Could Chapter 11 solve the US legacy crisis? October 2005

The US Chapter 11 process has long been blamed for keeping excess airline capacity in the domestic system and for preventing industry consolidation. However, Delta’s and Northwest’s initial moves in bankruptcy and the successful completion of the US Airways/America West merger suggest that Chapter 11 may in fact help solve some of the industry’s problems.

It is hard for airlines to shrink in size significantly when they are stuck with aircraft (through long–term operating leases or debt financing obligations). The Chapter 11 process enables them to get rid of unwanted aircraft, thus facilitating a sizeable capacity reduction if desired.

Both Delta and Northwest have moved promptly to cut capacity since their simultaneous Chapter 11 filings in mid–September. This is perhaps not surprising in light of the current fuel environment, which has forced even a solvent carrier like American to temporarily cancel 15 flights in high–frequency domestic markets this month to save money. However, the scale of the initial domestic "right–sizing" announced by Delta and Northwest has impressed many industry observers.

Delta is cutting its domestic mainline capacity by 15–20% in 2006. It will right–size domestic hubs and increase point–to–point flying. The airline has rejected leases on 40 mainline aircraft and plans to shed an additional 80–plus mainline aircraft by the end of 2006. This will simplify Delta’s fleet from 11 to seven mainline types.

However, Delta still plans to increase its international capacity by 25% in 2006 "to pursue routes with greater profit potential". Its winter schedule adds new or expanded service to 41 international destinations. This will include major expansion to Mexico and new Atlanta–Tel Aviv and Atlanta–Copenhagen routes in the spring. Northwest has so far outlined plans to reduce domestic mainline capacity by 10% and international ASMs by 4–5% in the current quarter. Additional schedule reductions in January will cut first–quarter system mainline ASMs by 11–13%. The airline has talked about an eventual reduction of 15% or more, which nevertheless would have only minimal impact on the three domestic hubs.

CEO Doug Steenland explained the strategy to the bankruptcy court as follows: "Northwest will become a smaller airline to compete successfully in a world where fuel may continue to be priced at $60 per barrel or more and refining costs are at record levels.

Routes that might have been commercially viable with oil at $40 per barrel are not profitable at $60 per barrel or higher. Moreover, a number of aircraft in our fleet have above–market lease rates." Although specific plans have not yet been disclosed, Northwestcan be expected to continue to focus on international flying. In the Chapter 11 filing, CFO Neal Cohen described the airline’s Pacific routes as one of its most valuable assets.

Northwest began its fleet restructuring by returning seven aircraft, and it has identified 100–plus additional aircraft as candidates for return. Somewhat surprisingly, that includes 50 Northwest–owned or leased regional jets operated by two regional partners.

Northwest has already notified Pinnacle and Mesaba that it will remove 15 CRJs and 35 AVRO RJ85s from their respective fleets. The airline has told its creditors that it wants to establish a new subsidiary that would operate 70–100 seat RJs.

US Airways and America West, which completed their merger on September 27 (when US Airways also emerged from its Chapter 11 reorganisation), are in the process of shrinking their combined mainline fleet by 59 aircraft. That will constitute a useful 15% capacity reduction.

Furthermore, US Airways (as the combination is now known) has chosen not to have any commitments to grow in the next couple of years, as the company focuses on integrating the two cultures. Washington/Dulles–based Independence Air, a small carrier that has been highly disruptive with its steep price–discounting on the East Coast, has announced plans to cut a third of its flights by the end of October, in an effort to save money and avoid bankruptcy. The airline is reducing its daily flights from 350 to 230 by eliminating all West Coast destinations except Las Vegas, as well as six cities in the East. Some 600 of the 3,400 workers will be laid off this month.

All the indications are that Independence Air’s parent FLYi will run out of cash and file for Chapter 11 in the current quarter. Unlike the legacy carriers, FLYi is probably also headed for liquidation, which would further help the capacity situation on the East Coast.

In its latest global capacity report, OAG noted that US airlines scheduled 2% fewer domestic flights for October than a year earlier, while international flights rose by 4%. The largest declines are at Washington/Dulles (25%) and Dallas Ft. Worth (12%), reflecting capacity cuts by Independence Air and Delta.

The combination of reduced capacity and relatively robust demand has led to an improved domestic pricing environment — something that has been evident since the spring. If fuel prices remain at the current levels, further domestic capacity reductions are likely — also by the solvent legacy carriers like American and Continental — which would further improve the revenue picture.

The strongest LCCs are, of course, expected to continue growing as they take advantage of opportunities that arise from the legacies' cutbacks. AirTran anticipates growing ASMs by 25% in 2006. JetBlue has just announced major service expansion from JFK, including plans to introduce the first new 100–seat E190s on the New York- Boston route. JetBlue is taking one new E190 every 20 days, plus 16 new A320s in 2006.

JP Morgan analyst Jamie Baker estimated in an early–October research note that total US domestic industry capacity would decline by at least 2% in 2006, driven by a 6.6% reduction by the eight largest carriers and Independence Air. Internationally, capacity is likely to grow by 6.2%, down only slightly from 2005’s 9%. In Baker’s estimates, thanks to the favourable capacity trends, domestic unit revenue (RASM) growth in 2006 could exceed this year’s anticipated 6.5% and possibly top 10%. The main gains are expected to be on the East Coast, driven by estimated capacity declines at Delta (15%), US Airways (5%) and Independence (100%). Baker expects international RASM to be flattish next year.

Facilitating mergers ?

In addition to the Chapter 11 process helping airlines shed capacity, there is a school of thought that it will facilitate more mergers along the lines of US Airways/America West. As US Airways’ CEO Doug Parker explained at a recent Wings Club lunch, "the bankruptcy process allows things to happen that will be friendly to consolidation".

As well as removing aircraft and capacity (to avoid duplication and permit synergies), Chapter 11 can reduce high legacy labour costs, as happened with US Airways. In other words, the Chapter 11 process can be used to prepare and transform a high–cost legacy carrier into an attractive, or at least lower–risk, merger target.

Many people in the industry, including Parker, are convinced that Washington regulators have "airline fatigue". After telling the industry for quite some time that airlines must fix themselves and not expect any more assistance, in the end the regulators will have little choice but to allow mergers. Merrill Lynch analyst Michael Linenberg suggested such a scenario for Delta immediately after its Chapter 11 filing: "We would not be surprised if down the road Delta borrows a page from the America West/US Airways playbook and emerges from bankruptcy in the form of a merger. That would be one way of achieving airline consolidation — an objective that has eluded the industry for years."