06:44am EST 29-Sep-04 Bear Stearns (Strine,David 212-272-7869) DAL DAL.N -DAL:
The Last Inning ...
A Look at Potential Cash Savings, Cash Burn and Liquidity:
Delta provided more detail on non-pilot cost cutting on Tuesday afternoon. As it stands, we estimate that DAL will burn $1.3bn in 2004 and another $2bn in 2005 if oil averages $45/bbl. To avert chapter 11, at the very least, the carrier needs to stop the cash burn. DAL is still negotiating for $1bn from the pilots. What is new is DAL's announcement of a 10% across-the-board pay cut for the employees at will (non pilots that are not covered by a collective bargaining agreement) beginning January 1, 2005. (This is less than expected.
In our previous analysis, we had assumed the cut would be at least 15%). We estimate the 10% cut will result in about $430 million in annual savings (assuming the pilots account for about one third of current labor costs). In addition, on Sept 9, DAL announced layoffs of 6,000 to 7,000 employees (not pilots). Assuming the average cost per employee is about $65,000 implies savings of about $425 million. The company mentioned some other, harder to pin down, labor cost savings (e.g. changes in health care benefits) which we do not expect to amount to material cash savings near term as we believe they are largely designed to pass through expected future increases in health care costs. The other meaningful issue is the exchange offer, announced on September 15th, which we estimate could save about $60mn in interest expenses. Accordingly, if all goes according to plan, DAL could achieve about $1.9bn in annual cash savings all-in. This is cutting it very close and provides very little cushion, but it would be likely be enough for the Board to avoid filing for chapter 11 this year.
DAL ended 2Q with $1,966 million in cash. We estimate that the carrier has been burning about $3.5mn per day ($320mn for 3Q), however, DAL entered an agreement to sell 8 MD11s and four spare engines for an estimated $200mn during 3Q. Accordingly, we expect DAL to end the quarter with about $1,836mn in cash (assuming the MD11 proceeds hit the books), still above the $1.5bn level at which a filing becomes nearly certain. The problem is that cash burn gets much worse in 4Q. In 4Q, we expect DAL to burn another $500mn (about $5.5mn per day). This would place DAL at $1.5bn by November 30th. We believe a deal must be struck with the pilots within the next few weeks and the savings will have to kick in immediately in order for the carrier to avoid Chapter 11 this fall.
That said, this is just a near term fix if oil trends even higher and yields go down more dramatically than expected and/or United Airlines and US Airways survive and emerge from chapter 11 free of defined benefit plans and have unit costs that rival the LCCs. DAL still has an enormous defined benefit pension problem and as DRC relief legislation expires in 2006, we will likely see a dramatic increase in required cash contributions.
The lingering problem of DAL's defined benefit plans:
In the debate about the fate of Delta Air Lines, we often hear investors argue about the import of wage rates and work rules, but the lingering problem of the defined benefit pension plans is something that will have to be dealt with if the company is going to truly prosper in the long term. Unless oil craters, one by one, we will see the pension issue rise to the forefront at the legacy airlines. Promises were made in fat times over the past few decades that are now exceedingly difficult to keep while running a business that can attract capital. The crux of the issue is well illustrated by what is happening at United Airlines. The DIP financiers do not want to put money into an entity that has a massively under-funded pension plan that will siphon off cash flow for years to come. On July 23rd, United secured an additional $500 million in DIP financing with liquidity covenants, which effectively prevent the carrier from making cash contributions to its pension plan. To wit, United elected to skip July and September's required pension contributions (an additional $3 billion looms for the 2005- 2008 period) (US Airways announced early this month that it too intended to skip its near-term pension contributions). Not surprisingly, the decision to withhold pension funding has not gone down very well with employees. The IAM (International Association of Machinists and Aerospace Workers) filed suit charging United's officers with a breach of fiduciary duty and the Pension Benefit Guaranty Corporation (PBGC) issued a statement citing its "great concern " over United's behavior and has asked for more details on the matter.
Looking at Delta specifically, the defined benefit plans were under-funded by $5 billion at 12/31/03 on an accumulated benefit obligation basis (which differs from ERISA, though comparable as both only use liabilities already accrued), and north of $450 million in cash must be contributed to the plan next year under ERISA guidelines (note that April 10, 2004, legislation passed that allowed for a two year deferral of 80%/60% of 2004/2005's previously required deficit reduction contributions, DRC, (catch-up contributions to the plan), though the timing of Delta's plan year shifts the benefits to 2005/2006 instead of 2004/2005). Despite the DRC respite, pension payouts continue to rise (see Table 1 below). In addition, the funding status could weaken further should an increasing number of pilots jump ship and take lump sum distributions. Due to a higher than expected number of pilots (356) taking lump sum distributions, DAL reported a $117 million charge in 2Q. Delta's pension plan payouts have ballooned over the past few years to $1.1 billion in
2003 from $600 million n 2001 (exacerbating the funding situation), partly as a result of the increased number of pilots taking lump sum distributions. Part of this can be attributed to the expectation of higher rates and therefore a lower present value of retirement benefits and some may be due to uncertainty about the viability of the plan itself. (The pilots have seen what happened to US Air's DB plans and what is happening now at United.)
In 2003, Leo Mullin (DAL's former CEO) recognized the enormity of the pension problem and made an effort to address it by shifting non-pilots to a cash balance defined benefit plan. (Cash balance plans have often been favored by employers as a lower-cost way of offering a DB plan because benefits accrue more evenly (and typically at a lower rate) during employee tenure.
Employees close to retirement, being switched to a cash balance plan generally appears to deprive them of the faster, late-career accrual available under traditional DB plans.). While helpful, this change did not address the enormity of the problem. To be sure, the obligations are no small rock to get out from under, and given the stringency of ERISA and potential litigation surrounding an attempt to alter benefits, history shows that the only carriers that were able to radically change their pension plans and obligations (e.g.
terminate the plans and distribute to the PBGC) did so through Chapter 11 proceedings including: Pan Am, Eastern, TWA and most recently US Airways pilots.
