Description

Northwest Airline (NWAC) bank loans presents an interesting low risk investment opportunity. It is an investment for institutional investors as individual investors cannot buy bank debt. Northwest Bank debt offers nice current carry of 11% (I will use Northwest Bank debt B tranche as the reference instrument for my returns analysis), IRR of approximately 10% to emergence from CH 11 in 2 years, has limited downside risk (2.25 points), is secured by solid collateral and is floating rate with no interest rate risk. The bank loans could also get a step up to prime rates and/or default interest rates. In my analysis I assume no step up in interest rate to be conservative.

Business Description

Northwest operates the world’s fourth largest airline, as measured by revenue passenger miles. Northwest is currently operating in CH 11.

Northwest Operations

 Domestic hubs at Detroit, Minneapolis/St. Paul and Memphis.
 An extensive Pacific route system with a hub in Tokyo.
 A transatlantic joint venture with KLM Royal Dutch Airlines, which operates through a hub in Amsterdam.
 A domestic and international alliance with Continental Airlines and Delta Air Lines;
 membership in SkyTeam, a global airline alliance with KLM, Continental, Delta, Air France, Alitalia, Aeroméxico, CSA Czech Airlines and Korean Air.
 Exclusive marketing agreements with two domestic regional carriers, Pinnacle Airlines, Inc. and Mesaba Aviation, Inc., both of which operate as Northwest Airlink.
 A cargo business that operates 12 dedicated freighter aircraft through hubs in Anchorage and Tokyo.

Northwest Bank Debt

Bank Debt Amount Rate Price

Term Loan A $431 L + 5.25% $100.75-$101.25
Term Loan B $396 L + 6.75% $101.75-$102.25
Term Loan C $148 L + 6.25% $101.25-$102.00

Syndicated Bank $975

U.S. Bank $150 Credit Card Facility

Total Bank Debt $1.125 Bil.

Bank Debt is secured by a lien (priority/first) on NWAC’s US-to-Asia routes, some related assets and 53 airplanes. The airplanes are old 747-200, DC-10 and DC-9. Planes are worthless. All asset valuation is based on the Asia-Pacific routes. All other assets are assumed to be worth zero.

Routes Background

• Routes are intangible financial assets. US and foreign countries limit access on international airlines routes between each other.
• A route’s value is influenced by the level of restriction and the demand to fly to a particular country. International routes and access to the airports by U.S.-registered airlines are governed by bilateral aviation agreements between the U.S. government and the governments of foreign countries. These agreements can restrict access to U.S. gateway cities and the foreign destination by limiting the number of airlines that may provide service to certain airports, restrict service to certain airports or types of aircraft, limit frequencies of flights, or limit the beyond rights1 of the airline.
• The routes also give the airline the right to take off and land at certain airports at specified times.
• Bilateral aviation agreements that govern routes provide that route certificates are awarded by the U.S. government to individual airlines for a specific period and can be renewed upon expiration by the DOT.
• The regulations include an affirmative rebuttable presumption standard in favor of renewal of the route by the incumbent airline upon its expiration.
• Administratively, the route is considered a license for continuing activity and is renewed by the incumbent airline based on the filing of a timely application combined with maintaining a certain level of service. Even if an airline files timely for renewal of its route, DOT may not take action, in which case the route would be extended by the applicable provisions of the law.
• The cost to renew existing routes is nominal. Applications for renewal of the routes by the incumbent airlines have been approved in almost all cases.
• In the 1990s, the U.S. government has pursued a policy of “open skies” under which it has negotiated a number of bilateral agreements with governments of foreign countries allowing unrestricted access to those foreign markets.
• Even in an open skies country, an airline must still acquire a route to operate to a specific destination within a country and to obtain access to the airport.
• While certain governments have allowed open skies, some markets, most notably the United Kingdom, Japan and China, are still subject to restrictive bilateral agreements.
• The ratification of open skies would generally not eliminate the value of the routes and related airport access due to the airline’s existing competitive advantage from its customer base, infrastructure, and the size and breadth of its operations versus those that can be established by its competitors after the ratification of open skies.
• In an open sky environment, these competitive advantages will generally lessen causing the value of the routes to decrease; value of the restricted access routes (those that provide access to a high demand airport or with favorable take-off and landing slots) may not decline much, if at all.



NWAC Asia Pacific Routes

• Northwest has one of the world’s largest Pacific route networks with operations concentrated at Narita International Airport in Tokyo, where it has 362 permanent weekly takeoffs and landings as of December 31, 2004 (the most for any non-Japanese carrier).
• As a result of a 1952 U.S.-Japan bilateral aviation agreement, Northwest has the right to operate unlimited frequencies between any point in the U.S. and Japan as well as extensive “fifth freedom” rights.
• Fifth freedom rights allow Northwest to operate service from any gateway in Japan to points beyond Japan and carry Japanese originating passengers. These rights have no termination date, and the Company has the supporting infrastructure (airport gates, slots and terminal facility leases) in place to operate air service to Japan and beyond from its U.S. hub airports indefinitely.
• Northwest and United Airlines, Inc. are the only U.S. passenger carriers that have fifth freedom rights from Japan and Northwest currently has 55% more Narita-Tokyo slots than United Airlines.
• Northwest is currently the number 1 between the U.S. & Japan
• Northwest uses these slots and rights to operate a network linking eight U.S. gateways and twelve Asian destinations via Tokyo. The Asian destinations via Tokyo are Bangkok, Beijing, Busan, Guam, Hong Kong, Manila, Nagoya, Saipan, Seoul, Shanghai, Guangzhou and Singapore Additionally, Northwest flies nonstop between Detroit and Osaka and Nagoya, and uses its fifth freedom rights to fly beyond Osaka to Taipei and beyond Nagoya to Manila

