The Downdraft at Delta and US Air

Despite efforts to fix their financial crises, neither carrier could escape a ratings downgrade, as S&P's Phil Baggaley explains

With an eye for mounting debt and struggling labor talks, Standard & Poor's Ratings Services last week lowered its corporate credit ratings on Delta Air Lines (DAL ), the third-largest U.S. airline, and US Airways (UAIR ), the seventh-largest carrier, to reflect increased risks of bankruptcy or default.

BusinessWeek Online's Suzanne Robitaille corresponded with S&P credit analyst Phil Baggaley by e-mail about the carriers' persistent troubles and whether the rest of the industry could soon feel the burn. Here's an edited excerpt of their exchange:

Q:You lowered Delta's rating for the fourth time this year, this time to 'CCC' from 'CCC+.' What's behind the latest downgrade?


There's now an increased risk that Delta will try to restructure its debt without declaring bankruptcy (see BW Online, 8/23/04, "Delta: A Wing, a Prayer, a Revamp"). On Aug. 18, the airline asked holders of some of its airplane-backed debt, called equipment trust certificates and pass-through certificates, to lift limitations on its ability to buy and hold the securities. These certificates were issued by trusts that lease various aircraft to Delta to assist in financing the cost of the planes.

Delta says this move would provide it with "greater flexibility to effect a successful out-of-court restructuring." This is the clearest signal yet that Delta will seek to avoid bankruptcy. And in a July 30 letter to Delta's pilots, CEO Gerald Grinstein said management is "working hard to restructure debt, renegotiate aircraft leases, and reconstruct [its] relationship with vendors and suppliers" as part of a comprehensive turnaround plan. Meanwhile, the airline is seeking cost cuts from pilots, but $1 billion in savings may not be enough to keep the airline solvent.

The consent solicitation, if successful, would put Delta in a position to offer certificate-holders stock or debt securities worth less than par value, in exchange for their certificates. This would be considered a default, however, and Delta's corporate credit rating would be lowered to 'D' [default] or 'SD' [selective default].

Q: What does the 'CCC' rating mean?


A 'CCC' rating is deep into speculative-grade, or junk-bond, territory. It indicates a significant risk of bankruptcy or default in the near term.

Q: How about US Airways? Is there a different story here?


We downgraded US Airways to 'CCC' from 'CCC+' due to an increasing risk that crucial labor negotiations won't be completed successfully by Sept. 30. After this time, the airline could be in default under its federally guaranteed loan. Thus, financing arrangements for regional jet deliveries could be withdrawn, and added cash collateral would be required by a credit-card processor.

Furthermore, US Airways faces pension payments of $133 million during the second half of 2004, and a substantial portion of this is due on Sept. 15. The lack of progress in labor talks, and the dwindling time in which agreements must be reached, shows a substantial and increasing risk of bankruptcy in the near term. US Airways' pilots are in active negotiations, but talks with other labor groups are less advanced.

Q: What's the likelihood that either airline can make any significant headway?


They both need to cut labor costs -- wages, benefits, work rules, pensions -- and implement other cost reductions across their operations, which includes a whole range of process changes, part of which are under way. They're making progress, but time is running out, especially for US Airways, to do so outside of Chapter 11.

Q: What else could go wrong for U.S. carriers?


United is already in bankruptcy and struggling to pull together a plan of reorganization. The other legacy carriers -- American Airlines (AMR ), Northwest Airlines (NWAC ), and Continental Airlines (CAL ) -- are under pressure, but they're in better financial shape. They aren't at near-term risk of bankruptcy, but if there was a recurrence of significant terrorism, or if oil prices stay at current levels for an extended period, that could change.

Q: It looks like a shakeout is inevitable. Which airlines can survive, and which ones probably can't?


In a few years, there will probably be fewer legacy carriers, but exactly how and when that will happen is more difficult to say. If some airlines shut down, that will probably happen over the coming year, with US Airways being the most likely candidate.

Over the longer term, a shakeout could occur through mergers. At the moment, the legacy carriers don't have the financial or management resources to devote to that.

Q: Which of the newer airlines has the best business model for the future?


There's no single best business model. For example, Southwest Airlines (LUV ) and JetBlue Airways (JBLU ), the two strongest low-cost airlines, have somewhat different models but both have been successful. So far, no low-cost airline has entered transatlantic or transpacific markets. Operating internationally would require a different model.

What these successful, newer, airlines have in common, though, are flexible work rules, which allow them to use their employees and assets most productively. They offer less generous benefits than the legacy carriers and are resourceful with new technologies and standardization, which helps to simplify their operations and squeeze out costs.

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