Is Bankruptcy Back on Airlines' Itinerary?

Updated with closing share prices.

Bankruptcy chatter has resurfaced in the airline industry.

Perhaps that is to be expected. Airlines benefitted from a round of bankruptcy filings in the middle part of the decade. Now, despite cutting costs by significant margins, they are caught in a vicious cycle of low business travel demand, intense pricing competition for leisure passengers and rising fuel prices.

Today, shares of the seven biggest airlines are all priced in the single digits. Among the three lowest priced airlines, US Airways ( LCC) closed Thursday at $2.46, down 68% this year. United ( UAUA) closed at $3.31, down 70%. And American ( AMR) closed at $4.22, down 60%.

"Airlines are trading as if headed for bankruptcy this year," Avondale Partners analyst Bob McAdoo wrote in April, when the shares were higher than they are today.

It should be noted that at the end of the first quarter, all three carriers were holding cash. US Airways had $2.1 billion. United had $2.5 billion. American had $3.3 billion.

Nevertheless, in a recent report, Fitch analyst Bill Warlick wrote that "a bankruptcy filing by any of those (three carriers) could occur as early as the winter if operating trends fail to stabilize." The observation was included in a report last week on Delta ( DAL), which Fitch expects will "report another year of substantially negative free cash flow in 2009 as (it) struggles to adjust capacity to a diminished level of demand."

Delta's $5 billion in liquidity, and lower costs, provides the carrier with a bigger margin of safety than most of its legacy carrier competitors, Warlick wrote.

Standard & Poor's analyst Phil Baggaley says bankruptcy concerns are justified, given the combination of weak revenue and rising fuel costs, but "It's too early to sound the alarm definitively." Baggaley said a key question is whether the capital markets will be receptive to airlines in need of refinancing debt. "Both United and American have substantial debt maturities," he said.

Baggaley noted that today's airline economy bears little resemble to the situation 20 years ago, when Eastern and Pan American World Airways filed for bankruptcy protection and subsequently shut down. "The difference is that Eastern and Pan Am were in long-term decline and pretty much hopeless cases," he said.

Eastern Airlines, a throwback that never made it out of bankruptcy.

Today's carriers are far stronger, but face an extremely challenging environment. Because they completed another round of bankruptcies and cost-cutting in the middle of the current decade, opportunities to further reduce costs are limited, but "they could probably bargain down some aircraft debt," Baggaley said.

It is conceivable that airport charges, which have been steadily rising in spite of industry weakness, could also be addressed were bankruptcies to occur.

FTN Equity Capital analyst Mike Derchin forecast this week that American and United will lose around $1 billion each this year, but he notes "I don't see bankruptcy as a reasonable near-term issue."

Derchin says questions remain: "Will international business travel resume? What impact will the swine flu have on travel in the coming flu season? How high will jet fuel prices go over the coming months?"

But he also sees "recent green shoots among the garden of weeds," including two domestic fare increases in June, strong leisure demand, and a balance between domestic supply and demand, helped by "late booking strength for June and July."

Despite the sector's weakness, Credit Sights analyst Roger King says: "It's hard to talk about airline bankruptcies. Two variables -- demand and oil -- affect cash flow, and they are basically imponderables right now. No one knows where demand is going, and no one knows where oil is going.

"Airlines have been on bankruptcy watch for the past 50 years," King adds. "There's really nothing new there."

In the past week, both United and American have issued public debt, to sharply different market receptions.

On Monday, United announced pricing for $175 million of senior secured notes due in 2012. The notes were issued at a discount to face value and will carry a coupon rate of $12.75% annually: S&P rated them B+. In a report, King said that with the discount, the yield on the notes is 17%.

"The pricing indicates a lack of investor interest and management desperation," King wrote. "This type of issuance is frequently a few steps from the grave - it signifies that sources of liquidity are drying up."

However, in an employee publication, United CFO Kathryn Mikells said "the credit rating on our transaction was relatively low, driving up the cost" because the issuance was secured by spare parts, and "over 50% of the collateral in the transaction is not eligible for Section 1110 bankruptcy protection." Additionally, she said, "our transaction did not have any type of structural credit enhancement."

By contrast, on Monday, American sold $520 million of notes, with a yield of about 10.375%. The debt is backed by aircraft, some in the carrier's fleet and some scheduled for delivery. Analyst King said American "did a deal for airplanes, which are better collateral" than the airplane parts backing the United debt. Additionally, unlike the United debt, American's debt had a provision that a third party would protect interest payments for 18 months.

S&P analyst Betsy Snyder assigned an A- rating to the American issue, but noted in a report that the carrier's outlook is negative, saying that "liquidity could face pressure" given current conditions and that "we could lower ratings if such conditions (led) unrestricted cash to consistently fall below $3 billion."

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