Description

Delta’s January 2007 put options (strike price of $5 or $2.50) represent a compelling opportunity. While there is more theoretical downside potential in this trade than in most investments I consider attractive, I nevertheless think the potential reward and the likelihood of achieving it make this quite interesting.

To put it simply, I think it is more likely than not that Delta will file Ch 11 before next winter, and almost a certainty to occur before winter 2006. With 50% of the float short, tremendous leverage to oil, and an insane amount of financial leverage, I would not try to short the common. However, buying the put options gives you plenty of upside potential and caps your potential downside. Admittedly, the common would not immediately trade to 0 upon filing and the common wouldn’t get cancelled until confirmation of a reorganization plan. But the $5 strike puts should trade above $4 after filing (I sold my UAL $5 strike puts after United filed for $4.40), plenty of upside from the current price of $1.50. The relative attractiveness of the $2.50 strike puts depends more on exactly how low the common would trade after a filing but before cancellation, so I am more comfortable with the $5 strike puts (I am skeptical that the common would get cancelled or trade to 0 before expiration in Jan 2007).

Delta stock has skyrocketed in recent weeks after narrowly avoiding Ch 11 this year with the announcement of rescue financing from GE and Skymiles prepayments from Amex. But the situation remains untenable, and I expect the inevitable Ch 11 filing to come before next winter (and almost certainly before winter 2006) for the following reasons.

Capital Structure
To put the capital structure in context, Delta has amassed over $13 billion in balance sheet debt (roughly $4.5 billion of that unsecured), with an additional $5-$5.5 billion if you capitalize operating leases (even after the benefit of recently announced lease rate cuts of $57mm per year). Not to mention a pension funding gap of $5.7 billion at Dec 2003 and unfunded OPEB liability of $2.3 billion at Dec 2003. LTM EBITDAR comes out to $929mm (LTM EBITDA $202mm).

Pension
First off, the pension situation at Delta screams for a “distress termination”. Pension laws are extremely complex, but basically, the only way Delta could shed its severely underfunded defined benefit pension obligations would be in bankruptcy. (Even if the pilots union were in favor of it, Delta legally could not trim back existing pension obligations). Promised pension benefits that have already been earned can never be taken away, only foisted onto the PBGC in a distress termination.

While the plan has been “frozen” effective Jan 1, 2005, the existing obligations ($5 billion underfunded versus ABO at 12/31/03) still must be funded on an accelerated timetable. “Freezing” essentially stops future service benefits from getting added to the balance, but does not delay the necessary “catchup” payments. Typically, a plan this underfunded would require accelerated “catchup” payments under ERISA on an extremely short amortization timetable of just 3-4 years.

That said, Congress has granted some relief for 2004-2005 by raising the discount rate upon which the PV of obligations is calculated. But this is scheduled to expire at the end of 2005. Congress also granted further emergency relief for pensions operated by airlines and steel companies in 2004 and 2005. Even with such special treatment, Delta’s latest forecast is for $500-550mm cash contribution in 2005. But come 2006, the required annual cash contribution could hit a whopping $1.5 billion if not more!

Those who have looked at Delta’s pension funding history over the past few years may be skeptical. After all, Delta only contributed $144mm, $77mm, $50mm in 2003, 2002, and 2001, respectively, and the required portion of its 2004 contribution was just $130mm. But Delta has made generous use of “credits” built up years ago to delay its cash contributions. While it isn’t totally clear from the public filings, it appears that such “credits” are finally running out. Barring further “emergency measures” from courtesy of Congress, the day of reckoning will come in 2006.

Incidentally, this is the very reason why United’s pension plan was able to become so incredibly underfunded – like Delta, United made use of “credits” built up from the heady days to delay the day of reckoning. United made just $6mm of cash contributions to its pension in 2001-2003, but as its 2003 10-K shows, come 2004, as the “credits” ran out, United was faced with over $1.1 billion of required cash contributions for 2004 and a further $2.4 billion for 2005-2006.

Furthermore, the termination of United’s pension plan, all but a foregone conclusion at this point (and the union now seems to clearly acknowledge that), should provide further pressure on Delta to do the same. Also note that US Air terminated its pilot pension in the last run through Ch 11, and will likely terminate the other plans this time through, assuming it emerges.

Delta’s pension plan financial position may even have deteriorated further since Dec 2003 given the magnitude of recent early pilot retirements (703 so far in 2004, including 71 in September, 55 in October, 197 in November). Pilots who retire early immediately receive 50% of their pension benefits in the form of a lump sum.

Unsecured Debt
Delta is also an extremely logical Ch 11 candidate because it has so much unsecured debt. Secured debt, of course, can be difficult to haircut in bankruptcy because lenders can at least theoretically take their collateral. The same difficulty typically applies with lessors. Equitizing unsecured debtholders, therefore, is the simplest way to chop the debt balance and interest expense on a go forward basis. In a simplistic sense, Ch 11 would enable Delta to “easily” eliminate $9-10 billion of pension and debt in one fell swoop. Especially given that Delta’s unsecured debt as a % of total debt is so high relative to other airlines, the logic in Delta using Ch 11 to restructure its debts is even more compelling than for its peers.

