Deal of SkyWest vs Delta

 

Who Dares, Wins: SkyWest Takes Delta For Everything It's Got (Long)

By now, readers may be tired of us banging on about how it sucks to be a regional airline, however much they may (or may not) be convinced. There’s an exception to this, however, that’s worth studying, namely SkyWest. This didn't happen yesterday, this happened last fall, but few people seem to fully appreciate what SkyWest achieved, especially since it happened so quietly (which may have been the point).

SkyWest was a pre-9/11 regional darling, with good juicy contracts with both United and Delta, both for 50-seat RJs and turboprops. Both of these airlines subsequently entered Chapter 11 bankruptcy, United in Dec 2002 and Delta in Sep 2005. The 50-seat RJ is yesterday’s news and turboprops were largely unwanted even before 9/11. Those bare facts would strongly suggest that by now, SkyWest would be a pale shadow of what it was. But it’s not. SkyWest is an example of how management can make a difference even when dealt a poor hand.

For instance, SkyWest was one of three pre-9/11 United regional partners. The other two were ACA (which became Independence Air, which recently winked out of existence) and Air Wisconsin, which despite its loyalty to United was unceremoniously dumped last year and had to buy its way (through a $125mm investment) into a contract with US Airways (this worked out in the end, but it looked pretty dubious at the time). SkyWest is the only United Express survivor, and now does much more for United than it did, including flying 70-seat RJs.

SkyWest has done a great job of capitalizing on the misfortunes of others. United was left in the lurch when ACA refused to renegotiate its deal after United filed Chapter 11. At the time, ACA flew about 50% of United’s regional jet capacity. United therefore (1) wanted to show that it could come to agreement with at least one of its regionals (i.e. the fault was that of ACA, not United) and (2) was thus not inclined to bargain for every last dollar when SkyWest offered to help United. SkyWest did well by helping United in its hour of need.

But that’s nothing compared to what SkyWest accomplished in the case of the Delta bankruptcy. What happened there was truly daring, perhaps the greatest coup of this downturn. In the weeks after Delta filed Chapter 11, SkyWest management secured hundreds of millions of dollars of value for their company from beneath the eyes of the bankruptcy court and Delta’s creditors, who didn’t seem to notice.

A More Dangerous Bankruptcy than United

SkyWest stood to lose a lot in the Delta bankruptcy, arguably significantly more than it lost in the United Ch 11 renegotiation. The reason is that in the meantime the 50-seat RJ market had softened considerably. As we previously discussed, the market for 50-seat RJs was never as strong as it was when ACA was pulling theirs from United. From then on, it’s been in steady decline, as relaxed scope clauses meant that legacy majors could focus on larger RJs and as Independence Air slowly collapsed.

Further, a Delta Ch 11 filing (which was widely anticipated in summer 2005) was itself likely to be the worst blow to ever hit the 50-seat RJ market because Delta was (and is) by far the largest employer of 50-seat RJs and (in summer 2005) had two regional subsidiaries, ASA (not to be confused with ACA) and Comair that between them owned or leased over 200 50-seaters. As we’ve discussed before, an airline in Ch 11 can mark-to-market its aircraft leases and loans, and with such a dominant position in the RJ market, Delta could do severe damage 50-seat RJ values in Ch 11.

This stood to be particularly dangerous to those airlines, like SkyWest, that had long-term obligations for 50-seat RJs, because they stood to be squeezed between their own static aircraft ownership payments and reduced RJ contract rates.

Aircraft ownership (aircraft rent or aircraft depreciation plus aircraft finance interest) is about 25% of the costs of a typical regional airline. Suppose post-Delta bankruptcy lease rates for 50-seat RJs dropped by 25%. That would mean the cost of providing 50-seat RJ lift under a new contract using newly-leased aircraft would drop by 6.25% (= 25% times 25%). That would mean that Delta would want to reduce its regional airline contracts (not its aircraft leases, but the contracts it had with SkyWest and other regional airlines for 50-seat RJ lift) by at least 6.25%, because an airline in Chapter 11 will seek to mark-to-market all its contracts, not just leases.

But that’s a huge problem for an airline like SkyWest with long-term RJ obligations. SkyWest isn’t in bankruptcy, it doesn’t get to mark-to-market its own RJ leases, yet Delta would get to (try to) mark-to-market the RJ contracts it had with SkyWest. In other words, SkyWest faced significant revenue reduction from a Delta bankruptcy without offsetting expense reduction. Since in round-figures, SkyWest’s operating margins are about 10% on such flying, cutting 6.25 percentage points amounts to approximately a 60% reduction in operating profit on flying 50-seat RJs. Reminder: this is just an example to demonstrate the scale of the issue that SkyWest potentially faced.

