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United Airlines From Here
BTC Travel blog / June 18, 2002
by Vaughn Cordle
Gary Chase's (Lehman Bros.) point about the positive effects of United pulling down capacity from an
industry's perspective is correct. From United's or any network airline's perspective, shrinking is a
very bad idea for a number of reasons including the fact that relative costs increase. Negative growth
means that the airline is basically dying and it is hard to make the investment case for a business
that has a negative return on retained earnings. Cyclical adjustments in capacity are normal, but this
is not the case with the legacy airlines. They are in a secular decline and they cannot survive unless
they bring down costs significantly.
Weighted average CASMs for the legacies are 33% higher than the weighted average of the LCC’s,
but RASMs are only 24% higher. Like Dan Kasper (LECG), I believe the fare premiums must be
lowered to a 10 to 12% premium. This implies that the CASM differential must be cut in half.
Capacity growth above a certain equilibrium growth rate is a zero-sum game. Those with negative
equity and negative cash flows will have no choice but to cede market share to those that have the
capability to grow fast. Maintaining adequate cash levels is critical and capital is prohibitively
expensive for those with negative returns and negative equity.
If the airlines do not have the potential to provide the required returns, it's best to wind down
operations and distribute the proceeds to the creditors who really own the airlines. Moreover, many of
the airlines are dying businesses because they do not have the capacity to properly reinvest in their
competitive resources. They have negative growth because they cannot finance growth through
internal or external means. And, because they must maintain liquidity, this means that profitable
pruning or selling assets may be the only options available - unless labor costs come down.
The airlines with the positive economic spreads and access to capital can grow as fast as they can
manage the growth. Airlines like Frontier are structuring their aircraft leases in a way that understates
true costs. They do this with large balloon payments at the end of the lease terms. Strategically, this
makes perfect sense because it allows faster growth in the short and intermediate term, and, it's the
fast growth that will force its higher cost competitors to cede market share. The danger with this type
of bold strategy and creative financing is that it could backfire if the higher cost competitors do not pull
back capacity. Too much capacity pushes down yields and lower yields means less revenue to cover
the large balloon payments that will have to be eventually financed. If Frontier's higher cost
competitors retreat, they win. If its competitors restructure costs and do not retreat or become more
competitive, Frontier is in trouble.
ATA's growth strategy is flawed because they have been growing above their long-run sustainable
rate. This has resulted in an over leveraged balance sheet, poorly rated debt, and high capital costs.
It's hard to believe that they can stay out of bankruptcy and it appears that they do not have a proper
understanding of how to best manage their balance sheet and growth. They are an example of a
dumb competitor who competes in manner that destroys value for their investors and the industry.
Southwest, Jetblue, and Airtran are smart competitors and they will take market share from the
legacies. AMR, DAL, NWAC, USAir, and United have been dumb competitors also because they
invest in negative return capacity at levels that destroy pricing power. The airlines with the highest
labor costs – in all of its forms – have had the most liberal accounting policies. This allowed capacity
growth above long term sustainable growth rates and this explains, in large measure, why they have
negative equity balances and prohibitively high capital costs.
Gary's comment about the need to lower non-labor costs is valid, but only to a certain point.
Unfortunately, the magnitude of the cost reductions required at the legacy airlines is such that the
ability to reduce (and in terms of the level of) any potential non-labor cost savings pales in
comparison to the labor cost reductions that will have to take place for these airlines to survive. It's
not the wage and benefits of the working employees that is the problem, it's the costs of supporting
large retiree populations, and the cash required to close a $20 billion pension funding gap that gets
to the heart of the cost disadvantage. For the DB airlines, this works out to be almost $3b a year
through 2008.
A liquidation of USAir and United will not help the other legacy airlines. The bulk of the capacity will
remain in the system in the form of significantly lower cost capacity. It's hard to build a case that USAir
can survive. United is different because of its superior route structure. I'm of the opinion, and have
been saying for some time, that it will take a real liquidation threat to force the needed changes at
United. It would appear that management did not understand the magnitude of the problem. Agreeing
to give the unions an ownership stake in the post-bankruptcy company based on 100 cents on the
dollar of concessions is a strategic mistake. Half of those concessions are a function of past
featherbedding and payroll padding. Any potential post bankruptcy value will be only a fraction of the
concessions and pension deficit claim against the company. This is the real reason no outside
equity is available to United. Moreover, the unsecured creditors’ claim may not be realistic in view of
what will happen as a result of a NO vote by the ATSB.