In addition, with so many different public debtholders (including those holding secured public debt in the form of EETCs), an out-of-restructuring is next to impossible. Delta’s recent Herculean efforts in that regard were largely a non-event (~$130mm of 7.7% Notes due ’05 were exchanged for 8% Notes due ’07, less than a year after the puts would expire and thus within the timeframe that could precipitate a winter 2006 filing, not to mention that the dollar amount is a drop in the bucket. Also, $235mm of PTCs due ’05 and ’06 were exchanged for 9.5% Sr Secured Notes due ’08, with amortization beginning in ’06 and necessitating the encumbrance of 32 previously unencumbered planes).

Lack of Unencumbered Assets
In order to arrange its recent rescue financing from GE and Amex, Delta essentially pledged all of its remaining unencumbered assets. While the company does get to “live to fight another day” in the short term, the orderly liquidation value of the encumbered assets was well over $2 billion to secure just $630mm of potential GE financing ($580mm drawn). Management has now backed itself further into a corner and given itself even less flexibility in attempting to avoid Ch 11 in the event that anything unforeseen arises in the future. Furthermore, in the same way that US Air was unable to get DIP financing this time, Delta may not be able to either. This effectively serves to raise the threshold amount of cash that precipitates a filing, as that cash must be adequate to get through a potentially lengthy Ch 11 process without the benefit of a DIP.

Pilot Deal is Not Enough
While the recent pilot deal sounds big on face, it is likely to prove inadequate. While accepting a 32.5% pay cut, the starting base wage rates were already so far above market that the new rates are still higher than American and United. Not to mention that United pilots are now agreeing to a further 15% pay cut and American has said that its costs must further be cut too.

Potential Holdbacks
Delta’s current Visa/Mastercard processing contract expires in August 2005. The current contract does not require any holdbacks. Delta’s “air traffic liability” was $1.755 billion at 9/30/04. I don’t know what the split is between Amex/Visa-Mastercard/Other, but Visa/Mastercard likely represents in excess of 50%. Assuming just 50% is Visa/Mastercard, and using just a 50% holdback, this would represent a potential cash use of at least $438mm (note that ATA’s holdback from its Visa and Mastercard processor got up to 100%!).

Future SkyMiles sales to Amex Unlikely
The recent pre-purchase of SkyMiles by Amex announced in concert with the GE rescue financing is something that few, if anyone, could have predicted. But once again, this “magic trick” represents one less lever left to be pulled. The $500mm prepayment covers the purchase of SkyMiles for the 2 year period between Dec 2005 and Dec 2007. Stranger things have happened, but I doubt Amex would look to pre-purchase miles even further into the future than 2008! Moreover, the $500mm is a prepayment only, which effectively functions as a working capital use of cash as that balance is bled off over time. Plus, Amex got junior liens on the GE rescue financing collateral. Given the extent of over-collateralization on the GE financing, these junior liens are likely still well “in the money”. If Amex required such security this time around, I find further pre-purchases even less likely as Delta has now encumbered substantially all its assets.

Competitive Position
Little comfort can be derived from Delta’s market position. Along with US Air, it has some of the very highest overlap with low-cost-carriers, especially on the east coast. Yields have been decimated from overcapacity, yet Jet Blue, AirTran, and others continue to take delivery of planes at a rapid pace. Delta is also increasing effective ASM capacity under its new plan.

Moreover, while the other legacy carriers excluding US Air have roughly 30-35% of revenues coming from international business, Delta’s international revenues are less than 20% of its total. Furthermore, the bulk of Delta’s international business is Atlantic, which is generally more competitive and less profitable than the Pacific/Asia.

Further Lease Rate Concessions Unlikley
Recently announced lease rate concessions amounting to $57mm annually are again, not much more than a drop in the bucket. It’s hard to envision further lease rate cuts outside of bankruptcy, especially as lease rates have continued to strengthen with strong demand coming from Asia in particular.

Ongoing Cash Costs Below EBITDAR Line
After giving effect to the $57mm of annual lease rate cuts recently announced, Delta’s annual aircraft rent expense comes out to $667mm. LQA interest expense of $210*4=$840mm probably understates interest expense going forward as that was prior to the recent GE rescue financing at healthy interest rates (for instance, the term loan gets L+600 with a LIBOR floor of 3%) and the recent debt exchanges that resulted in higher coupons. A more realistic number is probably closer to $900mm, but let’s assume $875mm of annual interest expense going forward. Add on $450mm of non-aircraft capex and we’re at $1,992mm of run-rate uses of cash below the EBITDAR “line”. Note that this assumes all aircraft purchases going forward get full incremental financing. This also ignores working capital changes, such as the possibility of credit card holdbacks. And of course, this is before cash contributions to pension.

