US Airways: The riskiest legacy or a possible over-performer? November 2008

US Airways has significantly shored up its liquidity position in recent months and, because of its domestic focus, is now poised to benefit more than its peers from the dramatic decline in fuel prices and the 10% reduction in domestic industry capacity this winter. The airline is also well–positioned to grow ancillary revenues and to diversify risk through international expansion. Is US Airways now a likely long–term survivor?

The new US Airways, the sixth largest airline in the US, is the result of the first merger between US legacy carriers in the post–2001 era: America West’s acquisition of the old US Airways in September 2005. (The second post–2001 merger, between Delta and Northwest, closed on October 29 — see Aviation Strategy, September 2008, for analysis).

The merger created an AWA–managed operator described as the "first full–service, low–cost, low–fare airline" — a new type of legacy/LCC hybrid. This means CASM between the legacy and LCC ranges and characteristics and strategies from both groups. However, in reality US Airways is more similar to (and usually grouped with) the legacies. It is a network carrier with a nationwide presence and a family of two owned and seven affiliated feeder airlines. It has an international franchise that accounts for a quarter of its mainline ASMs and includes 20 cities in Europe, with service to other continents following in the next year or two. US Airways offers a combination of premium amenities not available on LCCs, including a global FFP, airport clubs, first class cabin and the hourly US Airways Shuttle between Boston, New York and Washington.

The 2005 transaction effectively provided a lifeline for both carriers. US Airways was in its second post–2001 stay in bankruptcy protection. Even though it had restructured its balance sheet and even succeeded in substantially reducing labour costs and lining up new equity funding, it was struggling to come up with an acceptable business plan and was widely expected to liquidate. While AWA was already a low–cost carrier, its geographically limited, leisure oriented network posed a hurdle to long–term survival as a stand–alone entity. The merger offered something AWA had coveted for years: access to the higher–yield East Coast market.

The merger was the brainchild of US Airways' current chairman/CEO Doug Parker, who, while at the helm of AWA, saw the opportunity provided by Chapter 11. The bankruptcy process had enabled the old US Airways to get the right cost structure — most importantly, reduce its high legacy labour costs to effectively LCC levels, which made it a lower–risk merger target. Also, removing aircraft and capacity while in Chapter 11 made it easier to avoid duplication and obtain synergies. The merger was notable for its speedy completion and for raising as much as $1.7bn in new equity investment and partner support (see Aviation Strategy, December 2005).

But the subsequent integration effort did not go well. The new entity had terrible problems combining reservations systems, which led to serious operational issues. By early 2007 US Airways occupied the bottom ranking in the airline on–time performance league compiled by the DOT.

The other problem area has been labour integration. After three years, US Airways and AWA still have separate pilot groups, each with different sets of work rules and pay rates and not permitted to fly the other party’s aircraft. The management insists that labour issues have never caused operational problems, but there are obviously negative implications in terms of efficiency and staff morale.

However, US Airways has staged an impressive operational turnaround this year, thanks to a specific programme. The airline has literally leapt from the bottom to the top of the industry league, ranking number one in on–time performance among the ten largest airlines in January–August.

Until very recently, the new US Airways outperformed its peers in terms of financial results. The new entity turned profitable quickly after the merger, had the highest pretax margin among the US network carriers in 2006 and continued top–level performance through 2007 and first–half 2008. The strong results reflected industry–leading RASM performance, as well as the low cost structure. US Airways enjoyed double–digit RASM growth well before its peers, thanks to the 10% capacity reduction associated with the merger and the revenue benefits derived from combining the two networks.

But US Airways under–performed its peers in the quarter ended September 30, posting a disappointing $242m net loss excluding special items, or an $865m net loss including such items, on revenues of $3.3bn. The staggering $623m of special charges included $488m of unrealised mark–to–market losses on fuel hedges (required by the accounting rules) and $127m of impairment charges. A comparison by Merrill Lynch indicated that the negative 7% pretax margin (excluding special items and mark–to–market hedging losses) was the worst among the network carriers.

US Airways was disadvantaged in several ways in the third quarter. First, it felt the full brunt of the fuel price hike (in a period that saw crude oil peak at $147 per barrel) because of its higher fuel cost exposure relative to its peers — reflecting its older fleet and lower non–fuel cost structure.

