The basic question is whether DAL will be another AMR or a UAL. Our view is that DAL is actually in much better position than AMR was. The one constant regarding the legacy airlines is that no significant wage concessions can be obtained from the unions without a VERY credible threat of bankruptcy.

As was the case with AMR, this produces a significant buying opportunity in the securities of the airline involved. AMR is the prime example. In 2003 AMR management prepared papers to file chapter 11 and demonstrated a credible threat to file. The securities of the airline reached all-time lows as the various unions voted on accepting or rejecting the concessionary contracts. Ultimately after a controversial narrow revote by the flight attendants union, the concessions were achieved and the securities soared.

We think DAL will have a much easier time achieving concessions. Only the pilots are unionized. In all of the other legacy carrier situations, the pilots were the “easiest” to obtain concessions from. This is because the pilots have by far the most to lose in a bankruptcy situation.

The UAL pension situation illustrates that bankruptcy probably will result in the terminating of the defined-benefit pension plans, as happened at US Air. The PBGC insures pensions in such events, typically up to limits of about $35,000. Thus, the lower paid union groups at an airline are not risking much, if any, of their accrued pension benefits in bankruptcy. However, the higher paid pilots stand to lose most of their pension benefits in bankruptcy.

The pilots also have very little prospects of alternative employment and are aware that in bankruptcy DAL would swiftly move to void their contracts. As “at-will” employees the pilots would earn no more than the wages now paid by the low-cost airlines.

If the contract between the pilots and DAL were to be voided, DAL would become a very attractive target for airline “vultures” like Texas Pacific. With no union contracts in force, DAL could be converted into a low-cost airline very quickly. The debt securities of DAL would be the new equity in such an airline or could even be made whole in a section 1114 “cure” exit. We view them attractive at current levels, but are aware that there will be considerable volatility as the drama of the bankruptcy threat is played out.

Update on SGI
At present levels we view SGI attractive. We particularly like the 6.5% convertible bonds. We project that SGI will earn between 0.25 and .50 per year over the remaining term of the bond starting next year. At some point that should support a return of SGI stock to the $4 level.

In a worst-case scenario the bonds return the coupon and a repeat of the exchange offer process occurs when the bonds approach maturity. We feel SGI will survive in either case, but the almost assured positive return on the convertible bonds along with potential enormous upside make the bonds more attractive.

DAL Confronts its Tormentors, Bonds now Attractive
In a Webcast conference, Gerald Grinstein, DAL CEO, issued an ultimatum to the pilots union to agree to $1 billion in concessions by September 30th or DAL will file for bankruptcy.

Grinstein is choosing a path taken by American Airlines in contrast with the approach taken by Northwest Airlines. Delta could have sold assets and aggressively issued convertible debt and accumulated a cash hoard like Northwest. Northwest now has over $3 billion in cash after selling assets such as Pinnacle Airlines.

Delta has numerous assets that it could have put up for sale, including its wholly owned subsidiaries, Atlantic Southeast Airlines, Inc. (ASA) and Comair. However, unless the pilots wage issue was addressed, Delta could never hope to earn a profit much less pay a dividend. Since only the pilots are unionized, by imposing larger pay-cuts on the rest of the workforce and selling off assets piecemeal, Delta could have limped along for many years. The big winners from such a strategy would have been the pilots who would have continued to receive their bloated wages during that period. The shareholders’ representative Grinstein is in a sense choosing to risk “dying on his feet rather than living on his knees”.

Grinstein is not taking as rash a course as it might appear. In this high-stakes poker game Delta has all the high cards and the pilots are four-flushers. Grinstein slyly alluded to poker is the Webcast conference and referred to his program as “four aces”.

Bankruptcy would wipe out Delta’s shareholders. Continuing to pay the pilots current wages would eventually have the same effect of the shareholders. The pilots have much more to lose in a bankruptcy relative to $1 billion in annual concessions. Loss of most of their pension benefits would be only the first blow and it is quite likely that Delta would be able to have the pilots’ contract voided entirely in bankruptcy.