Pro Forma Cash Balance at 9/30/04
Unrestricted cash at 9/30/04 was $1,446mm. Add on proceeds from the sale of the Orbitz stake for $143mm in November and $227mm of proceeds from selling 8 MD-11s in October. Also add on $580mm of cash from the GE rescue financing, drawn on Dec 1. Finally add on $500mm of Amex pre-payments ($250mm drawn Dec 1, the other $250mm to be drawn sometime after 3/31/05). This gets to pro-forma 9/30/04 cash balance of $2,896mm.

Estimated Cash Balance at 9/30/05
Now subtract off $1,992mm of cash costs below the EBITDAR line from above, 1 year of “roll-off” of Amex pre-payments of $250mm, and $525mm of 2005 cash pension contributions (10-Q estimates $500-550mm). That leaves a cash balance of $1,058mm at 9/30/05, below the level at which Delta would be forced to file. Thus, barring a massive drop in fuel costs (every $1/barrel roughly corresponds to $60mm of annual fuel cost for Delta), I would expect Delta to file before next winter. Even if Delta were to find a way to get to a healthy EBITDAR margin of 15%, that would correspond to EBITDAR of ~$2.1 billion, still not enough to avoid drawing down its cash balance on an ongoing basis. And that’s before pension contributions and the possible institution of a “holdback”.

Estimated Cash Balance at 9/30/06
Assuming the company manages to squeak through winter 2005 and its seasonal drain on cash, I don’t see how Delta can avoid filing before winter 2006. Again, even at EBITDAR margin of 15% the company is drawing down its cash balance. $175mm of 7.7% notes also come due 12/15/05. Pension contributions should be well in excess of $1 billion, perhaps north of $1.5 billion for 2006, with a similar expectation for 2007.

Valuation Multiples
Finally, while valuation is never enough in of itself to go short, the valuation multiples here are ridiculous under virtually any scenario. With over $13 billion of balance sheet debt, over $5 billion of capitalized operating leases, and a $5 billion pension gap, there is at least $23 billion senior to the equity. This comes out to 25x LTM EBITDAR. Even looking at peak EBITDAR of slightly less than $3.7 billion, achieved in the bubble days when dot comers will willing to pay business class fares 8x higher than economy fares and when the LCCs were far smaller, this comes out to over 6.25x peak EBITDAR.

Risks
If fuel prices drop significantly, it is possible Delta may be able to stave off bankruptcy long enough to have the Jan 2007 puts expire worthless. That said, given the level of overcapacity, it is not a forgone conclusion that the airlines could keep this windfall. Furthermore, as the entire industry would benefit, Delta’s weak relative positioning in a commodity market would still likely necessitate a bankruptcy down the road (though admittedly, that would be a Pyrrhic victory for put option buyers).

Equity markets could explode upwards, lowering the pension funding gap. That said, the ABO funding gap at 12/31/03 was still 74% of plan assets (said another way, plan assets were only 57% of ABO at 12/31/03), and not all plan assets are in equities, so it is inconceivable another equity market bubble alone could erase the funding gap.

Interest rates could skyrocket, lowering the pension funding gap. Again, it is unlikely this alone could erase the funding gap. Even in concert with another equity market bubble, it is unlikely a combination of the two could erase the funding gap, especially given the level of early pilot retirements already in 2004.

Congress could further delay the day of reckoning with regard to pension funding. This is certainly possible, though the government may finally be growing tired of subsidizing the airline industry (witness the rejection of United’s ATSB loan proposals 3 separate times). Moreover, given the untenable state the PBGC is now finding itself in, the government may finally need to take decisive action to put the PBGC on firmer ground, rather than delay the inevitable and allow the financial position of such sick pension plans to further deteriorate. And again, this wouldn’t absolve Delta from closing the funding gap, it would simply stretch out the time frame.

Credit market bubble. We read about the frothiness of the credit markets on a daily basis. Delta stock’s volatility is very high. Perhaps the company could access the capital markets, maybe in the form of a convert offering. Again, though, while this may delay Ch 11 past winter 2005, it seems unlikely a large enough deal could get done to get Delta past winter 2006.

Liquidation of Independence Air and US Air. The result could be a temporary strengthening in yields. But with so much industry overcapacity, and the upcoming delivery schedules at the LCCs, it is hard to see how this would be enough to disprove the thesis.

Catalysts

“Emergency” pension measures scheduled to roll off in 2005 – 2006 cash pension contribution likely to exceed $1 billion or even $1.5 billion.

Termination of United’s pension plan.

Renewal of Visa/Mastercard processing agreement that expires Aug 2005 could result in holdbacks going forward.

Ruthless competition from LCCs continues to drive down yields.

Erosion of cash balance necessitates Ch 11 filing before winter 2005 or winter 2006.

Catalyst

“Emergency” pension measures scheduled to roll off in 2005 – 2006 cash pension contribution likely to exceed $1 billion or even $1.5 billion.

Termination of United’s pension plan.

Renewal of Visa/Mastercard processing agreement that expires Aug 2005 could result in holdbacks going forward.

Ruthless competition from LCCs continues to drive down yields.

Erosion of cash balance necessitates Ch 11 filing before winter 2005 or winter 2006.