A dogfight for dominance of the skies
Kenneth R. Sheets
Airline takeover battles peak with a jumbo-size battle for United. And the flying public will pay
Keep your seat belts securely fastened and your hand on your wallet. Your airline is taxiing for takeover.
Hardly a day passes on which the airline industry doesn’t get another jolt. Virtually every U.S. airline company has either recently gone through a change of ownership, is in the process of changing hands or is threatened with a takeover. UAL Corporation, parent of United Airlines, on September I got a $6.5 billion bid from its pilot union and management, with a major stake going to British Airways. Oilman Marvin Davis, who already had a $6 billion offer on the table, said he might top the UAL employes’ bid of $300 a share. Texas Air Chairman Frank Lorenzo is trying to peddle Continental Airlines. The stock of AMR Corporation, American Airlines’ parent, shot up 13 percent August 29 on takeover rumors. Northwest Airlines (NWA) is awaiting approval of a $3.65 billion leveraged buyout (LBO) by a group of investors led by Alfred Checehi, while financially distressed TWA and Pan Am are constantly looking for buyers or partners.
A warning shot. Unlike much of the takeover activity in the decade since the industry was deregulated, the latest round of airline fever is not producing further consolidation. The industry is already dominated by a handful of giant carriers and more mergers among them would likely run into antitrust problems. But the higher debt incurred as the airlines change hands and the growing involvement by foreign carriers-KLM owns part of Northwest and SAS has a 10 percent stake in Continental-drew sharp criticism last week from Assistant Transportation Secretary Jeffrey Shane. Airlines burdened by heavy debt could compromise safety, while European carriers could gain an unfair edge in the U.S., Shane warned in one of the toughest messages a U.S. official has sent the airlines in years. The statement sent most airline stocks, which have been soaring, into a temporary nosedive.
LBO artists such as Davis and Checchi are betting that the handful of major carriers at the top of the heap are strong enough to support their brand of financial engineering, enabling them to ride the tailwind of global economic growth. Since the airlines were deregulated over a decade ago, 214 scheduled carriers have gone out of business, mainly because of mergers, acquisitions and bankruptcies. As a result, says George James, president of Airline Economics, a Washington, D.C.-based consulting firm, nine large airlines control nearly 94 percent of the market. United, American, Delta, Northwest, USAir, Pan Am, Continental, Eastern and TWA operate 29 major airline hubs in the U.S. and have bought all or part of some 21 smaller feeder airlines to funnel passengers into those hubs. Combined, their route networks reach about 500 U.S. cities and communities.
Loading up an airline with debt does seem a bold move. Traditionally, investors have viewed airlines as highly cyclical, recession-prone businesses. Carriers with high debt loads weren’t considered to be good targets for hostile takeovers, especially since many of them had already unloaded unrelated assets that could be sold to help finance takeovers. For example, UAL disposed of its Hertz rental-car and Westin and Hilton International hotel subsidiaries two years ago, in part as a takeover defense.
Hidden assets. But the unconventional wisdom seems to be gaining supporters, at least on Wall Street. The stock market, says James, now sees previously overlooked assets, such as the value of air fleets, spare parts, landing slots at overcrowded terminals, reservation systems and even orders, delivery dates and deposits on new airplanes from backlogged manufacturers such as Boeing. “The assets have always been there,” says Ed Greenslet, analyst and publisher of the Airline Monitor, a Jacksonville, Fla., trade journal. “Now the fairly reliable cash flow is there as well.”
One key to unlocking such “values” may be the sale and lease-back, in which an airline sells its planes, then leases them back from the buyer. Takeover artists have discovered that such arrangements allow them to borrow from banks at interest rates lower than junk bonds would offer. Leases also let airlines convert debt into an operating expense that often does not show up on the balance sheet as a liability. Airlines can gain the flexibility to cope with a downturn in business, allowing them to return planes to the owner as leases expire rather than parking planes until passengers again begin filling up the seats. The leasing trend is evident at Delta and American, which now lease about half their aircraft, up from almost none five years ago.
