New sources of liquidity May 2005

It is quite remarkable that, after the enormous financial losses of the past four years, all of the US legacy carriers that existed before September 11, 2001 are still in business.

Three have filed for Chapter 11 — UAL, US Airways (twice) and ATA — but there have been no actual shutdowns or liquidations. Why? Because unique public and private support systems have been in place to ensure that even the financially weakest carriers continue operating.

Initially, the airlines made it through the worst of the post- September 11 crisis thanks to government cash grants and the federal loan guarantee programme. Subsequently, the legacy sector was kept going by the ingenuity and willingness of the US capital and banking markets to continue providing them new funds.

The Chapter 11 process, which has long been criticised for enabling carriers that are clearly not long–term survivors to continue operating for many years, has helped US Airways and UAL enormously since their bankruptcy filings in the second half of 2002. Most recently, on May 10, United’s bankruptcy court allowed it to terminate its pension plans and shift $5bn of pension obligations to the Pension Benefit Guaranty Corporation (PBGC), the federal agency that insures corporate pensions in the US.

Symbiotic financiers

In the past six months or so, US airlines have attracted significant financial assistance from yet another source: private–sector suppliers that are in "symbiotic relationships" with the airlines (a term used by Peter Morris of Airclaims in a recent speech).

Most notably, General Electric (GE), which has heavy exposure to US airlines through lessor GECAS, has recently played a key role in preventing Chapter 11 filings by Delta and Independence Air and enabling US Airways to avoid Chapter 7 liquidation.

The Delta deal in November 2004 was a $500m secured debt financing, which included a term loan and a credit facility, and it was made in conjunction with a financing provided by American Express. The US Airways deal, also signed in November, was a comprehensive agreement on aircraft leasing and financing and engine services. It provided $140m in interim liquidity, deferral of debt and lease payments coming due over six months and leases for new RJs, while preserving the vast majority of US Airways' mainline fleet owned by GECAS.

In the first place, GE’s motive is obviously to try to keep major customers in business. GECAS has around 94 mainline aircraft and 30 RJs at US Airways, and it would be a nightmare scenario to have to take them all back. However, UBS analyst Robert Ashcroft pointed out in a recent report that GE’s support was not necessarily an endorsement of that airline’s long–term future; rather, it may be a way of ensuring a "soft landing" for GECAS relative to its exposure to that carrier.

That certainly seems to be the case with US Airways, because GE is reducing its exposure while helping the airline.

The other notable recent cases of supplier assistance involved two regional airlines.

In February, an investment entity owned by Air Wisconsin provided a $125m debtor–in possession (DIP) loan to US Airways, which will convert to equity upon emergence from Chapter 11. In March, Republic Airways and its majority shareholder Wexford Capital made a provisional commitment to also provide $125m in new equity funding to US Airways, plus an optional $110m from the sale of EMB–170s. However, the latter is a very soft commitment in that Republic can pull out if it does not like US Airways' business plan or if US Airways fails to raise a total of $500m in Chapter 11 exit funding.

All of these deals at US Airways would obviously be renegotiated and revised, possibly involving added investment from the regional airlines, in the event that US Airways and America West reach agreement on a merger (see page six in this month’s issue).

The regional carriers' motives are simple: to keep or obtain new business for their RJ fleets. Air Wisconsin, worried that it was losing its UAL contract (which it did), wanted somewhere new to place its 50–seat RJs. Republic, an old–established feeder partner for US Airways, wanted to safeguard its future role.

There is something odd about the regional carriers needing to invest in a failing major legacy carrier. It reflects on their changed fortunes (except that most of them continue to post healthy profits).

Only a couple of years ago they were in great demand because of their RJ fleets. Now, as JP Morgan analyst Jamie Baker noted recently, they have to pay a "$125m cover charge to join the party". Baker also noted that Pinnacle, another regional carrier, recently had to pay $15m to Northwest to "circumvent the negotiating process".

The GE factor

However, it is GE’s spectacular intervention that has caused a lively debate in recent months. Ashcroft, who has been most vocal on this subject among the analysts, has criticised GE for the major role it has played in "changing airline downturn dynamics" in the US. Aircraft financing agreements are such that airlines can only get rid of aircraft through Chapter 11 or Chapter 7. GE’s rescue deals have prevented Chapter 11 and Chapter 7 filings, which has kept excess capacity in the industry. This in turn suppresses fares, which reduces earnings and ultimately depresses airline stock prices.

