A dark time for aviation is about to get darker

Industrial Strength
Bloomberg

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After months of political wrangling and public pleas, U.S. airlines are in serious jeopardy of going empty-handed when it comes to additional government aid. Politicians from both sides of the aisle have voiced support for extending government grants to safeguard jobs, but with less than a week to go before the initial $25 billion of assistance expires, the odds aren't looking good. The debate over the next Supreme Court justice has stolen the limelight and there's still disagreement over whether airline aid can stand alone or has to be part of a larger stimulus package that's at a similar stalemate. Some wonder, too, if continued support for the airlines risks veering into corporate welfare territory and why that industry deserves more support than workers at, say, restaurant, hotel or motor-coach companies

The fact is that the coronavirus pandemic has proved to be a much more painful and long-lasting crisis for the airline industry than politicians anticipated when they passed the Coronavirus Aid, Relief and Economic Security Act in late March. Daily travel figures from Transportation Security Administration checkpoints remain stubbornly below the 1 million mark and are averaging about a third of last year's levels. Pockets of coronavirus outbreaks keep popping up, with a resurgence of cases and lockdown measures in Europe serving as a warning signal for the U.S. this fall. Airline worker unions have called for an extension of the payroll-aid provisions for another six months, with a fresh $25 billion going to support jobs. White House Chief of Staff Mark Meadows has echoed that $25 billion figure, but even that amount is unlikely to be enough to get airlines through the deepest travel rout the industry has ever seen. Moody's Investors Service has estimated it will take until the end of 2023 for global airline passenger demand to recover to pre-pandemic levels, and that's assuming effective vaccines and medicines are available. The International Air Transport Association pushed back its timeline for such a recovery to 2024. 

Cutting off the money means adding more than 30,000 American Airlines Group Inc. and United Airlines Holdings Inc. workers to the unemployment figures. Delta Air Lines Inc. and Southwest Airlines Co. have said they will largely be able to avoid forced layoffs for the time being (at least through the end of the year in Southwest's case and through summer 2021 for most Delta workers). But that's only because so many of their employees have elected to take buyouts, early retirement or temporary unpaid leave. Bloomberg News has estimated some 150,000 workers across the four biggest U.S. carriers have taken these options. Given the extent to which the airlines have worked around the government's efforts to limit furloughs, it's fair to ask whether renewing the payroll aid as currently structured would be all that effective in achieving the end goal of saving jobs. But it would buy some workers more time, and time is what the industry needs right now.

What's less appreciated is the damage the lapse in payroll aid would do to the aerospace suppliers. The Cares Act aid also required the airlines to maintain minimum service levels on the routes they were flying before the pandemic. The Treasury Department later granted some allowances on flights with particularly low demand, but airlines are already preparing additional significant cutbacks in capacity should that provision expire. U.S. airlines' current flight schedule for October is about half of what the carriers had been planning for the month as of August, according to an analysis by BloombergNEF's David Doherty. American Airlines has said it will drop service to 15 cities including Springfield, Illinois, and Greenville, North Carolina, as of Oct. 7 without an extension of the payroll aid and associated requirements. Carriers may also further consolidate flights out of larger hubs, so that there are fewer options per destination each week and fewer direct flights. Apart from the obvious strain that will have on airports and travel destinations, that spells even more pain ahead for the maintenance and repair work that's the most lucrative part of aerospace suppliers' business.

Data from IATA through July shows airline passenger traffic has now been down 80% to 90% for four straight months; by contrast, aftermarket sales at aerospace suppliers dropped 53% on average in the second quarter, according to Vertical Research analyst Rob Stallard. The companies have explained this divergence by pointing out that service work is more closely correlated with the number of planes that take off, not the number of people that are on them. But while the decline in passenger traffic has likely hit rock bottom (even if there's not much improvement to celebrate), the number of flights arguably hasn't. "Airlines cannot indefinitely keep flying half-empty planes," Stallard wrote in a note earlier this month. "We could see a scenario where aftermarket sales remain subdued for some time, as airlines need to better fill existing flights to generate cash before adding much more capacity." Service work is hard to predict but there may even be a situation in 2021 where the dynamic flips and aftermarket sales are declining more than passenger traffic, before eventually balancing back out, Stallard wrote. 