Second, because it is primarily a domestic operator, US Airways benefited less than its peers from the strength in international markets. With much capacity in leisure markets such as Florida, Arizona and Nevada, and with a bit more overlap with Southwest than other carriers, US Airways took the full brunt of the weaker RASM growth seen domestically over the summer.

Third, US Airways reduced its mainline capacity by only 1.4% — much less than the industry average. This was partly because it lacked flexibility on the fleet front due to a high percentage of operating leases and as a result of the Chapter 11 and merger–related restructurings.

As a result, US Airways' mainline passenger unit revenues (PRASM) increased by only 4.4% in the third quarter — much less than the industry average. There were also non–fuel cost pressures: ex–fuel CASM rose by 5.3%, mainly due to higher maintenance costs.

But the good news is that some of those disadvantages may reverse in the upcoming quarters. US Airways' top executives have argued recently that the airline is well–positioned for the future vis–à-vis its peers especially for two reasons. First, US Airways stands to benefit more than the legacies from the massive industry domestic capacity reduction implemented this autumn and in 2009. Second, just as it suffered more when fuel prices surged, the airline is poised to benefit disproportionately from the decline in fuel prices.

US Airways is also likely to see one of the highest growth rates in ancillary revenues. This is because in the US those efforts focus mainly on the domestic market (international services being mostly excluded from the new fees) and because US Airways has enthusiastically embraced a la carte pricing strategies this year. It has gone a step further than its peers with programmes such as "Choice Seats", which allow customers to reserve a window or aisle seat for a fee.

Domestic capacity reductions

Most importantly, US Airways has decisively addressed earlier concerns about its liquidity position. With the help of old trusted business partners (Airbus, GE Capital, etc.), it has raised a staggering $1.2bn in additional liquidity since July. In June, in response to the unprecedented spring/early summer run–up in fuel prices, US Airways joined its peers in announcing a sizeable pull–back of domestic service this autumn. Current plans see domestic mainline capacity declining by 6- 8% in the fourth quarter and by 8–10% in 2009, while regional capacity will fall by 1- 3% and 5–7% in those periods. International ASMs will down by a modest 1–3% in the fourth quarter, followed by 9–11% growth next year. The cuts have resulted in 2,200 job reductions across the board (6.5% of the workforce), which were implemented in the third quarter through a combination of voluntary and involuntary furloughs and attrition.

The first phase of fleet reductions involved returning to lessors 10 aircraft (six 737–700s this year and four A320s in first–half 2009) and cancelling leases on two A330–200s that US Airways was due to receive from ILFC in the second half of next year. There will be further fleet reductions in 2009 and 2010.

The cuts have focused on the Las Vegas hub, where US Airways closed most of its night operation in early September. Daily departures there are reduced from 141 a year ago to 77 by year–end. The move was not related to Virgin America’s recent inroads; rather, the Las Vegas night operation was US Airways' lowest–RASM flying and the revenues no longer exceeded the incremental cost. The Las Vegas cuts follow serious downsizing at the Pittsburgh hub in recent years. This time, US Airways has also closed certain uneconomic airport lounges and cargo stations and removed its in–flight entertainment system from domestic aircraft (to save $10m annually in fuel expenses through reduced weight). This year’s planned non–aircraft capital spending has been slashed by $90m to $225m. US Airways is maintaining "critical operational projects" such as cabin and airport club refurbishments and investments in check–in kiosks and new technology.

US Airways' domestic capacity reduction has been smaller than the double–digit (even 20%) cuts implemented by its legacy peers. This is mainly because US Airways leases 95% of its aircraft and negotiating out of those contracts would have been cash–negative in the near term.

US Airways also has contractual impediments in its pilot agreement that prevent significant further fleet downsizing; it must maintain a certain minimum number of mainline aircraft. It was not a limiting factor this year but could mean reduced flexibility to respond to a severe downturn.

Of course, US Airways still has significant numbers of old–generation 737s in the fleet — some 70 737–300/400s at the end of 2008, down from 87 a year ago. The 737s are being gradually retired upon lease expiration and as A320s are delivered. At year end, the A319/320/321 fleet will total 201 and there are 97 firm orders or commitments.