The pilots are aware that bankruptcy would leave them much worse off than any concession agreement. As the September 30th deadline approaches a tentative agreement between Delta and the pilots will be announced, As with American Airlines there will be a roller-coaster ride for the securities as the vote on the concession package occurs and some dissident union members make noise.

Unless, some tragic personality clash intervenes, within a short period after September 30th Delta should be well on its way to prosperity. With the pilot concessions ratified, access to the capital markets is assured. The pilots will insist on pay-cuts for rest of the workforce and Delta will, of course, comply.

Where does this leave Northwest Airlines? Under all possible scenarios, Delta's pilots’ wages will be at least 35% lower after September 30, 2004. That will leave Northwest Airlines with the highest paid pilots in the industry. Ultimately, NWA will have to adopt some type of strategy to deal with its pilots more along the lines of the approach taken by Delta and AMR.

September 13, 2004
US Air Bankruptcy – Could help DAL, hurt AMR and others
With no prospect of obtaining sufficient concessions form all of its unions; US Airways (UAIR) filed for chapter 11 bankruptcy for the second time in two years. In the short run there will be no change in operations, so no airline will gain from any capacity reduction.

It is likely that this will lead to the first conversion of a major legacy airline into a true low-cost carrier (LCC). While there had been so speculation that UAIR might have been liquidated in a chapter 7 proceeding, it is now clear that it will try to actually expand as a LCC. US Airways President and Chief Executive Officer Bruce R. Lakefield said in the release announcing chapter 11 filing: “on lower costs, a simplified fare structure, and expanded service in the eastern U.S., the Caribbean, Latin America and Europe…..a restructured US Airways with low costs and low fares will be a dynamic competitor."

This has broad implications for almost all airlines. The risk to the darlings of the dwindling number of airline investors such as Jet Blue (JBLU) is that the magic behind the profitability of the LCCs will be exposed as simply lower wages and benefits. The emergence of UAIR (symbol will be changed) as a true LCC could hurt all airlines. For the other LCCs it would be mean lower profits. For the other major legacy carriers the effect will depend on where they are along the legacy-to-LCC path.

A potential winner could be Delta (DAL). If UAIR comes to the court with a motion to cut pilots wages and benefits much more than the last proposal which dissident union leaders prevented the membership from voting on, it could effect the DAL pilots negotiating stance. Such a motion by UAIR under section 1113 of the bankruptcy code is likely. Only wage cuts much deeper than the 20% that was the last proposal from the airline to the pilots would make UAIR truly a LCC.

American Airlines (AMR) already obtained wage concessions from its unions by threatening bankruptcy last year. Continental Airlines (CAL) already has a lower wage structure due to prior bankruptcies. However, none of the major legacy carriers are true LCCs. If UAIR does convert from legacy to LCC, Delta and UAL which are in the process of lowering wages now are better positioned to take advantage of the shock value that a UAIR conversion would have on union members.

In terms of opening the eyes of airline unions, a conversion by UAIR would be much more significant than a liquidation of the airline. Airline union members have seen over 100,000 of their fellow employees lose jobs. Seeing other airline workers become unemployed from layoffs or shutdowns has not had much of an effect on union posture. However, seeing UAIR employees working for a third of their former wages as the result bankruptcy court action, would make unions such as the those representing the DAL pilots think long and hard before rejecting concessions that would keep the airline out of bankruptcy. Thus, the key thing to watch is how the wage reductions UAIR obtains in bankruptcy compare to the last offers given to the unions.

NEW YORK, September 15 (Investor’s Economic Resources)
Delta offered to exchange up to $680 million aggregate principal amount of three series of newly issued senior secured notes to the holders of $2.6 billion aggregate principal amount of outstanding unsecured debt securities and enhanced pass through certificates.

This looks like a reasonable move by Delta as the ratios are well within parameters in insure that arbitrageurs will favor the exchange. Given the current market prices of the existing securities and comparable secured securities, holders can add value by participating in the exchange. Completing the exchange will give DAL the appearance of having a somewhat better balance sheet. However, all that DAL is really doing is, via a convoluted route, is borrowing against the last of its unencumbered aircraft. Thus, while aggregate debt outstanding will be lower after the exchange, DAL’s actual fiscal picture will not be changed much.