These concerns also reflect a realisation, over the past couple of months, that the US legacy carrier sector is headed for a liquidity crunch next winter. A combination of high oil prices, excess capacity, LCC competition, ticket prices at historic lows and a slowing economy (a new problem) means that the frantic additional cost–cutting now being implemented will not be enough to stave off huge losses.

As a result, of the currently solvent legacy carriers, Delta and Continental are likely to end the year with dangerously low cash reserves (in the $500–700m range) unless they can raise additional funds.

Northwest might be on the borderline with $1–1.3bn liquidity at year–end — its key challenge is to secure labour concessions.

American is an important exception among the currently solvent legacy carriers.

The consensus is that, at the current fuel prices, it has sufficient liquidity to ride out 2005 through to the spring of 2006 without raising cash or approaching its unions for further labour concessions (something that it is expected to have to do at some point). Baker estimates that AMR will end the year with a comfortable cash balance of $2bn, but that it may still try to raise $350m in long term debt this year.

Delta is now a possible Chapter 11 candidate this autumn, based on its liquidity position and limited ability to raise funds -the company formally warned about such a possibility in an SEC filing in early May. The consensus is that Delta’s fortunes could be different had US Airways liquidated this past winter, as had been widely expected.

It would have provided an immediate substantial (short–term) revenue boost for Delta, which has the highest exposure to US Airways among the legacy carriers.

Independence Air’s disappearance would have further helped the situation.

However, GE is not entirely to blame if Delta fails to remain solvent. The airline’s fortunes hinge heavily on the US Congress passing the recently proposed pension reform laws, which would allow companies to spread funding over 25 years instead of the current four if they freeze their plans.

According to Merrill Lynch analyst Mike Linenberg, that should mitigate a $3.15bn cash funding requirement for Delta in 2006- 2008.

S&P analyst Philip Baggaley has been warning for some time that UAL and US Airways shedding their pension plans, which has now happened, could have a domino effect on the rest of the industry. The combination of that, the scale of the first–quarter losses and the generally grim outlook led Baggaley to warn in late April of the possibility of a "broader wave of bankruptcies".

Bailouts by suppliers and other interested parties are nothing new in the airline industry.

In particular, aircraft manufacturers have a long history of providing support for their customers and have played a very important role in allowing order cancellations and deferrals since September 11.

GE itself has always been very proactive in helping its customers. Among the earlier deals, it helped Continental out of Chapter 11 in the early 1990s by providing exit funding.

More recently, it has provided financing to America West, Air Canada and UAL.

There are also new types of suppliers emerging to provide support for airlines — notably credit card issuers and processors.

Frequent–flyer credit cards are among the most lucrative of all cards, giving issuers strong incentives to support airlines.

Other industry observers have noted that US Airways' disappearance would not have helped the industry capacity situation for very long, because LCCs would have quickly filled the void.

Consequently, GE is not likely to change its behaviour. Ashcroft expects it to continue to assist those airlines to which it has high exposure, "even when those airlines appear conventionally fully–encumbered".

This is potentially good news for Continental and AWA, where GECAS has around 90 and 60 aircraft respectively, and perhaps Northwest (12 mainline aircraft and 84 RJs). GE would probably not extend credit on an unsecured basis, but it would be motivated to be creative.

One potential scenario suggested by Ashcroft is Continental monetising its ownership in Continental Micronesia and GECAS participating in the deal as a way of protecting its existing exposure.

While access to the capital markets is currently impossible or too expensive (and there is a general lack of unencumbered assets), Continental may be able to do a convertible debt offering this year. Of course, many of the airlines should be able to refinance debt, particularly given that asset values are on the upswing.

Asset sales are likely to play a greater role this year. For all its troubles, Delta still has marketable assets, particularly its two wholly owned regionals Comair and AtlanticSoutheast (ASA).

SkyWest, Delta’s partner and one of the financially strongest US regionals, disclosed in March that Delta had expressed an interest in selling one or both of them. In Ray Neidl’s estimates, the two airlines could raise $600–800m.

Neidl also estimated that Continental could raise $600m through the monetisation of its Pacific subsidiary, the sale of its 49% stake in Copa Airlines and the sale of its remaining 8.5% in ExpressJet. He noted that other estimates have valued those assets at up to $1.2bn. Northwest, in turn, could raise around $75m from the sale of its remaining stakes in Pinnacle and Mesaba and $200m from the monetisation of some Japanese real estate and its vacation wholesaler.