Competitors

United Airlines

• Serves the Pacific from its U.S. gateway cities of Chicago, Honolulu, Los Angeles, New York, San Francisco and Seattle, providing non-stop service to Beijng, Hong Kong, Osaka, Seoul, Shanghai, Sydney, Tokyo, Bangkok, Ho Chi Minh City, Melbourne, Singapore and Taipei. On March 26, 2005, United began nonstop daily service between San Francisco and Nagoya, Japan

• NWAC has had stable market share during 1999-2005 of between 37-39%.

Route Valuation

How does one value an intangible airline route?

I value NWAC’s pacific routes as I would value a radio/TV license. The routes give NWAC the license to operate limited number of flights (the frequency) between certain geographic areas (location).

The value of airline route has two components. The value to the current holder and the value to a potential acquirer.

1. NWAC Route Value = PV of Cash Flows Generated from the Route

2. Route Value to Acquire = PV of Cash Flows than can be generated from the Routes using the acquirer cost and revenue structure.

PV Valuation of Routes using 9.75% EBITDAR Margin Rate, $2.44 Bil. Revenue, $237 mil. EBITDAR, and 8% Discount Factor over 20 years is $1.02 Bil.

PV using a useful life of 20 years. AIPAC uses an infinite life – this would result in a higher PV and requires using a perpetual annuity/bond valuation method.

Financial and Operation Data

10-K Annual Data

Annual and Quarterly Data on Department of Transportation Form 41.

NWAC Pacific

Passenger revenues $1,839,193
Freight & Mail $508,705
Other revenues $91,667
Total revenues $ 2,439,565

LTM Pacific Route Revenue – $2.440 Bil. ending 1Q. 2005


Sensitivity Analysis for Route Valuation

Two Potential Buyers – AMR and CAL. No other legacy US Airline is in any condition to expand operations in Asia Pacific. In my analysis I have used NWAC revenue data and NWAC’s EBITDAR margin to derive EBITDAR that AMR and CAL could generate on the routes.

This is a conservative approach as it assumes AMR and CAL both have the same yield that NWAC generates on Pacific Routes. NWAC has a very weak feeder structure to its routes. CAL and AMR could definitely generate higher yield than NWAC using their stronger domestic network and hub system.


Routes would generate EBITDAR of over $ 237 mil. for AMR and CAL.

• AMR = 2,439,565 * 9.75% (was 12.47% last quarter 2Q 2005) =$237 mil. EBITDAR = 4.75x Projected EBITDAR

• CAL = 2,439,565 * 9.75% (was 18.4% last quarter 3Q 2005) = $237 mil. EBITDAR = 4.75x Projected EBITDAR

The EBITDAR stream is also more valuable than its domestic EBITDAR because it is derived from a regulated and licensed route system with govt./treaty controlled competition. No risk of a Jet Blue or Southwest operation flights on the Asia Pacific network.

Routes are value under 5 times the EBITDAR they would generate for AMR and CAL. Purchasing NWAC routes would be a strategic home run for CAL and AMR.


How is my asset Valuation conservative?

• 20 year terminal life
• Assumption that revenue is at NWAC yield not purchasers yields and revenue does not grow.
• EBITDAR Margin 9.75% - historic margins have been 12-15%. Agreed the legacy airline sector is in turmoil. But I am also using aggregate EBITDAR margin to look at international routes where competition is restricted by government treaty.
• Cargo and Passenger should be bifurcated with higher value on Cargo.
• I include the $150 mil. US Bank Credit Card Facility in the bank loan category even though it is secured by credit card receivables. I assign zero value to credit card receivables that are for all practical purposes cash collateralized. All valuation has a $150 built in cushion.


Positives for Asia Pacific Routes

• Routes are country specific w/ lock in via slots/gates at Narita. They are not restricted on specific US cities. If AMR and CAL acquire the routes they can use them on their primary yield cities. JFK-NYC, Dallas, EWR-Newark, Houston, Chicago ect.
• Routes can be bifurcated – some sold to CAL and some sold to AMR.
• Cargo routes can be sold independently to AMR and CAL. Cargo routes can be sold to Atlas Air, Fed Ex, UPS ect. Cargo routes should command a higher valuation as the revenue stream is more consistent, greater growth opportunity
• Routes can be easily financed. Routes currently back the bank agreement for AMR. Routes also key asset in the DIP financing of UAL and DAL. Financial institutions have been willing to lend capital if routes are provided as security.


Risk Factors

• Open Skies agreement with Japan, China or Hong Kong. Unlikely as the routes are tied into complex trade negotiation with these countries, all of whom have massive current account surpluses with the US. Very unlikely the US government would agree to an open skies agreement with any of these governments.
• In a few years B-777-200 LR, B-787 and A-350 may make the “5 Freedom Flight” right irrelevant by allowing direct flights to the US. No need to stop in Japan when flying from South Asian cities.
• Global recession/depression that significantly curtails air travel and air cargo.
• Northwest decides to get a DIP and refinances the bank loans – lose 2.25 points.

Catalyst

CH 11, Asset/Collateral Coverage, Current Carry