Doubling Down

SkyWest did something unexpected. In August 2005, prior to Delta bankruptcy, SkyWest bought ASA from Delta. On the face of it, this was sheer lunacy. ASA flies 100% for Delta, mostly 50-seat RJs. ASA has value as a regional airline only to the extent it has a contract with Delta. Any such contract can be rejected by Delta the minute Delta hits bankruptcy. With Delta facing imminent bankruptcy, SkyWest was essentially doubling down on what already looked to be a loser bet, including taking responsibility for almost all existing ASA aircraft finance obligations (Delta did keep responsibility for 40 such ASA aircraft financings, subleasing these aircraft to ASA instead).

The terms were interesting. SkyWest was to pay $350mm cash up front ($20mm representing aircraft purchase deposits that ASA had already made) and then $125mm cash in additional payment ($30mm representing aircraft deposits) to be made should a bankrupt Delta assume the SkyWest and ASA RJ contracts untouched (or after four years, whichever came first).

If you knew Delta would escape bankruptcy (or, if for some reason you knew that Delta would assume its ASA contract in Chapter 11) then $425mm (= $350mm + $125mm -$20mm - $30mm) was likely a bargain price for an airline the size of ASA (over $1bn in yearly revenues, and presumably an operating margin not dissimilar to that of SkyWest). But if Delta filed Ch 11 and rejected its ASA contract, then ASA was worth, well, potentially very little.

An Unpersuasive Sweetener

What about that sweetener of $125mm ($95mm net of the aircraft deposit amount) that Delta would get if it affirmed SkyWest’s and ASA’s contract in Chapter 11? Couldn’t that be inducement enough for Delta to want to affirm the ASA and SkyWest contracts?

Not hardly. We’ll give an example in round terms. We’re not saying these would have been the actual figures, we’re saying here are some plausible figures that show the order of magnitude of what was at risk.

We’ve already discussed how the reduction in 50-seat RJ values post a Delta bankruptcy would feed through to a reduction in 50-seat RJ contract rates. We think that a reduction in 50-seat RJ contract rates of around 10% is well within the realm of possibility, between the drop in 50-seat RJ rents and other reductions that Delta would demand.

In round figures, between ASA and SkyWest, Delta was probably paying over $1 billion for 50-seat RJ lift. So the potential savings to Delta of crushing ASA and SkyWest contract rates after a bankruptcy was in the $100mm range (10% of $1 bn/year – nice round numbers). Perhaps it was only $50mm, perhaps it was more than $100mm, this is only to establish an order of magnitude. That’s an annual savings.

Stack that up against the one-time $95mm figure and you can plainly see that there’s an excellent argument to be made that in bankruptcy the economically rational thing was for Delta to tear up its agreements with ASA and SkyWest, because the recurring savings from doing so was more valuable than the one time additional payment of $95mm it would get for assuming the contracts.

[Some will say that regardless of legalities, it seems awfully unfair that Delta could ever do such a thing. But that’s how bankruptcy law works, and it’s designed to do so to make sure that all creditors in a similar position get equally screwed. Just because Delta happened to enter its agreement with SkyWest only weeks before it ultimately filed doesn’t mean, legally (as we understand it, and we are, thank heavens, not lawyers) that SkyWest is any more entitled to having its agreements assumed than any other party.]SkyWest Walks Away Unharmed

That’s not what happened. Delta did go bankrupt, and weeks later, it did assume both the ASA and SkyWest contracts. In effect, the capitalized value of the foregone potential savings (again, likely on the scale of $100mm per year) were thus transferred from Delta to SkyWest for a payment of $95mm. SkyWest’s apparently massive gamble paid off big time, and it acquired ASA for $425mm plus neither the ASA nor SkyWest contract was molested. Awesome, incredible deal. Gigantic value transfer/preservation by SkyWest.

Why did this happen, and moreover, why did creditors permit it to happen? We don’t know for sure, but here's one possibility (and we’d love to know more details because we’re almost certainly wrong about something).

Delta was in dire straits when SkyWest entered the agreement to buy ASA. In August 2005, Delta’s credit card processing agreement expired and its processor required a massive deposit from Delta to continue to run Delta’s credit card purchases. Clearly an airline has no ability to stay in business if it can’t charge customer credit cards, which was at stake. Delta needed to raise money, and it needed to raise money fast. This almost certainly motivated the sale of ASA at that time.

That still doesn’t explain why Delta didn’t turn around and screw SkyWest (as its creditors would have wanted it to if they understood what was happening, see below) the minute Delta went bankrupt. The only thing we can think of is that there was a gentlemen’s agreement between Delta and SkyWest managements that the minute Delta went Ch 11, it would seek to assume the ASA and SkyWest agreements, because that’s what happened.

