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PlaneBusiness
Holly Hegeman, Editor
http://www.planebusiness.com
June 22, 2004
One of my complaints with the previous ATSB loan application by United was that I do not
believe United Airlines has stripped enough of the costly "padding" the airline continues to lug
around from its underlying structure. The airline simply has not cut its cost structure sufficiently
to survive. And no amount of money thrown at the current structure is going to help the
underlying problem. Until that underlying cost issue is addressed, any money given to the
airline is wasted.
Over the last couple of weeks, many analysts have talked about how the worst that could
happen to United, if it did not receive the ATSB guarantee, is that the airline would be forced to
"shrink" more, while working out a new, and no doubt, more expensive equity infusion.
Vaughn Cordle, CFA, and president of Airline Forecasts, has followed the airline's continued
financial decline closely for the last several years.
Last week, he not only put his observations about United down on paper, but he talked about
other airlines as well. I think he makes some excellent points.
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 dying business. 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. As a result, I believe that 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 capacity to grow fast. Maintaining adequate cash levels is critical and capital is
prohibitively expensive for those with negative rates of return and negative equity. It makes no
sense to invest in companies that cannot provide opportunity cost returns.
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,
negative growth 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 a 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.
American, Delta, Northwest, US Airways, and United have been dumb competitors also
because they maintain 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 aggressive accounting
policies. This allowed capacity growth above long-term sustainable growth rates and this
explains, in large measure, why they have large negative equity balances and prohibitively high
capital costs.
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.
A liquidation of US Airways 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 US Airways 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, however.
[CEO Glen] Tilton's failure is that he 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 $6.4 billion concessions and $6.1 billion pension deficit claim against the
company. This is the real reason no outside equity is available to United. Moreover, the
unsecured creditors' claim of $10 billion may not be realistic in view of what will happen as a
result of the ATSB's no vote.
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 avoid liquidation, it will have to terminate the defined benefit plans and
reduce operating costs. Defined benefit plans can be replaced with additional defined
contribution plans (DC).
My work suggests that it will take an additional 10% or $500 million cut in labor costs.
Terminating the defined benefit plans will save the company $500 million a year in net
expenses and on average, $820 million a year in cash contributions.
If this were to happen, the income statement savings would be $1 billion, which includes the
additional costs of new DC plan contributions.
The company will report approximately $800 million -- $1billion 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 $1 billion a year, the company can retain $400 million 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 ballpark
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 dependent 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 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 own work suggests that restricted cash will be close to $700 million by
the end of the year. It was interesting to see that Jim Higgins with CSFB estimated cash level to
be $800 million. $2.2 billion is a minimum level in my view. This implies that the company must
come up with around $1.4 billion in external and/or internal financing.
The choice for labor will come down to a choice between liquidation or defined benefit plan
termination. Selling assets and pulling down capacity to generate cash will be insufficient in my
view because this will not generate the cash needed 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 $1 billion will
do the trick and this is what is required to attract exit financing.
The unions' behavior at the airline 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 irrationally,
the capital will be much more expensive 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 and management 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 they cannot, they will continue to lose market share and eventually go out of business.
Time for a reality check.
Holly Hegeman, Editor
http://www.planebusiness.com
June 22, 2004
One of my complaints with the previous ATSB loan application by United was that I do not
believe United Airlines has stripped enough of the costly "padding" the airline continues to lug
around from its underlying structure. The airline simply has not cut its cost structure sufficiently
to survive. And no amount of money thrown at the current structure is going to help the
underlying problem. Until that underlying cost issue is addressed, any money given to the
airline is wasted.
Over the last couple of weeks, many analysts have talked about how the worst that could
happen to United, if it did not receive the ATSB guarantee, is that the airline would be forced to
"shrink" more, while working out a new, and no doubt, more expensive equity infusion.
Vaughn Cordle, CFA, and president of Airline Forecasts, has followed the airline's continued
financial decline closely for the last several years.
Last week, he not only put his observations about United down on paper, but he talked about
other airlines as well. I think he makes some excellent points.
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 dying business. 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. As a result, I believe that 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 capacity to grow fast. Maintaining adequate cash levels is critical and capital is
prohibitively expensive for those with negative rates of return and negative equity. It makes no
sense to invest in companies that cannot provide opportunity cost returns.
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,
negative growth 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 a 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.
American, Delta, Northwest, US Airways, and United have been dumb competitors also
because they maintain 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 aggressive accounting
policies. This allowed capacity growth above long-term sustainable growth rates and this
explains, in large measure, why they have large negative equity balances and prohibitively high
capital costs.
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.
A liquidation of US Airways 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 US Airways 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, however.
[CEO Glen] Tilton's failure is that he 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 $6.4 billion concessions and $6.1 billion pension deficit claim against the
company. This is the real reason no outside equity is available to United. Moreover, the
unsecured creditors' claim of $10 billion may not be realistic in view of what will happen as a
result of the ATSB's no vote.
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 avoid liquidation, it will have to terminate the defined benefit plans and
reduce operating costs. Defined benefit plans can be replaced with additional defined
contribution plans (DC).
My work suggests that it will take an additional 10% or $500 million cut in labor costs.
Terminating the defined benefit plans will save the company $500 million a year in net
expenses and on average, $820 million a year in cash contributions.
If this were to happen, the income statement savings would be $1 billion, which includes the
additional costs of new DC plan contributions.
The company will report approximately $800 million -- $1billion 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 $1 billion a year, the company can retain $400 million 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 ballpark
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 dependent 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 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 own work suggests that restricted cash will be close to $700 million by
the end of the year. It was interesting to see that Jim Higgins with CSFB estimated cash level to
be $800 million. $2.2 billion is a minimum level in my view. This implies that the company must
come up with around $1.4 billion in external and/or internal financing.
The choice for labor will come down to a choice between liquidation or defined benefit plan
termination. Selling assets and pulling down capacity to generate cash will be insufficient in my
view because this will not generate the cash needed 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 $1 billion will
do the trick and this is what is required to attract exit financing.
The unions' behavior at the airline 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 irrationally,
the capital will be much more expensive 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 and management 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 they cannot, they will continue to lose market share and eventually go out of business.
Time for a reality check.
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