In my view, the ATSB has rendered the correct decision in the case of United. United Airlines does in
fact have access to private capital, but not with the current reorganization plan. What was left unsaid
is that this access is contingent upon a second restructuring of costs. Those costs include (deficit
reducing) pension cash contributions and net pension expense. If United is to return to health, it will
have to terminate the DB plans and reduce operating costs. DB plans can be replaced with additional
defined contribution plans (DC). My work suggests that it will take an additional 10% or $500 mm cut
in labor costs AND a termination of the DB plans. Terminating the DB plans will save the company an
additional $500 mm a year in net expenses and on average $820 mm a year in cash contributions. If
this were to happen, the income statement savings will be $1b, which includes the additional costs
of new DC plan contributions. The company will report approximately $800m-$1b in operating losses
and perhaps $1.3 billion in net losses this year. With slightly higher revenue growth - combined with
already underway cost saving initiatives - the company should break-even on operating bases in
2005. By lowering costs an additional $1b a year, the company can retain $400 or so in net earnings.
This is a good point estimate for the level of GAAP earnings required to build up equity and to attract
equity capital that can provide exit financing. These numbers are ball park estimates and will vary
depending on the actual variances in fuel costs and revenue.
It would be a strategic mistake for United to pull down capacity too far and its long term survival is
depended upon maintaining the integrity of its network. Labor will cooperate if an effective
communication strategy is developed and once they understand that the alternative to lowering costs
to proper levels is liquidation. Inadequate cost reduction in the short term simply results in a drawn
out liquidation. Short term liquidation is a real threat because cash levels will be at unsustainable
levels by this winter. My work suggests that restricted cash will be close to $700 by the end of the
year. It was interesting to see that J. Higgins estimated cash level to be $800. $2.3 billion is a
minimum level in my view. This implies that the company must come up with at least $1.5 billion in
external and/or internal financing.
The choice for labor may come down to a choice between liquidation or DB plan termination. Selling
assets and pulling down capacity to generate cash will be insufficient because this will not generate
the cash need to keep the company solvent. United needs outside capital to remain liquid and to exit
bankruptcy, but no capital will be available as long as the potential post-bankruptcy market value is a
fraction of the employees' and creditors’ claims. Reducing that total claim and lowering annual
expenses by approximately $1b will do the trick and this will be required to attract exit financing.
The unions’ behavior over the coming weeks and months will determine if United can survive. Risk is
a function of uncertainty and labor's response to the needed cost reductions will be factored into the
risk profile of the airline. In other words, if they act irrational, the capital costs will be higher than it
needs to be and this will be a factor in what happens next. Communication is the key, but there may
not be enough time for the current management to get the job done because the employees have not
been properly prepared for what will happen next. The unions have been in denial in terms of what it
really takes to fix United.
The bottom line: United and the legacies cannot invest in growth until they earn their cost of capital. If
the cannot, they will continue to lose market share and eventually go out of business. Time for a
reality check and it's time for the unions to cut out the silly rhetoric.
The unions and labor will decide whether or not United survives. If they wait too long, the game is
over.
BTC Travel blog / June 18, 2002
by Vaughn Cordle
Gary Chase's (Lehman Bros.) point about the positive effects of United pulling down capacity from an
industry's perspective is correct. From United's or any network airline's perspective, shrinking is a
very bad idea for a number of reasons including the fact that relative costs increase. Negative growth
means that the airline is basically dying and it is hard to make the investment case for a business
that has a negative return on retained earnings. Cyclical adjustments in capacity are normal, but this
is not the case with the legacy airlines. They are in a secular decline and they cannot survive unless
they bring down costs significantly.
Weighted average CASMs for the legacies are 33% higher than the weighted average of the LCC’s,
but RASMs are only 24% higher. Like Dan Kasper (LECG), I believe the fare premiums must be
lowered to a 10 to 12% premium. This implies that the CASM differential must be cut in half.
Capacity growth above a certain equilibrium growth rate is a zero-sum game. Those with negative
equity and negative cash flows will have no choice but to cede market share to those that have the
capability to grow fast. Maintaining adequate cash levels is critical and capital is prohibitively
expensive for those with negative returns and negative equity.
If the airlines do not have the potential to provide the required returns, it's best to wind down
operations and distribute the proceeds to the creditors who really own the airlines. Moreover, many of
the airlines are dying businesses because they do not have the capacity to properly reinvest in their
competitive resources. They have negative growth because they cannot finance growth through
internal or external means. And, because they must maintain liquidity, this means that profitable
pruning or selling assets may be the only options available - unless labor costs come down.
The airlines with the positive economic spreads and access to capital can grow as fast as they can
manage the growth. Airlines like Frontier are structuring their aircraft leases in a way that understates
true costs. They do this with large balloon payments at the end of the lease terms. Strategically, this
makes perfect sense because it allows faster growth in the short and intermediate term, and, it's the
fast growth that will force its higher cost competitors to cede market share. The danger with this type
of bold strategy and creative financing is that it could backfire if the higher cost competitors do not pull
back capacity. Too much capacity pushes down yields and lower yields means less revenue to cover
the large balloon payments that will have to be eventually financed. If Frontier's higher cost
competitors retreat, they win. If its competitors restructure costs and do not retreat or become more
competitive, Frontier is in trouble.
ATA's growth strategy is flawed because they have been growing above their long-run sustainable
rate. This has resulted in an over leveraged balance sheet, poorly rated debt, and high capital costs.