Foreign carriers’ rising interest in U.S. airlines has been an added bonus for takeover investors because it gives the new buyers relatively “safe” access to foreign capital. Under U.S. law, foreign investors cannot buy more than 25 percent of a domestic carrier. Foreign airlines are interested in developing feeder traffic for their lucrative international routes. The Netherlands’s KLM kicked off the current trend by contributing $400 million to the Checchi-led buyout of NWA. British Air is expected to spend $1.5 billion for a stake in United if a worker-led buyout is consummated. Government concern about foreign carriers seems to be motivated by “Fortress Europe” fears: Why let foreign carriers have access to the U.S. when creation of a single market within Europe after 1992 could discriminate against non-European carriers?
Turbulence ahead. At least foreign airlines pump in cash. It is the debt loads that have many critics besides the DOT’s Shane worried. The industry’s total debt now stands at about $14.8 billion. In addition, airlines have committed another $108 billion to purchase more than a thousand new airplanes needed to replace the aging craft now plying the skies. If a recession hits, some airlines may be unable to pay off their debts. “Airlines have good years and bad years, and we’re projecting the good years into perpetuity,” declares Jim Grant, editor of Grant’s Interest Rate Observer newsletter. A longtime Cassandra about the perils of LBO debt,Grant recently noted that financial projections released by the new investor-owners of Northwest anticipate pretax earnings of $723 million in 1993, nearly four times 1988’s record profits. Meanwhile, Northwest’s debt burden will more than triple to $3.9 billion. “For most of the past few decades, bankers would as soon have burnt the depositors’ money as lend it to a leveraged airline. Now they are lending en masse,” writes Grant. However, the Northwest buyout still must win approval of the Transportation Department, and snags could arise. A Northwest spokesman says the new owners are counting on revenue growth to service debt payments. A new Labor contract with pilots could also add stability to operations, but at a price. Flight-deck salaries will go up 9 percent in the first year and 4 percent a year for three years thereafter, causing Northwest’s Labor costs to rise faster than those of any other major carrier.
An elusive edge. Relatively debt-free competitors, with their greater financial maneuverability, could theoretically run rings around debt-laden carriers. American Airlines, which was just beginning to savor such a prospect, may never get a chance to enjoy it. The airline is thought by Wall Street to be vulnerable to a takeover. When word leaked out that AMR had hired investment banks Goldman Sachs and Salomon Brothers as financial advisers, it seemed to confirm that the airline was “in play.” AMR Chairman Robert Crandall is expected to quickly restructure the company to help it fend off a takeover. His moves could include more sales and lease-backs, a partial sale of AMR’s valuable Sabre computerized-reservation system for $1 billion or more or perhaps a special cash dividend to shareholders,
What will all this takeover activity do to fares? There is no direct link between new owners and higher fares, but the same basic condition that is making the biggest airlines takeover targets-their place at the top of the heap-will keep fares rising, argues James of Airline Economics. The major airlines’ pervasive route structures, dominance of certain hubs, ability to adroitly manage discount fares to maximize profits, sophisticated reservation systems and loyalty-building tactics such as frequent-flyer programs give them enormous advantages and help keep out new airlines. The result is an economic climate in which fares will trend upward.
Still, there are limits to fare hikes, as carriers have recently discovered. Passenger traffic has slowed noticeably since fares began creeping up this year, forcing American and several other airlines to delay further increases that already had been announced. “The airlines can push the market in their direction, but if the market rebels, it won’t go,” argues trade-journal publisher Greenslet. “They don’t have an unlimited ability to raise the price.”
One way to view the takeover activity sweeping the U.S. airline industry is to look at the bigger picture: The evolution of megacarriers that will serve global markets through a network of marketing alliances and ownership ties. In this brave new world of transportation, traveling from Fresno, Calif, to Frankfurt, Germany, and to Fukuoka, Japan, will be a matter of choosing between three or four airline networks. It will be as convenient as going from Dallas to Denver. But it won’t be a bargain. n
COPYRIGHT 1989 All rights reserved.
COPYRIGHT 2005 Gale Group