Airlines: Where Capital Goes to Die
The big U.S. carriers have a broken business model and little relief in sight. Some long held assumptions about the industry could soon be upended
By Justin Bachman

As U.S. banks grapple with federal "stress tests" on their balance sheets, a similar process is playing out in the airline industry. Mix a deep recession with tight credit and fear of an influenza pandemic, and there's plenty of stress on airline balance sheets this spring. That has carriers conserving every last penny and hoping the summer travel months provide a sufficient cushion to last through to an economic recovery.

But what if the summer is not bountiful, or the global recession turns nastier? What if another health or terror scare further depresses flying? For most of their history airlines have been growth enterprises, with heavy capital needs but plenty of people willing to invest. That was then, however; today a share of most airline stocks costs less than a six-pack of microbrew.

Those shares serve as little more than a proxy for the price of crude oil—a trading stock that can turn a quick profit. Legacy airline debt yields a 20% or better return, but only because the risk is so high. The current times are sapping cash; maintaining liquidity has become a central job for airlines. "We have in this business been able to fund long-term losses with outside capital … and that is going to be harder to do in the future," US Airways (LCC) CEO Doug Parker said on May 4, citing "fundamental" changes for airlines' financial partners such as banks, aircraft makers, lessors, and other suppliers.

All Eyes on the Baby Boomers
So where will operating capital come from? It's a crucial question for airlines. If demand doesn't return to the same degree as in past recoveries—indeed, if in coming years aging baby boomers wracked by stock losses and shaky home prices fundamentally change their spending habits and don't travel as much as predicted—revenues could be severely crimped. That might combine with two rising expenses: higher payments to underfunded pension plans that cover older airline workers, and more capital to update aging jet fleets.

Yet as the recent experience of troubled American banks and car companies has shown, once far-fetched scenarios can quickly morph into solutions for vital yet ailing industries. U.S. taxpayers have been summoned repeatedly for aid, as have investors abroad. Uncle Sam has also offered enticing terms to spur certain investments—similar incentives could be devised for the airline industry. And for practical purposes, the Obama Administration has been managing General Motors (GM), Chrysler, and American International Group (AIG). Why not an airline or two?

If airlines are eventually forced into bankruptcy, pensions may be jettisoned, as US Airways, Delta (DAL), and United (UAUA) have all done in Chapter 11. But federal officials could require more funds from companies that wish to do so. As for aircraft, the U.S. lags Europe and Asia in terms of commercial fleet age because cash-strapped U.S. airlines have bought very few of the latest models (zero of the jumbo Airbus A380s, for example). Airbus and Boeing (BA) are themselves scrambling to keep business and tend to offer large customers attractive financing and other breaks, but that would hardly cover the needs of an industrywide order for 1,000 or more new planes.

Consolidation Among the Big Five?
"Looking ahead, with credit tight, where will capital—affordable capital—be found unless it is from another participant in the same industry?" Bill Swelbar, a research engineer with MIT's International Center for Air Transportation and a Hawaiian Airlines (HA) director, wrote recently on his blog. "If companies are struggling to realize any return on invested capital today, then what happens as interest rates continue to increase in lockstep with capital scarcity?"

As Swelbar suggests, the logical answer would be consolidation among the five big carriers. A new round of bankruptcies might even see one or more of a large airline's best bits sold off to a rival, or outright liquidations—steps that were largely avoided during the reorganizations that followed the 2001 terrorist attacks. Even after the capacity cutbacks spurred by crude oil's spike in the summer of 2008, many observers say far more—25% to 35% of the current capacity—must be removed before any meaningful profit-margin improvements will be realized.

"There are too many airlines," says Vicki Bryan, a senior bond analyst with Gimme Credit in New York. "Even last year when they were all just getting killed, slaughtered, massacred on fuel … the net reduction in capacity was just not significant."

Ownership Issues Coming to a Head
But airline consolidation remains a minefield that encroaches on union and political interests. Ditto for another potential source of capital, healthier European and Asian carriers. U.S. law restricts foreign airline ownership in U.S. carriers to a minority stake, but the International Air Transport Assn. and big European airlines have made that issue a central part of the debate over further liberalization in U.S.-European air links, with the matter coming to a head in 2010 when a second phase of the "Open Skies" treaty is set to be negotiated.

"From California to the eastern banks of Europe, this should be one market, and we should treat it as one market," Lufthansa (LHAG.DE) CEO Wolfgang Mayrhuber said Apr. 29 in a speech to the U.S. Chamber of Commerce in Washington. Lufthansa has been on the forefront of consolidation in Europe, taking controlling ownership since 2005 in various carriers: SWISS, Austrian, Belgian, and bmi, and a 19% stake in JetBlue (JBLU).

The long argument against foreign control of U.S. carriers, dating from the 1940s, has been based on national security and the government's ability to gain access to the civilian fleet in emergencies. Others worry that European or Asian operators would slash jobs and decline to serve small, less profitable U.S. cities. But nationalistic arguments may hold diminishing sway at a time when an Italian industrial group, Fiat (FIA.MI), is negotiating to acquire one of Detroit's iconic Big Three automakers, and the largest U.S. bank—Citigroup (C)—has sold a nearly 9% stake to investors in Abu Dhabi and Saudi Arabia.

Going Private Not Likely
One other option that might apply in other industries—going private—is unlikely to come to airlines. Jesup & Lamont analyst Helane Becker raised the question with United's management during a recent earnings call: With their public equity virtually worthless, why don't airlines seek funds from public debt? But to go private, airline executives would have to borrow heavily to buy their shares—and even if they did so, they'd be spending those funds on a severely distressed asset.

That's not a scenario lenders would care to see. As for an outside takeover, private equity firms have lost the financial firepower they deployed in 2006 and 2007 as the worldwide credit markets seized. And even if they had escaped the market collapse unscathed, an airline would be among the least favorable places to invest. Moreover, the legacy carriers already have substantial leverage on the books, leaving a takeover artist no space to add debt. "It becomes an opportunity cost, too," says Ben Baldanza, chief executive of privately held Spirit Airlines. "If you got a billion dollars are you going to go buy an airline?"

For cash-strapped airlines, the looming crisis could produce relief in many forms: a new European owner, a government-overseen industry consolidation that forces travelers to pay more, or the sort of terms that may make a large investment fund scramble for its checkbook. As recent history demonstrates, old problems in this environment have a way of attracting new solutions.

Bachman is deputy news director for BusinessWeek.com.