One might wonder why DAL is tinkering with its capital structure now when the only real issue it faces is labor costs. Certainly American Airlines did not bother with such matters while it successfully struggled to obtain labor concessions from all of its various unions. DAL's balance sheet is better (less worse) than AMR, CAL or NWAC and there is no large debt service payments looming.

The exchange offer and the previous consent solicitation, are not simply pointless distractions from DAL’s actual challenge of obtaining concessions from the pilots. Rather they are part of DAL’s efforts to obtain concessions from the pilots. Since the pilots are the only unionized group, they can not utilize the normal stalling tactics of unions in such situations by requiring ALL of the unions to agree before any of the concessions become effective. The DAL pilots union, DALPA, is conducting a more sophisticated delaying battle. Each day the pilots can delay concessions is worth about $3 million.

DAL finds itself in a catch-22. The only real reason to file for bankruptcy is if the pilots union rejects concessions. However, the pilots will never outright reject concessions, but will instead always say the terms are not exactly right, but that after more negotiations there should be an agreement.

If the only event that could precipitate a bankruptcy filing were a complete refusal by the pilots, then the pilots union would be confident that they will always get “the last phone call” and thus could stall indefinitely.

In order to counter the stalling tactics, Delta is issuing ultimatums and the new exchange offer is explicitly contingent on achieving $1 billion per year in pilot concessions, among other savings. However, ultimatums do not work if the union thinks that a bankruptcy filing can occur only after a final impasse between the union and DAL occurs and not for any other reason.

The main reason DAL is mentioning the debt issues now, when the only thing that matters now is labor costs, is to raise the possibility that it could file for bankruptcy even if the pilots agreed to concessions.

It is useful for the pilots to think that there is the possibility of a post-concession-agreement bankruptcy. That is because the concession agreement will include a clause that DAL will not seek further concessions in bankruptcy. That is why the UAIR ALPA leaders who desperately tried to get the union to approve the agreement argued that the agreement would "include protections that might not be available later". Now UAIR has announced that it intends to lower wages to below or at LCC levels.

If DAL files for bankruptcy the judge will give little or no weight to any argument DALPA might attempt to make that DAL should have to pay any pilot more than the lowest pay that any airline pays for comparable service.

However, some judges do give some weight to agreements signed by both parties with full knowledge of impending events in which the company agrees not to seek further wage cuts in bankruptcy.

At minimum such a protection clause would give DALPA lawyers something to argue about, while if they simply force DAL into bankruptcy they will have no way to prevent DAL from setting wages at whatever level its wishes.

While the prospect that DAL might file for bankruptcy even if it obtains the required concessions from the union is absurd, it fits right in with the union’s official line “ that the pilots’ contract is not the only problem”. Thus, the pilots union will have a reason to reach an agreement with DAL, to protect them from an eventuality that exists only in their rhetoric.

As to the debt issues, an agreement with the pilots and the other wage cuts will allow DAL access the credit markets, just as it did for AMR. This will allow DAL to solidify its position as the legacy carrier with the “best” balance sheet. (Which is not saying much).

Our view is that the pilots will be able to stall for a few more months, which will produced numerous opportunities to trade DAL debt from the long side. Eventually the pilots will opt to protect themselves form the prospect of having a bankruptcy court reduce their wages to LCC levels.

NEW YORK, September 16 (Investor’s Economic Resources)
DAL Sends a Message with Debt Exchange Offer
The exchange offer in which DAL uses its remaining unencumbered aircraft to reduce debt sends a defiant message. Those ETC holders who refused to give their consent are now wondering if their “leaders” may have given them poor advise when they refused to give DAL consent to buy back their securities. DAL has simply gone around them and not included those ETCs in the exchange offer. Surely some of those ETC holders now wish the consent had been given.

This message will also not be lost on DAL’s pilots. The UAIR pilots seem to already regretting their refusal to accept the airline’s last pre-bankruptcy offer, which will look awfully good, compared to what the company will get now.

This is all part of a strategy of DAL shareholders defiantly drawing lines in the sand. The shareholders’ representative Grinstein is in a sense choosing to risk “dying on his feet rather than living on his knees”.

