006. If that were to be the case, the Airline Data Project estimates that the increase in productivity to Continental levels would mean that 460 fewer United pilots would be needed. While final 2007 numbers will not be available for another six weeks, rate and productivity calculations underscore just one of many difficulties faced in estimating the offset of overall network synergies by the “rent sharing” calculation between management and labor.

On both the compensation and productivity calculations included in the Airline Data Project, please read the footnote that suggests problems with the US Airways and America West calculations for 2006. Further, and based on the calculations there should be no secret as to the difficulties American has in considering whether to play in this round of consolidation or not. The math for them is particularly difficult.

So maybe we just will not be able to get there. Bankruptcy is less an option unless it is a liquidating bankruptcy like we saw most recently with American and TWA where American purchased the assets of TWA. The few combinations left to consider do little to address the immediate need to minimize exposure to the US domestic market unless the opponents to change recognize that the current structure is simply not healthy. US Airways has too many eggs in the US domestic market basket. Hell, everyone has too many eggs in that basket.

Maybe we should start thinking about consolidation as the world thinks about our marketplace and engage in a consolidation of North America and bring Air Canada and Mexico fully into the conversation. This idea would address the US centric mindset that seems to dominate the conversations among the naysayers.

Talk about a bad time to be a CEO in the airline industry. Someone has to get their fingernails dirty. To be sure, private equity would not want to touch the issues left for the industry to work through. Last night, United said in a statement following the Continental Board’s decision: "Ensuring you have the right partner is everything,"

As the late Johnny Cochran might have said: If it doesn’t fit, you must attrit. And in the long run the survivors will benefit.

“A Flying Pig”

Eric Reguly of the globeandmail.com writes a cutting and provocative piece on the situation at Alitalia. I have been looking for an excuse to write about the Alitalia story as it provides a bit of a reflection of US airline industry tendencies. Particularly when politics and labor stand in the way of economic forces that demand change. Fighting an industry’s evolution seems to ultimately result in the failure of the very entity the entrenched believe somehow will flourish in its status quo state.

Whatever date will decide Alitalia’s fate is nearing. Mr. Reguly writes: “Alitalia, with some 18,000 employees (far too many) and 174 aircraft (far too old and fuel inefficient), has been a flying pig for as long as anyone can remember. It was plastered with bandages when radical surgery was required. Between 1999 and 2005, it lost €2.6-billion. In 2002, it was kept alive only by the emergency injection of €1.4-billion from the government. The bleeding still continued. The airline lost €605-million in 2006 and another €364-million last year. The politically motivated strategy of flying from two hubs - Milan's white-elephant Malpensa airport and Rome's Fiumicino - unnecessarily deepened the losses. Alitalia is too small for a two-hub operation (to its credit, the airline was slowly downgrading Malpensa in favour of Fiumicino)”.

The US airline industry is fast approaching a date where something is going to have to give as well with high oil and an economy in recession on a collision course. Whether consolidation or liquidation, the next 12-18 months promises to be the most challenging period in the industry’s deregulated life cycle. The barriers to exit that have historically existed will be challenged. My guess is that they will not provide the same safety net that has been experienced in the past.

Today, Alitalia is Europe’s sixth largest carrier in terms of revenue. The Big 3 in Europe (Air France/KLM, Lufthansa/Swiss and British Airways) are beginning to dwarf numbers 4-6 in terms of size. It would certainly seem that for Alitalia, being part of the world’s largest airline group is its best case scenario. But when parochial interests get in the way, somehow it becomes an all or nothing game rather than to preserve as much of the legacy as possible.

The US airline industry seems poised to experience some similar scenarios. Maybe the best path for the US is consolidation through liquidation? A path of lesser resistance? Some will say to me in various ways: Swelbar, this will only happen when pigs fly. What we are seeing in Altialia is that pigs can’t stay airborne forever – even in Open Skies.

Pigs don’t fly and neither will an industry that refuses to adapt.