Airline Bankruptcies: Who's Next to Fall?

Bankruptcies are nothing new to the airline industry, which has seen hundreds of carriers become defunct since the infancy of the business. But a recent spate of bankruptcies by several prominent carriers--including  Frontier Airlines , Aloha Airlines, ATA Airlines, and Skybus--has spooked the industry and investors. While the demise of these carriers was preceded by cutthroat competitive dynamics and faltering liquidity, it seems that escalating oil prices (and in Frontier's case, nervous counterparties) finally pushed them over the edge.

Deteriorating Industry Fundamentals
With oil prices topping more than $130 per barrel, more carriers are in danger than ever before. A lethal combination of high oil prices, falling domestic demand, and unwieldy debt loads makes for treacherous terrain in this notoriously cyclical industry. Fuel now represents the single largest expense item at more than 30% of costs (exceeding labor costs), and inflation-adjusted fuel prices now exceed all-time highs reached back in the 1970s.

Domestic carriers are slashing capacity, seeking ancillary revenue streams, selling noncore assets, and pursuing consolidation to mitigate rising crude, but in our opinion, these steps may not go far enough to ensure survival for all participants. Even the current merger plans of  Delta (DAL) and  Northwest  are somewhat disappointing, as the combined entity has not targeted sufficient capacity cuts beyond what the stand-alone carriers had originally planned. And though  American Airlines  will be flying 11%-12% fewer mainline domestic seats by the end of this year, we estimate that airlines would need nationwide capacity cuts to the tune of 15%-20%, coupled with double-digit price increases, in order to show accounting profits at current oil prices.

Record-high oil prices couldn't come at a worse time because the U.S. economy is beginning to show signs of weakening. Year-over-year gross domestic product growth rates have slowed to an anemic 1% level, and consumer sentiment is at its lowest reading since 1980. To top off the bleak picture, airline debt levels are still too high for most carriers (despite bankruptcy restructuring in some cases) because of a legacy of low-cost debt financing to fund airline fleets. The cash hoard that airlines built up during the last several years as a cushion against a downturn will almost certainly be tapped to meet near-term debt obligations as operating losses mount.

Balance Sheet Strength Points to Likely Survivors
At Morningstar, we've long been bearish on airline stocks, with 1-star ratings (stock prices well above our Consider Selling prices) on names such as Frontier before the carrier filed for Chapter 11 protection. As the industry downturn plays out in the face of higher crude oil prices, we think there's a relatively high probability of more failures. Because airline debt is largely rated as "junk" and the debt financing markets are still under meaningful strain, it's highly unlikely that most airlines will be able to easily tap new sources of liquidity. We also think the renegotiation of financial covenants will just buy more time for carriers, particularly if crude oil prices move higher. As such, we believe that the most important determinant of survival for airlines will be how well existing cash balances stack up to expected debt obligations and the intensity of cash burn.

To gauge the preparedness of the 17 domestic airlines in our coverage universe (16 when Northwest and Delta are combined), we apply two different metrics. The first metric utilizes the airline's effective cash balance plus any expected cash flow generated or used during the next three years (NTY) compared with explicit debt obligations coming due during the same period. To calculate the effective cash balance, we exclude illiquid auction-rate securities because the market for these instruments has come to a standstill, and it's therefore difficult to gauge when an airline holding these securities will be able to redeem them for cash.

NTY Liquidity Position =
(Cash balance � auction rate securities + NTY free cash flow) / (NTY debt obligations)

The second metric utilizes a more traditional coverage metric--earnings before interest, taxes, depreciation, and amortization--during the next three years compared with interest expense during the same period.

NTY Coverage Ratio =
(NTY EBITDA) / (NTY Interest Expense)

Airline Liquidity and Debt Coverage Rankings
	Next 3 Years Liquidity Position	Next 3 Years Coverage Ratio
Southwest Airlines (LUV)	8.7	8.6
SkyWest (SKYW)	3.9	3.0
Delta/Northwest (DAL)	2.5	3.7
Continental	1.9	2.8
UAL	1.4	2.7
Republic Airways	1.2	3.3
Hawaiian Holdings (HA)	1.1	1.3
Alaska Air Group (ALK)	0.9	0.2
Pinnacle Airlines	0.8	11.4
AirTran Holdings	0.8	0.8
AMR	0.7	1.4
JetBlue Airways (JBLU)	0.7	1.8
Frontier Airlines	0.2	-0.6
ExpressJet Holdings	0.1	-10.6
US Airways	-0.1	0.3
Mesa Air Group	-0.5	-0.2

Top of the Class
Without question, the airline most prepared to deal with high oil prices is  Southwest Airlines (LUV). Several years ago, Southwest locked in below-market fuel hedges, which have protected the airline from escalating oil costs during the last few years. As a result, the airline realized higher profits and free cash flow, bolstering its cash hoard to well more than $3 billion. The firm has hedged 70% of its 2008 fuel requirements at a price around $50 per barrel; however, fuel hedges diminish during the next couple of years with less coverage at higher prices. That said, Southwest is one of the few airlines whose cash balance exceeds its total long-term debt, so there is little reason to think that Southwest will have serious issues near term. The firm's low-cost competitors,  JetBlue Airways (JBLU) and  AirTran , don't appear as well-situated because they hedged less of their oil exposure and have taken on significant debt to fund fleet expansion.

The combined Delta-Northwest entity is in a decent position, if only because it would probably be the last to fall among the legacy group. The two carriers were the last two to emerge from bankruptcy protection, and we estimate the integrated entity will have the lowest mainline nonfuel cost structure among full-service airline competitors. The soon-to-be merged carrier, however, has yet to negotiate integrated labor contracts and plans to use as much as $1 billion in cash to integrate both airlines during a long timeline. We'll be watching to see how quickly Delta-Northwest may have to tap into its undrawn revolver of $1 billion.