Sounds really unlikely, doesn’t it? Managements of big companies are supposed to do the economically rational thing. But we are unpersuaded by other explanations. We are pretty certain that Delta was exceptionally desperate to raise money at the time it sold ASA to SkyWest. Nor do we believe, for instance, that the additional $125mm that SkyWest then paid Delta in bankruptcy was desperately needed cash that was couldn’t be found any other way. Delta stood to gain a lot from renegotiating its 50-seat RJ deals with SkyWest and ASA, and there was no reasonable alternative for ASA and SkyWest to keeping its 50-seat RJs employed at Delta, so we don’t believe SkyWest and ASA could have credibly threatened to take their RJs elsewhere – though we don’t rule out the possibility that Delta management could have been conned into thinking so.

You could have probably designed a security to give Delta $125mm in exchange for paying back investors from the ASA/SkyWest contract savings (there are a lot of hedge funds that follow the airline business closely which might well have been interested). Even if that were not possible, Delta was in a position to obtain the last $125mm payment from SkyWest at any time by assuming the ASA and SkyWest contracts. Having the right to get $125mm at short notice is almost as good as having the $125 then and there, so there was no reason for Delta to assume the ASA/SkyWest contracts immediately. Finance 101: don't exercise your options early.

The other striking thing was how simple it was for Delta to get the assumption of these contracts past the bankruptcy court. There are no objections in the court docket, although both US Airways and United renegotiated their regional airline contracts for significant savings (and Northwest is in the midst of wreaking havoc with its unfortunate regional partners). Had the court understood this, we doubt it would have permitted the SkyWest and ASA contracts to be assumed so easily.

The motion itself (pdf) is brief, as if the request was routine (whereas it was anything but). It cites as supporting reasons only getting Delta's hands on the $125mm and the need to maintain SkyWest/ASA's services. But vendors have no ability to withdraw services until the bankrupt company rejects a contract, and if regional service is so important, why did Delta fail to affirm its regional contracts with Republic/Chautauqua and Mesa?

But it turns out that it’s easy to assume contracts in the early days of a bankruptcy. The judge is new to the case, the creditor committees are not fully formed and are thus not perhaps as alert as they should be. Apparently no one with standing (the right to be heard by the judge – you can’t just walk off the street and object to something that Delta wants to do) objected that what Delta wanted to do was at odds with precedent. No one so much as argued for a delay. We bet that's the way it was designed to be. Slide it through before anyone's in a position to argue.

[There’s also a structural issue with creditor committees – they’re often stacked with folks with no desire to anger the management, like manufacturers. Does a manufacturer really want to anger someone who may be in a position a few years hence, to order airplanes (perhaps at this airline, perhaps at another)?]

Sitting Pretty

Whatever the exact reasons, whether you think SkyWest cut a gentlemen's agreement that Delta hurried past the judge, or whether it convinced Delta that it, SkyWest, had a gun to Delta's head, the fact of the matter is that SkyWest pulled off a tremendous coup. It's now a monstrous regional airline, by far the largest, and with Delta contracts that go for 15 years. Skywest stock is now trading at levels last seen shortly before and after 9/11 and a market cap 2.5 times that of the next highest regional.

This doesn’t mean everything is peaches and cream for SkyWest. Delta's not out of bankruptcy yet, and there's a (probably remote) chance that it could liquidate rather than restructure. ASA’s pilots have been negotiating a new pilot agreement for years, and are unhappy about it. SkyWest’s pilots are non-union, but unhappy about their pay and may not stay non union. And the fact that SkyWest has maintained the integrity of its Delta contracts will be used by ASA/SkyWest employees as a reason for to pay them more. But these are high quality problems to have relative to other regionals.

Further, at some point SkyWest will have to pay the piper. Contracts (even the 15-year ones it has with Delta) aren’t forever – Delta could always go bankrupt again, for instance. So in the long run, SkyWest has the same problems as everyone else. But as Keynes said, in the long run we’re all dead, what matters is the immediate future, and for SkyWest, that is bright indeed, compared to its peers.

Bonus Linkage:
Sale agreement for ASA from Delta to SkyWest
SkyWest regional jet contract with Delta
ASA regional jet contract with Delta
(unfortunately, some of this is heavily redacted, but if you want to see a contract between a regional airline and a major airline, here you go. Most other regional airline contracts are available as part of various Edgar filings, if you poke around long enough, but most economic terms are redacted)

Delta has sought guarantees that ASA and SKYW costs will not increase unreasonably.
Skywest has supreb management and loyal employees. Their challenge will be to do the same at ASA. Two days ago, SKYW offered ASA employees profit sharing.
Within days after the ASA purchase, SKYW CEO sent a letter to SKYW employees stating ASA employees would not be treated like the red headed step children.
Quality is the name at Skywest. I see that everyday at work.