New revenue initiatives

If additional capacity cuts become necessary, US Airways has the ability to sell its 25 owned E–190s, which are flown as mainline aircraft. The airline could also further reduce daily aircraft utilisation by perhaps 3- 4%. Some of the 300–plus regional aircraft in the Express carrier fleets could also be grounded. US Airways has moved to develop ancillary revenues more aggressively than any of the other top 10 US carriers this year. In addition to first and second checked bag fees, call centre fees and FFP award processing fees (all of which have become quite commonplace in the US this year), the airline has begun charging for advance seat selection, soft drinks in domestic coach class, pillows, blankets, headsets, etc. These programmes have been highly successful and are now expected to generate $400–500m of additional annual revenue, up from initially estimated $100m, at no material cost.

US Airways has had no large operational issues and no observed market share impacts, even in markets where it competes directly with Southwest (which is at the other extreme and has a rather clever "Freedom from Fees" advertising campaign).

Furthermore, US Airways has found that the new strategies have created a cleaner and more consistent product. First, the bag fees have led to a 25% reduction in total checked bags, which has improved on–time and baggage handling performance. Second, charging for soft drinks has resulted in only 25% of customers buying drinks which, according to the management, has created a "much calmer and more efficient" cabin environment. Previously 90% of the customers took a drink because it was free, resulting in logjams on the aisle, lines for restrooms and the need to collect large volumes of rubbish. With the à $1 products, US Airways is better able to fulfil its raison d'etre, which is to "get people where they want to go, on time, with the minimum amount of hassle and with their bags".

International expansion

Consequently, the à $1 offerings are being expanded. The "Choice Seats" programme now covers 25% of the main cabin (rather than just a few rows) and by year end will be available at all airport kiosks and ticket counters (rather than only at web check–in). More initiatives, particularly related to charging for premium seats, will be rolled out next year. US Airways has not grown its widebody fleet since the merger but has still managed to expand in Europe with its 10 767s and nine A330–300s. 2006 and 2007 saw the addition of Milan, Athens, Zurich and Brussels, as well as seasonal flights to Stockholm, Lisbon, Shannon, Venice, Barcelona and Glasgow, and Heathrow followed in March 2008. Most of the new service has been from Philadelphia.

Building an international franchise is a top priority for US Airways, because international service has proved lucrative for the other large US carriers in recent years and is seen as a good way to diversify risk. With currently only 24% of it mainline ASMs derived outside North America, US Airways has a lot of catching up to do with the rest of the industry.

Last year saw US Airways move into a higher gear on that front. The airline added some A330 orders, announced that it would be adding three or four new international markets per year in 2009–2011, applied to extend the network to South America (Bogota, Colombia) and Asia (Beijing) and reaffirmed its commitment to the A350.

There have been some setbacks: the Bogota application was turned down by the DOT, and, like other US carriers, US Airways had to delay its planned China service by a year due to weak market conditions (Philadelphia–Beijing is now expected to start in March 2010). But, with the longer–range A330–200 deliveries starting in 2009, the stage has been set for a new international growth phase and expansion further afield. To start with, US Airways is launching its first route to the Middle East, Philadelphia–Tel Aviv, in July. Next summer’s plans also include new seasonal service to Birmingham (UK) and Oslo, with 757ETOPs.

As of the October 23 third–quarter earnings conference call, international demand had remained strong but US Airways was closely monitoring the situation. In the event of a slowdown (which some other US airlines have detected), US Airways could reduce frequencies or move some 757s back to domestic flying.

There is much flexibility in the fleet plans. The 15 A330–200s currently on firm order will provide for growth and facilitate the retirement of the 767 fleet. But they can also be converted to the larger, shorter–haul A330–300s or A340s (which might be the preferred aircraft for the China service).

The liquidity situation

US Airways' A350 orders total 22 and include both 800- and 900–series models. Deliveries are now expected to begin in 2015 and continue through 2018. The aircraft can be used for modest international expansion or replacement, eventually forming the single intercontinental fleet type for US Airways. The A350 will open up new profitable markets across the globe. US Airways envisages eventually operating intercontinental service also from its West Coast hubs. US Airways is fortunate in that it got a major liquidity–raising effort under way in mid–August, a month before the turmoil began in the global financial markets. The company has raised $1.2bn in additional cash, financings, liquidity commitments and partner support. It is all the more impressive that most of those transactions closed in October and some $150m remain on target to be completed by year–end.

