Northwest Airlines' ( NWAC) quest for $950 million in annual wage concessions from unions will be a long process fraught with conflict, but a recent offer from pilots has Wall Street seeing potential upside.

This week, Northwest's pilots union, represented by the Air Line Pilots Association, offered $200 million in cost cuts through 2006, which include wage concessions and work rule changes. The details of the ALPA proposal have not been released, but the union's concessions represent a 20% pay cut for pilots, whose salaries range from a low of $35,000 to a high of $240,000.

Union leaders Wednesday hit the road for a week-and-a-half of meetings to present the cost-cutting proposal to 5,000-plus pilots and weigh their feedback. After ALPA's road show ends Mar. 27, the findings will be discussed at an April meeting and the pilots will be polled. If the wage concessions are accepted, they'll be brought to the negotiating table.

In ALPA's eyes, concessions are not a gift, but an investment in the company's future. As a result, analysts think the union will be looking for a share of profits or equity, which could dilute earnings going forward.

"After reviewing Northwest's finances, we feel the $200 million target is the appropriate amount," said Will Holman, communications director for the ALPA. "The reason why we consider it an investment is there needs to be acceptable quid pro quos and protections to ensure the pilots' investment is properly used."

First Step on a Long Road

While ALPA's offer is a promising breakthrough after nine months of negotiation, it is far less than the $442 million in annual wage concessions through 2009 that Northwest management was looking for. Nonetheless, as far as first offers go, analysts are hopeful the proposal will lead to lower costs both sides can live with.

"There apparently remains a significant divergence in views on just how much needs to be done, but we take this as a step in the right direction in what will surely continue to be a tough negotiation," said David Strine, airline analyst at Bear Stearns, in a research note.

The gap between pilots and management may be wide, but negotiations with other unions may be even tougher. As part of its $950 million restructuring plan, Northwest is also looking for $173 million in cuts from mechanics, $134 million from flight attendants, $120 million from ground employees and $81 million from other, smaller employee groups.

"I think it's a huge step for the pilots -- a move they had to make," said Jeff Mathews, contract coordinator for the Aircraft Mechanics Fraternal Organization, which represents 5,700 Northwest mechanics. "But it doesn't affect us at all. Our contract comes up in May 2005."

Because pilots represent such a sizeable chunk of costs and have an open contract, Northwest's negotiations with ALPA will likely dictate how it proceeds with mechanics and flight attendants. Since both unions refuse to open up their contracts for early negotiations, cutting pilot costs to offset continued losses is important.

"Exactly how much labor cost savings Northwest needs to remain viable over a full cycle is not clear, but we suspect that, subject to other unions coming through with proportionate cuts, somewhere between the two sides' offers gets them there," said Jim Higgins, airline analyst at Credit Suisse First Boston, in a research note.

Lower Costs, Higher Leverage

Though Northwest won't get everything it wants, any help on the labor front would be immediately beneficial to earnings. According to Bear Stearns research, just $200 million in cuts from pilots would put Northwest's 2005 EPS at $3.65, up from the current expectation of $2.20, which doesn't assume any labor concessions.

The $950 Million Question
By mid-2005, contracts with all of Northwest's major union groups will be open for negotiation. Here's a look at what Northwest is looking for, in terms of concessions, and when it can start asking for it.
Employee Group No. of Employees Union Date When Contact Is Amendable Northwest Concessions Target
Pilots 5,100 Air Line Pilots Association September 2003 $442 million
Mechanics 5,700 Aircraft Mechanics Fraternal Association May 2005 $173 million
Flight Attendants 8,500 International Brotherhood of Teamsters May 2005 $134 million
Agents 8,800 International Association of Machinists & Aerospace Workers February 2003 $120 million
Equipment Service and Stock Clerks 6,000 International Association of Machinists & Aerospace Workers February 2003 $81 million
Source: Northwest Airlines, Bear Stearns, TSC Research

"We performed a sensitivity analysis of Northwest's EPS and EBITDAR earnings before interest, taxes, depreciation, amortization and rent for a variety of labor cost reductions to better understand the potential value that could be realized. For example, our 2005 EPS estimate could swing from $2.20 to $4.36 if Northwest got half of the $950 million it is looking for, which implies a forward PE multiple of 2 times," said Strine.

Cost cutting would provide significant upside for Northwest shares, which were off 8 cents, or 0.9%, to $9.10 on Thursday afternoon. In a best-case scenario, including the dilutive effects of giving pilots equity, Strine estimated shares could have an implied value between $46 and $55 a share in 20 months. But even if costs are cut by $200 million, in 20 months Bear said shares would have an implied value between $26 and $27 -- three times higher than current prices.

While these are rough estimates at best, they illustrate the power that wage concessions could have on Northwest's operations. But with other unions unwilling to negotiate early, Northwest is at the beginning of a long process. The full impact of cost cuts won't be felt until mid-2005 at the very earliest, which means such predictions could be optimistic, especially considering Northwest has not hedged any fuel needs going forward.

Ultimately, Strine said Northwest will need more than $200 million in concessions in order to compete with peers like AMR ( AMR), parent of American Airlines. And if Northwest can't convince unions to cut their pay enough, the carrier may face the same fate as US Airways ( UAIR), which said it needs additional pay cuts from labor, having already canceled the employee pension plan and secured a round of wage concessions while under bankruptcy last year.

Very Guarded Optimism

But with pilots weighing cost cuts, Northwest has been making progress, unlike rival Delta Air Lines ( DAL), whose pilot contract does not become open for negotiations until August. And while investing in Northwest requires a stomach for risk and a lot of patience, even analysts who are increasingly pessimistic about the industry's fortunes think the company could be worth looking at.

Cutting Costs: Four Scenarios
In a best-case scenario, Northwest would immediately cut costs by $950 million, helping the company eke out a profit in 2004, according to Bear Stearns estimates. While this is highly unlikely, any cost cuts will have a dramatic impact on earnings.
Scenario Amt. of Annual Concessions Est. Unit
Labor Costs
EPS Est. Implied Share Value in 2005*
2004 2005 2004 2005
Best Case Scenario $950 million 3.78 cents 3.26 cents $1.39 $8.89 $46-55
What Northwest Wants from Pilots $442 million 4.04 3.76 -1.33 5.54 $34-37
The Pilots Offer $200 million 4.19 4.04 -2.91 3.65 $26-27
Status Quo $0 4.32 4.26 -4.15 2.20 --
*assumes dilution from equity share with unions. Source: Bear Stearns

On Thursday, Sam Buttrick, analyst for UBS Warburg, said the airline industry would lose $2.3 billion in 2004 instead of an earlier prediction of a $500 million loss. Citing the fact Northwest faces less low-cost competition than rivals and generates 22% of revenue from Pacific routes, which are recovering nicely, Buttrick said Northwest could be the best of the worst.

"Northwest looks most interesting, down 40% with group, with strength in Asian markets, less exposure to domestic transcontinental routes, and is possibly the next airline to reach a labor savings deal with pilots," said Buttrick.

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