It's hard to believe that they can stay out of bankruptcy and it appears that they do not have a proper
understanding of how to best manage their balance sheet and growth. They are an example of a
dumb competitor who competes in manner that destroys value for their investors and the industry.
Southwest, Jetblue, and Airtran are smart competitors and they will take market share from the
legacies. AMR, DAL, NWAC, USAir, and United have been dumb competitors also because they
invest in negative return capacity at levels that destroy pricing power. The airlines with the highest
labor costs – in all of its forms – have had the most liberal accounting policies. This allowed capacity
growth above long term sustainable growth rates and this explains, in large measure, why they have
negative equity balances and prohibitively high capital costs.
Gary's comment about the need to lower non-labor costs is valid, but only to a certain point.
Unfortunately, the magnitude of the cost reductions required at the legacy airlines is such that the
ability to reduce (and in terms of the level of) any potential non-labor cost savings pales in
comparison to the labor cost reductions that will have to take place for these airlines to survive. It's
not the wage and benefits of the working employees that is the problem, it's the costs of supporting
large retiree populations, and the cash required to close a $20 billion pension funding gap that gets
to the heart of the cost disadvantage. For the DB airlines, this works out to be almost $3b a year
through 2008.
A liquidation of USAir and United will not help the other legacy airlines. The bulk of the capacity will
remain in the system in the form of significantly lower cost capacity. It's hard to build a case that USAir
can survive. United is different because of its superior route structure. I'm of the opinion, and have
been saying for some time, that it will take a real liquidation threat to force the needed changes at
United. It would appear that management did not understand the magnitude of the problem. Agreeing
to give the unions an ownership stake in the post-bankruptcy company based on 100 cents on the
dollar of concessions is a strategic mistake. Half of those concessions are a function of past
featherbedding and payroll padding. Any potential post bankruptcy value will be only a fraction of the
concessions and pension deficit claim against the company. This is the real reason no outside
equity is available to United. Moreover, the unsecured creditors’ claim may not be realistic in view of
what will happen as a result of a NO vote by the ATSB.
In my view, the ATSB has rendered the correct decision in the case of United. United Airlines does in
fact have access to private capital, but not with the current reorganization plan. What was left unsaid
is that this access is contingent upon a second restructuring of costs. Those costs include (deficit
reducing) pension cash contributions and net pension expense. If United is to return to health, it will
have to terminate the DB plans and reduce operating costs. DB plans can be replaced with additional
defined contribution plans (DC). My work suggests that it will take an additional 10% or $500 mm cut
in labor costs AND a termination of the DB plans. Terminating the DB plans will save the company an
additional $500 mm a year in net expenses and on average $820 mm a year in cash contributions. If
this were to happen, the income statement savings will be $1b, which includes the additional costs
of new DC plan contributions. The company will report approximately $800m-$1b in operating losses
and perhaps $1.3 billion in net losses this year. With slightly higher revenue growth - combined with
already underway cost saving initiatives - the company should break-even on operating bases in
2005. By lowering costs an additional $1b a year, the company can retain $400 or so in net earnings.
This is a good point estimate for the level of GAAP earnings required to build up equity and to attract
equity capital that can provide exit financing. These numbers are ball park estimates and will vary
depending on the actual variances in fuel costs and revenue.
It would be a strategic mistake for United to pull down capacity too far and its long term survival is
depended upon maintaining the integrity of its network. Labor will cooperate if an effective
communication strategy is developed and once they understand that the alternative to lowering costs
to proper levels is liquidation. Inadequate cost reduction in the short term simply results in a drawn
out liquidation. Short term liquidation is a real threat because cash levels will be at unsustainable
levels by this winter. My work suggests that restricted cash will be close to $700 by the end of the
year. It was interesting to see that J. Higgins estimated cash level to be $800. $2.3 billion is a
minimum level in my view. This implies that the company must come up with at least $1.5 billion in
external and/or internal financing.
The choice for labor may come down to a choice between liquidation or DB plan termination. Selling
assets and pulling down capacity to generate cash will be insufficient because this will not generate
the cash need to keep the company solvent. United needs outside capital to remain liquid and to exit
bankruptcy, but no capital will be available as long as the potential post-bankruptcy market value is a
fraction of the employees' and creditors’ claims. Reducing that total claim and lowering annual
expenses by approximately $1b will do the trick and this will be required to attract exit financing.
The unions’ behavior over the coming weeks and months will determine if United can survive. Risk is
a function of uncertainty and labor's response to the needed cost reductions will be factored into the
risk profile of the airline. In other words, if they act irrational, the capital costs will be higher than it
needs to be and this will be a factor in what happens next. Communication is the key, but there may
not be enough time for the current management to get the job done because the employees have not
been properly prepared for what will happen next. The unions have been in denial in terms of what it
really takes to fix United.
The bottom line: United and the legacies cannot invest in growth until they earn their cost of capital. If
the cannot, they will continue to lose market share and eventually go out of business. Time for a
reality check and it's time for the unions to cut out the silly rhetoric.
The unions and labor will decide whether or not United survives. If they wait too long, the game is
over.
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