Among the regional airlines,  SkyWest's (SKYW) liquidity position is the strongest, with more than $10 per share in cash and cash equivalents. For now, the firm sits in an enviable liquidity position, but the long-term picture is more cloudy. The firm flies uneconomical 50-seat planes (or smaller) and depends on traffic flow from legacy carriers that are likely to cut back capacity in a world of higher oil prices.

Bringing Up the Rear
Not surprisingly, bankrupt airline Frontier scores poorly on our scale, which explains in large part why the firm's credit card processor forced the airline into Chapter 11, despite the more than $100 million in cash on hand. Interestingly, however, several airlines score even worse than Frontier, including  Mesa Air  ,  US Airways , and  ExpressJet .

Mesa Air
Mesa Air is perhaps the weakest of the regional carriers. It has roughly $120 million-$130 million in unrestricted cash and marketable securities and roughly $50 million-$100 million of financeable spare parts. Assuming no cash burn, which cannot be guaranteed, and assuming that the spare parts Mesa owns are financeable at full price, the regional carrier could have $230 million in potential liquidity to satisfy roughly the same amount in debt and legal obligations during the next 10 months. This assumes the court requires Mesa to post a bond related to the Aloha trial of the same dollar value as the one it had ordered to cover  Hawaiian's (HA) damages. There's a chance Mesa might be able to squeak by during the next 10 months if the court upholds its position on the Delta dispute or if Mesa continues to dilute existing shareholders. However, we think there's a high probability of financial distress, particularly considering its long-term debt load of more than $550 million.

US Airways
Although US Airways has a relatively small amount of debt due during the next three years relative to its larger competitors, the airline is extremely vulnerable in this environment. The carrier has the greatest exposure to a domestic passenger slowdown and is perhaps the least attractive merger candidate, though we can't rule out a deal with United's parent  UAL . US Airways has burned through about $175 million in cash in the first quarter, and we'll be watching closely to see if this measure accelerates in coming periods. The company has roughly $2.1 billion in unrestricted cash, but at today's oil prices, it may only be a matter of time before this is materially depleted, triggering a default on its term loan.

ExpressJet
ExpressJet could be headed toward financial distress if it doesn't offer  Continental Airlines   significant concessions in a new contract, or if a bail out by private-equity investors or SkyWest doesn't happen. The airline continues to burn cash at a rapid rate, and with $65 million of its roughly $190 million unrestricted cash balance held in illiquid auction-rate securities, the company could be forced to dilute existing shareholders in order to redeem $134 million in senior convertible notes due in August this year. In light of major partner Continental's public plans to eventually terminate its capacity purchase agreement, ExpressJet must either renegotiate with Continental or sell the airline, as the status quo will ultimately leave its equity worthless.

American Airlines
American Airlines' parent AMR has announced drastic domestic capacity cuts, revenue initiatives, and head-count reductions, and has even renegotiated a key financial covenant. But in an environment of tightened credit, high jet fuel prices, and slowing domestic demand, it's far from out of the woods. AMR will have to find a way to retire or refinance roughly $3 billion of debt due within the next several years, while shelling out more than $2 billion for new aircraft. Such financial commitments could eventually prove too much for its stretched balance sheet, which, after adjusting for the recent American Beacon sale, holds less than $5 billion in unrestricted cash.

JetBlue and AirTran
Low-cost players JetBlue and AirTran also appear to have some difficult challenges ahead. Both airlines have been expanding their respective fleets, incurring hundreds of millions of dollars in secured debt that management had expected to repay with stronger earnings. However, neither airline anticipated that oil prices would escalate and crush profits, forcing them to divert needed cash toward fuel bills. As a result, both firms have slowed growth plans, sold assets, and raised cash by issuing additional equity. Near term, JetBlue may have a little more breathing room because none of its debt contains financial covenants, and foreign carrier Lufthansa appears keen to help the firm stay afloat.

Pinnacle Airlines
 Pinnacle Airlines  appears to be in decent shape, if one considers its EBITDA coverage ratio alone; however, its near-term liquidity is jeopardized because the firm holds more than 60% of its cash and investments in the form of auction-rate securities. Furthermore, the firm is in the process of a two-year, $580 million expansion. Although Pinnacle already has commitments to finance the majority of this expansion, any near-term cash shortage could be a devastating blow to Pinnacle.

UAL
Like AMR, UAL recently renegotiated a key financial covenant to ease the pressure. The amendment eliminates the threat of UAL having to accelerate the repayment of $1.3 billion in outstanding borrowings on its credit facility in the near term, but the carrier is far from financially fit. The airline's half-billion-dollar pretax loss in the first quarter coupled with Continental's swift rejection of a merger agreement are not encouraging signs. Further, UAL's quick move to advance merger negotiations with US Airways could indicate a more serious financial condition. Nonetheless, UAL's $2.9 billion unrestricted cash balance and $2 billion-$3 billion in unencumbered assets should keep it flying for some time, though the price of crude oil will largely determine whether Chapter 11 is in its future.

It's important to note that our metrics aren't intended as stand-alone valuation tools, but as starting points in determining which airlines are best-positioned to survive. A number of developments could materially alter the rankings, including changes in competitive dynamics (such as Southwest entering certain markets), significant capital expenditure cuts, or a dramatic drop in crude oil prices. Nonetheless, we think the list provides important insight to gauge which airlines are in the most danger.

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