DAL could have used the unencumbered aircraft that are being used to secure the new certificates issued in the exchange offer to raise new cash. As with much of the debt issued by DAL over the past few years the new cash would have effectively gone right into the pilots’ pockets.

In USAir’s filing brief they said that they were not going to continue “burning the furniture”. That along with DAL’s defiant posture signals the end of the long dismal pattern of legacy airlines selling or pledging assets to fund the demands of their unions.

This will create a whole new environment. The risk to the darlings of the dwindling number of airline investors such as Jet Blue (JBLU) is that the magic behind the profitability of the LCCs will be exposed as simply lower wages and benefits.

Southwest Airlines (LUV) is approaching a cusp where it may join the ranks of the remaining legacy airlines (AMR.NWAC and CAL). That is it might end up being more on the receiving end of the attacks by airlines that pay lower wages on the market shares of those airlines that pay less. Ironically, if UAIR is able to shed the shackles of its present union contracts in bankruptcy court, it may become a ferocious predator, as might a union-free DAL if the pilots think DAL is only bluffing.

NEW YORK, September 18 (Investor’s Economic Resources)
Mergers and Acquisitions Coming to the Airline Industry?
US Airways has rejoined UAL in bankruptcy. Delta is threatening to file for bankruptcy within a month unless it reaches agreement with its pilots union. Thus, a possibility exists that a record percentage of the airline industry could be in bankruptcy shortly. Furthermore, the number two and number three largest firms in the industry could be bankrupt at the same time.

The possibility of such a large portion of the industry in bankruptcy at the same time is not just a matter for the record books, but has important ramifications involving antitrust law. The "failing firm" and "existing assets" defenses and exemptions in antitrust law let otherwise anti-competitive deals proceed if the firms and industries attempting to merge are extremely dire straits.

Under those theories of antitrust law, the bankruptcy of Delta could open up a window during which mergers that would never be permitted otherwise could be allowed. The Justice Department blocked UAL’s attempt to buy US Airways on antitrust grounds. Today, such a merger would likely be permitted. If Delta were to enter bankruptcy, even larger mergers would probably be feasible based on “failing firm" and "existing assets" defenses.

Aside from any antitrust law considerations, there is no way that any of the non-bankrupt major legacy airlines could merge with each other because of their huge unfunded pension liabilities. Thus, any merger of major legacy airlines will have to be like American’s acquisition of TWA’s assets. After TWA’s pension plans were terminated along with all post-retirement employee obligations, American bought TWA’s assets.

American assumed certain of TWA’s debts and TWA employees were added to the bottom of the American Airlines seniority lists. As 9-11 occurred shortly after the merger, American furloughed most former TWA employees. Today there are no former TWA pilots or flight attendants still working at American Airlines.

If an antitrust law exemption based on the "failing firm" and "existing assets" doctrines were to develop, mergers thought inconceivable a few years ago might occur. American might be able to acquire the assets of Delta or even UAL on terms similar to those used in the TWA acquisition. The cash required would be relatively small, but it would involve the assumption of significant amounts of debt. Northwest and Continental might also try to take advantage of such an antitrust law exemption “window” to attempt to acquire the assets of UAL, Delta or US Airways on similar terms.

While the words “Penn Central” may come to mind when any such mega-mergers of legacy airlines are considered, there is no doubt that consolidation is sorely needed in the industry. One wrinkle may be that the non-bankrupt legacy carriers use the prospect of such acquisitions to obtain wage concessions from their unions. Many American Airlines pilots and flight attendants still have jobs today because the TWA employees went to the bottom of the seniority lists. Probably all of the employees at any major legacy airline now on furlough could all be recalled if their airline were to acquire the assets on a bankrupt legacy carrier and the bankrupt carrier’s employees were “stapled” to the bottom of the combined entity’s seniority lists.

The acquiring legacy airline might even be able to obtain wage concessions from its unions as a quid-pro-quo for giving its employees job security (at the expense of the bankrupt airline’s employees) significant enough to allow the to compete with the low cost carriers. That combined with the capacity reductions creation of local monopolies that such consolidation would entail might actually allow a legacy carrier to actually earn a profit.