US Airways: Legacy carrier to LCC? May 2004

S&P’s recent decision to downgrade US Airways' credit ratings is only the latest in a series of challenges facing the struggling carrier. As a result, US Airways is in danger of losing some of its RJ financings because its corporate credit rating (CCC+) is now one notch below the minimum stipulated by its deal with GECAS.

The downgrade was based on the "difficult challenge faced by US Airways as it seeks to rapidly lower its operating expenses in response to mounting pressure from low–cost competitors". S&P noted that failure to secure further substantial labour concessions over the next several quarters could force US Airways to undertake significant asset sales and/or file for bankruptcy a second time.

As an indication of decreased confidence that US Airways would be able to reorganise successfully in a second Chapter 11 visit, the ratings on most of the company’s EETCs were downgraded by more than one notch.

However, the chances are that US Airways will not lose the RJ financing commitments.

GECAS is expected to waive or amend the covenants — after all, it has extensive interests at stake ($2.7bn exposure to US Airways through leases and loans).

In a worst–case scenario, US Airways could transfer some of the RJ orders to an affiliate like Mesa, which has publicly expressed strong interest in acquiring assets that could be operated in partnership between the two airlines. Despite the pay cuts taken in 2002 and 2003, in late February US Airways' pilots agreed (in principle) to negotiations on a comprehensive package of new concessions.

All of the unions have indicated that they will work with Bruce Lakefield, who was appointed CEO after David Siegel’s resignation last month.

Also, in mid–March the ATSB again came to the rescue by granting US Airways covenant relief on its government–guaranteed loan, in return for the carrier prepaying $250m of the $1bn loan. The revised covenants reduced the minimum unrestricted cash requirement to $700m or the ATSB loan balance, though they still require US Airways to reduce losses significantly this year and return to profitability in 2005.

The ATSB also lifted certain restrictions on US Airways' ability to raise funds through assets sales. However, it has to be noted that the agency would probably like to defer any loan defaults beyond November’s presidential election.

All of this illustrates that US Airways continues to get a lot of help from its stakeholders and partners. Given its $978m unrestricted cash reserves, the peak summer season and modest cash obligations in 2004, it does still have time to get its house in order.

Essentially, US Airways' stakeholders and partners are looking for the management to produce just one thing — something that has eluded this airline for many years: a viable long–term business plan.

In recent weeks US Airways has, first, staged a leadership shakeup to bolster confidence in the management team — in addition to the CEO change, CFO Neal Cohen stepped down and was replaced by SVPfinance Dave Davis. Second, US Airways' board quietly endorsed another major restructuring, known as "the transformation plan".

Based on US Airways executives' comments in the company’s first–quarter earnings conference call on April 27, nothing much has changed in terms of financial targets and assumptions. The previous plans called for an ambitious 25% reduction in ex–fuel CASM (see Aviation Strategy, March 2004).

However, the new plan incorporates more drastic changes to the business model, at least in new competitive hot spots like Philadelphia, as well as hub and route restructuring. Also, the plan appears to be a work in progress, giving unions a chance to influence strategy.

The intention is to respond aggressively to Southwest in Philadelphia. The low–fare airline has reported overwhelming passenger response to the services that start on May 9 and has decided to double the frequencies in early July. Southwest expects Philadelphia to be a "very large, fast, high–growth market", at least matching Baltimore.

US Airways executives talked of "rebuilding the airline to carry more passengers at reduced yield". In other words, they are counting on the famous "Southwest effect", whereby traffic in a market triples or quadruples within 1–2 years of the low–fare carrier’s entry, benefiting all airlines. This may sound like putting a favourable spin on a disastrous development, but all it means is that there will be plenty of traffic for US Airways if it gets a cost structure than can sustain $29 or $49 fares.

Strategy implications

Implications for strategy are, first, upward pressure on aircraft size. On the RJ side, where much of the growth now focuses, the executives said that US Airways will be looking to add more 70–seaters rather than 50- seaters.

Second, US Airways is looking to de–peak operations at Philadelphia, to make it into a "rolling hub". It is worth noting that airlines like American have derived great benefits from hub de–peaking in recent years.

Third, US Airways plans to restructure its network to carry more local passengers at key East Coast cities like Philadelphia, New York and Boston — in other words, become less dependent on connecting traffic.Since the first–quarter call, US Airways has told its employees that it expects to downsize Pittsburgh from a hub to a "focus city", starting this autumn. Philadelphia will remain a hub for transatlantic flights and Charlotte for Caribbean services.

US Airways has announced a simplified low–fare structure for the 13 Philadelphia routes that will see Southwest service this summer. In JP Morgan analyst Jamie Baker’s analysis, the fares are "technically price–competitive with Southwest walk–up levels" (drastically lower than the previous fares) but US Airways also maintains two or three higher price categories, plus first class fares.

Baker observed that the new fares merely represent a reaction, rather than broader fare reform. However, he expects US Airways to "take a more proactive approach to fare reform in the future, potentially damaging industry revenue trends along the way".

US Airways has not yet commented on the possible implications for its fleet strategy. In early 2003 it rejected many A320 leases and orders, in favour of acquiring more A330s and placing orders for 170 RJs.

The current firm mainline order book includes only 18 A320- family aircraft and ten A330s for delivery in 2007–2009.RJs are important for US Airways because it serves numerous small or mid–sized cities. As the top executives noted, "ultimately, what drives profitability is flying rightsized aircraft for a particular market".

The margin results have been impressive when RJs have replaced mainline jets in smaller markets. However, the latest developments would seem to put a question mark over the strategy of relying so heavily on RJ growth. Given the desire to compete head–on with Southwest in large markets and the need to cut unit costs drastically, would US Airways not be better off focusing on 150–seaters?

Of course, were the management to raise the issue of mainline fleet growth in the context of labour negotiations, it could only help the prospects for securing concessions.

Another question is whether US Airways might be casting its net too wide. Catering for every possible market segment may make sense for global carriers like American and United, but could a niche–type operator with a limited network pull it off? US Airways is evidently pinning much hope on the Star alliance, which it formally joined on May 4, but could it be both a Star partner and an LCC catering primarily for local traffic?

Getting CASM down by another 25% in the wake of a Chapter 11 restructuring would be an unbelievable feat for any airline. Deep down, few in the industry hold out much hope for the carrier.

But could its disappearance help the rest of the industry in terms of capacity reduction and long–term profit potential? In UBS analyst Sam Buttrick’s estimates, US Airways' liquidation would not have any meaningful beneficial impact on the industry’s long–term profitability.

The short–term impact would, of course, be significant in terms of the distribution of revenues and profits.