To start with, US Airways raised $179m in a public equity offering in mid–August, taking advantage of a month–long slide in oil prices. The $790m of transactions that closed in October included a $200m pre–purchase of frequent–flyer miles by credit card partner Barclays, $355m of new (mostly GE Capital–administered) loans secured by aircraft and spare engines, a $200m cash advance from Airbus (related to US Airways' October 2007 purchase agreement; the details are confidential) and $35m in loans from regional partner Republic.

US Airways used $400m of the October proceeds to partially prepay a $1.6bn syndicated loan. As a result, the unrestricted cash covenant on that loan was reduced from $1.25bn to $850m. The remaining $370m of the net proceeds went to boost the cash position.

These liquidity–raising moves were important for two reasons. First, they provided a comfortable cushion against the term loan’s covenant, removing a near–term risk of default. US Airways' unrestricted liquidity had been only $250m above the covenant; now the cushion is well over $1bn.

Second, the transactions improved US Airways' cash position. When oil prices peaked in July, some Wall Street analysts had considered US Airways one of likeliest Chapter 11 candidates in 2009 because of its below–peer cash reserves and poorer capital–raising potential (lack of non–core assets, few unencumbered aircraft, etc.). The airline ended the third quarter with one of the weakest cash positions among the large network carriers: $2.28bn of total cash and marketable securities, of which $1.54m was unrestricted. After the October transactions, total cash amounted to $2.65bn, which, at 22% of lagging 12- month revenues, was the best among the large network carriers. However, in terms of unrestricted cash ($1.9bn or 15.9% of revenues) — arguably a more appropriate measure — US Airways was in the middle of the pack.

That middle position is not so comfortable when considering that all the other legacy carriers have much better remaining liquidity raising options. Furthermore, US Airways' fuel hedges are seriously out of money; if oil prices remain at the $70 level, the airline expects to have to post another $275m in collateral (on top of the current $159m) at hedge counterparties at year end. (US Airways did suspend its fuel hedging programme in the third quarter and is currently only 14% hedged for 2009.)

Prospects

On the positive side, the dramatic decline in fuel prices has significantly improved the liquidity risk for all US carriers. US Airways does not have any material debt payments until 2014. While aircraft capital spending will increase next year, all of its aircraft are financed through mid–2009. Like most other US carriers, US Airways will report a steep loss for 2008 but is poised to return to profitability in 2009, as long as oil prices do not return to the $100- plus range. The maths are very simple: Each $1 decline in the price of oil per barrel translates into a $35m improvement to US Airways' bottom line. So a decline from the July peak of $147 to $97 would bring in $1.75bn, or a decline to $70 would be worth $2.7bn. CEO Doug Parker noted in the late- October conference call that, given the magnitude of the oil price decline, "it would take a truly unprecedented decline in demand to overcome the impact of oil".

The industry’s 10% domestic capacity reduction in the current quarter is expected to result in a strong RASM environment. Over the winter, the domestic market is certainly likely to outperform the international market (which always tends to be hit harder in a recession anyway), and US Airways is well positioned to benefit from that.

The current (November 3) consensus estimate for US Airways is a profit of $2.14 per share, or about $240m, on revenues of $12.35bn in 2009, following from a loss of $7.42 per share ($740m) this year. However, given the volatility in fuel prices and all the economic uncertainty, the range in individual analysts' estimates is rather wide: from a marginal loss to a profit of over $900m in 2009. Calyon Securities' $2.89 EPS forecast (introduced in late October and slightly higher than the current consensus) assumes the WTI oil price averaging $71.50 in 2009 (Credit Agricole Group’s forecast, recently lowered from $96.50).

US Airways' challenges include completing the AWA integration by getting joint contracts in place with the two pilot and flight attendant groups. The top executives stressed recently that the company wants to get single contracts "because it is the right thing to do". US Airways expects the pilot contract to ultimately increase its costs by $120m annually, compared to a financial benefit of around $10m.

Oddly enough, despite being one of the strongest proponents of industry consolidation, US Airways has been almost sidelined in the latest round of link–ups between the legacy carriers. After being spurned by Delta (January 2007) and United (May 2008), US Airways now finds itself playing third wheel on the US side of the Star alliance, which will be dominated by United and Continental. However, Parker said recently that Continental’s future entry to Star was "probably a slight positive" for US Airways, making it more likely that US Airways stays in Star for a long time. But domestically, as the smallest of the network carriers, US Airways undoubtedly still hopes to gain strength through a merger at some point.