Fuel Costs Accelerate Risks to Airlines

It is a thrill ride nobody wanted.

Just months after reporting their highest annual profits in eight years, US airlines are in a nose dive that could leave some major carriers in bankruptcy.

Leaders at Chicago's United Airlines and across the industry are scrambling to devise business models that will hold up to the stresses of $128 per barrel crude oil and a sluggish economy.

If the 10 largest US airlines don't boost revenues and restructure loans, their cumulative cash could shrink 62 percent to about $8.6 billion by year's end, estimated Philip Baggaley, chief credit analyst at Standard & Poor's.

That's not sufficient to cover one month's expenses at the carriers, he said. "In other words, in this simplified example, the airlines, as a group, would be at risk of bankruptcy," Baggaley wrote in a research report Friday.

To gain pricing power in a fragmented, overserved industry, US airlines need to cut as much as 20 percent of domestic flights, analysts said. That's equivalent to grounding two major carriers.

It is uncharted territory; what American Airlines Chief Executive Gerard Arpey termed "an environment of continuous disruptive change" in a letter to employees last month.

It comes as United's directors ponder one of the biggest strategic maneuvers in the carrier's 77-year history: a high-risk merger with US Airways that could reap rewards if executives can steer clear of potentially ruinous labor showdowns.

United is also exploring a code-share partnership with Continental Airlines that would allow the carriers to sell tickets on each others' flights. Such a virtual merger could lead to the full-fledged combination similar to the deal that Continental executives rejected last month, analysts say.

But there's no guarantee either option will pan out, analysts warn.

Airline mergers are unwieldy and notoriously difficult to complete. Continental, meanwhile, has other suitors. The Houston-based carrier has also held talks with American Airlines and could opt to remain allied with its current marketing partners, Delta and Northwest Airlines, which are also merging, sources said.

\ No easy answers

Deciding on a course is not easy for executives at United or any other carrier, especially given the stakes involved and the volatility of the global fuel markets. Crude oil prices have doubled over the past year, rising about 15 percent in the past two weeks alone. "Fuel is astronomically expensive, to the point of pushing the industry past the point of economic viability," said Henry Harteveldt, travel industry analyst with Forrester Research Inc.

"Change clearly needs to be made, and it's going to have to come across a host of areas," said Kathryn Mikells, United's vice president for investor relations, who declined to discuss its negotiations with US Airways or Continental. "There isn't a single silver bullet."

A United-US Airways tie-up would bring about $1.5 billion in savings and new revenues to help offset the nearly $6 billion increase in fuel costs the two carriers could see this year, say people familiar with the discussions.

The resulting carrier would have a broad national network that would feed more passengers, particularly wealthier travelers in US Airways' eastern seaboard strongholds, to United's lucrative international routes, analysts said.

The carriers could also eliminate costs by paring operations at selected hubs where their networks overlap. Harteveldt sees US Airways operations at Philadelphia, Washington, D.C., and Phoenix as prime candidates for cuts.

And the sell-off that has battered both airlines' stocks could actually work to the advantage of investors in the merger. US Airways' market capitalization has shrunk to just $718 million, the lowest among major carriers; United's worth is $1.74 billion, down 61 percent since Jan. 1.

Given these depressed prices, any financial gains resulting from the tie-up would likely send shares soaring, providing larger returns than investors would have seen if the companies' combined market value had been higher.

"The lower the range the stock goes, the better the future return," said Roger King, airline analyst with CreditSights Inc. But that only holds true for recent investors in the companies, he added. Any gains wouldn't likely offset losses suffered by shareholders who have ridden United shares down from the $40-range to $13.81, Friday's closing price.

People close to the airlines say that while they have made progress, a deal is not imminent. Issues that must still be resolved include who will run the combined airline and how the resulting carrier would be branded.

Then there's the threat that disgruntled workers will undermine or disrupt operations following a deal. United's unions oppose the merger, in part because they don't want to be drawn into the labor strife that has riven US Airways since its takeover by Phoenix-based America West three years ago.

Tensions among US Airways' east- and west-based pilots are so heightened that there are reports of pilots refusing to allow their counterparts from the rival faction to ride on the jump seats in their cockpits, a common courtesy among U.S. airlines that lets off-duty pilots get to their destinations quickly.

Such distractions are the last thing the management teams need to deal with in this environment, said Kevin Mitchell, chairman of the Business Travel Coalition, a Pennsylvania-based advocacy group for large corporate travel buyers.

"That's a huge risk: These management teams are off in a quagmire trying to pull this together while their competitors eat their lunch," he said.

\ Most in the red

None of the major American carriers are expected to earn a profit in 2008, except Southwest Airlines, which is expected to benefit from costly hedges against rising fuel costs.

United, American and Northwest Airlines have all renegotiated covenants that would likely cause them to default on loans later this year if cash flows continue to decline. United also renegotiated an agreement with its largest credit card processor.

Even Southwest last week mortgaged 21 aircraft to raise $600 million in cash, bolstering the $3 billion it already has on reserve. Southwest spokeswoman Brandy King said the Texas-based discounter decided to "take advantage of attractive financing" and said the cash would go to "general corporate use."

While Southwest adds to its network, every other major airline is planning big cuts in flying after the busy summer travel season. United already has identified 52 flights that will be cut and is studying its network for others as it plans to ground at least 30 planes and trim its domestic network by 9 percent during the fourth quarter. It could reduce flying further if fuel costs continue to rise, Mikells said.

The nation's second-largest carrier is looking at a host of other ways to trim costs and raise revenues. Those initiatives are being coordinated by a council of senior leaders established to streamline planning. As of July 1, United will end a long-standing policy of awarding at least 500 frequent flier miles to its Mileage Plus members, no matter how short the flight. And earlier this month, it started charging passengers $25 to check a second bag, a policy other airlines also have adopted.

The baggage fees alone should generate $1 billion in new revenue for the 10 largest US carriers this year, estimates AirlineForecasts LLC. But that isn't nearly enough to cover the $23 billion jump in fuel costs that they face this year if oil stays at current levels, according to the Virginia-based market research firm.

If oil prices don't drop, financial pressures will grow for airlines as the year progresses, analysts predict. "There is probably no more challenging time for them since Sept. 11 in terms of running their business," said Forrester's Harteveldt.

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