Airline Investors Grounded by 'Domino' Factor

If only airline stocks enjoyed the same robust survival odds as airline passengers.

This week the industry's mounting casualty count reached into the realm of the household names, with a bankruptcy warning from the United unit of UAL ( UAL) and an actual filing by US Airways ( U). And though everyone agrees the future is hard to handicap, there's no question that investors are anxious that they could soon be watching a game of Chapter 11 dominoes.

That's because, as in other troubled industries, perhaps the airlines' greatest problem is a bloated cost structure. Analysts say companies that file bankruptcy can get a head start on trimming those costs, potentially further pressuring competitors whose costs remain high.

"If United goes bankrupt, it could mean that American ( AMR) and Delta ( DAL) and every other major airline has to file as well," said John Pincavage, an industry consultant who spent 30 years as an airline analyst at the major research houses. "Everybody is vulnerable."

Unfriendly Skies

For now, all eyes are on United. The nation's second-largest carrier desperately needs a $2 billion government-backed loan -- requiring wage concessions from stubborn unions -- to avoid a cash crunch that could hit as early as next quarter. Without that relief, United could soon follow US Airways up the courthouse steps in search of bankruptcy protection.

"The changes we need to make are urgent, significant and immediate," United Chief Executive Jack Creighton said on Wednesday. "And our conclusions are consistent with the feedback we're getting from Washington."

Despite that warning, investors abandoned their caution and gambled this week on United stock that could be rendered worthless in less than 30 days.

After some brief panic selling -- which pushed the stock below $2 for the first time ever -- United took flight to sail past $3 Friday, gaining more than 50% from its low. The stock soared a lofty 54 cents Friday to $3.24. That gravity-defying surge came just after company warnings of a possible bankruptcy that many view as inevitable.

"One way or another, United is going into Chapter 11," said Darryl Jenkins, director of the Aviation Institute at George Washington University. "Everybody in the industry has been making tough decisions -- except United.

"And its problems aren't just limited to labor costs, either."

Some viewed management's ominous bankruptcy threats as the brashest move yet in a yearlong "game of chicken" with employees who've resisted wage reductions that could slow the company's bleeding. United employees have unusually strong bargaining powers, even for the union-dominated industry, due to their 55% ownership stake in the company and their representation at the boardroom table.

Bankruptcy may not wipe out that ownership, either. Pincavage believes United employees would receive a reduced amount of stock under reorganization and, as a result, some of the airline's unique problems could linger.

"That airline is run like a commune," said an investment banker close to the industry. "And you can't run any business like a commune."

Leadership Vacuum

When United's top executive threw his hands in the air three months ago -- shocking the industry with sudden plans to resign -- the airline's cloudy skies grew even stormier.

Jenkins unapologetically calls that decision by Creighton, now a lame duck interim CEO, "one of the stupidest things that's ever been done in the history of the world." But few of Creighton's executive decisions could be classified as easy.

Before Creighton assumed power, stepping in last October after unions drove off former CEO James Goodwin, United was already on its way to a $2.1 billion annual loss that would shatter industry records. Since then, the country's second-largest carrier has remained its largest loser with a $341 million loss last quarter.

On Wednesday, Creighton appeared to throw his hands in the air again, this time leaving all his cards on table for the world -- but particularly the unions -- to see. The company wasn't bluffing. Unless the rules changed, and maybe even if they did, the game could soon be over.

"We are facing debt payments of $875 million in the fourth quarter, and we have insufficient access to the public capital markets to repay them," Creighton said.

"We have given ourselves a very short time frame -- 30 days -- to conclude our discussions with all stakeholders. ... Unless we lower our costs dramatically, filing for bankruptcy protection will be the only way we can ensure the company's future and the continued operation of our airline."

The Ripple Effect

Under bankruptcy protection, United would suddenly enjoy a number of competitive advantages over its more restricted peers.

For example, Pincavage said, United would have 60 days to renegotiate lease and debt arrangements on its airplanes. Right now, he said, airlines are paying hefty rates for older planes that sell new at a fraction of those prices.

Although equipment costs far less than labor and fuel -- the industry's biggest expenses -- savings in this column could be enough to pinch some of United's biggest competitors, he said.

Peter Cohan, a Massachusetts author and investment strategist, sees trouble ahead, particularly for American. During the past year, he said, the nation's largest airline has seen its debt climb -- and its equity diminish -- with each passing quarter. At the end of the second quarter, he said, American reported long-term debt and lease obligations of $10.6 billion and total equity of only $4.4 billion.

"A 2:1 debt-to-equity ratio is pretty high," said Cohan, who has no financial stake in the stock.

Pincavage prefers some of the regional airlines the market has favored as well. He does agree with widespread sentiment that Jet Blue ( JBLU) -- the current industry darling -- is overvalued. The stock, which enjoys a price-earnings multiple of 33, should probably be $30 instead of $40, he said. But at the same time, he said, Southwest ( LUV) should more than double and fetch a $30 price tag, too.

Due to affordable labor and systemwide efficiencies, these airlines enjoy operating costs that are 38% lower than their bigger peers, he explained.

"Southwest, Jet Blue, Air Tran, Alaska -- those are the guys I don't worry about," Pincavage said.

Big and Strong?

Some still have plenty of faith in the bigger guys as well.

Brian Campbell, president of his own aviation consulting firm, said that United's nonbankrupt peers are set to enjoy some competitive advantages of their own.

"Travel agents, or anyone booking a trip far into the future, would perceive greater risks booking on an airline in bankruptcy than one that is not," he said as an example.

Jenkins also downplayed the threat a United bankruptcy poses to even cost-laden majors like American and Delta. He said both airlines are in "reasonably good shape" and that bankruptcy is not even an option for them right now.

"You can only go into bankruptcy if you are, in fact, bankrupt," he said. "That case has to be made."

Chapter 12

For investors, United stock is approaching lottery odds, and US Airways is already a losing ticket.

But what about the postbankruptcy companies the airlines may become?

Many experts, led by the turnaround wizards at Texas Pacific Group, have already placed their bets on US Airways. TPG is known for its success with reorganizing America West and, more spectacularly, Continental ( CAL), which delivered the firm an 11-fold return after the airline emerged from bankruptcy.

With US Airways, TPG believes the turnaround could be even simpler. Unlike Continental, TPG said, US Airways already boasts an attractive product and market presence. It simply needs to cut costs, which US Airways management has already shown it can do.

"US Airways is making a lot of tough decisions -- and it's making them well," Jenkins said. "I'm very optimistic about that airline."

Campbell predicted that US Airways could turn into another Continental for TPG.

"Their return, for 38% of the stock in US Airways, could be very handsome," he said.

But Pincavage gave United a slight edge over US Airways in a postbankruptcy fight for survival. He said United will have more cash to carry it through its reorganization process, which should require fewer sweeping changes -- like market and fleet adjustments -- than those facing US Airways. But he stops well short of placing any bets.

"If this economy stays in the tank for another six months, or there's an ongoing recession, there ain't enough money in the world to reorganize some of these companies," he said.

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