Whatever happens, the slower-than-expected recovery is already taking a toll. Raytheon Technologies Corp. is now cutting 15,000 positions across its commercial aerospace engine and parts divisions, nearly double the headcount reduction it was targeting as recently as July, due to "the slope of the recovery," CEO Greg Hayes said last week at the Morgan Stanley conference. Other suppliers including General Electric Co. and Honeywell International Inc. have announced tens of thousands of job cuts between them. But if there's one lesson from this crisis for the aerospace industry, it's that things can always get worse. 

Troubled Spinoff

Garrett Motion Inc., the turbochargers business spun off by Honeywell in 2018, filed for bankruptcy this week, blaming liabilities it inherited from its former parent company. When the spinoff launched, Garrett took on $1.6 billion of debt to help fund a cash distribution to Honeywell, while also agreeing to cover 90% of the expenses Honeywell incurs in connection with certain asbestos liabilities over the next 30 years (up to a cap of $175 million annually). Garrett had $1.3 billion in obligations due to Honeywell (including a tax liability) on its balance sheet as of June 30. The company sued its former parent last year seeking to have the "unconscionable" indemnification agreement voided. If not for that burden, "the fundamentals of our business are strong," CEO Olivier Rabiller said in a statement. Indeed, just two months ago, Garrett was touting how "operating excellence" helped it preserve cash and maintain an attractive margin profile "even in an unprecedented crisis." Honeywell agreed in June to defer payments under the asbestos agreement until 2022, but Garrett has said that only set the company up for a big obligation down the road. For it's part, Honeywell has said that Garrett's bankruptcy filing is "unnecessary and unfortunate." Admittedly, it's a bit odd for a company to be claiming both financial strength and bankruptcy in the same breath. The argument is that if Garrett doesn't go down this path, its business will deteriorate because of the cumbersome capital structure and it will have less opportunity to salvage value for investors. But it's a bit of a mind warp. 

Garrett proposed to sell itself out of bankruptcy to KPS Capital Partners for $2.1 billion but the private equity firm wants the asset free and clear of the asbestos liabilities. Honeywell has pushed back on the sale structure for boxing out the company as a creditor. After initial arguments in court, Garrett agreed to consider a less restrictive restructuring loan than the original $250 million financing package that Honeywell and shareholders criticized because of deadlines that would have fast-tracked the KPS deal. Oaktree Capital Management and Centerbridge Partners submitted the rival financing proposal; the investment firms are seeking to cut a deal with Honeywell over the asbestos liabilities and get the company's approval for their bid, Bloomberg News reported. A group of bondholders is also reportedly preparing to submit a debtor-in-possession loan. The most likely outcome of all this legal back and forth may be some kind of settlement. Bloomberg Intelligence analyst Joel Levington says recovery rates for unsecured creditors in similar bankruptcies and a review of Garrett's other obligations suggest a settlement of 20 cents on the dollar. The worst-case scenario for Honeywell is that the company has to write off the roughly $1.3 billion undiscounted receivable tied to Garrett's obligations and resume the burden of asbestos-related payments itself, an outcome that is unlikely to make much of a dent on its share price or its cash flow. Frankly, I'm more interested in the philosophical questions at play here. Regardless of whether it was legal to set up the Garrett spinoff with this capital structure, was it the right thing to do? After talking to other manufacturing CEOs about the thought and effort that went into ensuring their spinoffs were not only viable but also competitive, the extent to which Garrett served as a dumping ground for liabilities does stand out. 

Deals, Activists and Corporate Governance

Boeing's board faces a shareholder lawsuit accusing it of taking a blase approach to safety matters and failing to press management hard enough for answers amid the 737 Max crisis, the Wall Street Journal reported on Friday. Boeing has dismissed the lawsuit – filed by the New York and Colorado public pension funds – as one-sided and misleading. But the shareholders got their hands on roughly 44,000 internal company documents. Among other things, they allege that Boeing directors waited nearly a month to hold their first meeting after the Lion Air crash in 2018 and even then the call was deemed optional because of the approaching Thanksgiving holiday. After everything that we have learned about Boeing's conduct with regard to the Max, perhaps the most surprising aspect of this lawsuit is that shareholders didn't come after the board sooner. On the positive side for Boeing, the Max finally appears to be nearing a return to the skies. Federal Aviation Administration chief Steve Dickson is set to fly the Max next week, a person familiar with the plans told Bloomberg News, in what would be a key step toward the agency's signoff on proposed fixes. European regulators, meanwhile, signaled they expect to complete their safety review in November.

3M Co. is considering selling its food-safety business, people with knowledge of the matter told Bloomberg News. The unit sells kits to test for pathogens and allergens, as well as quality-monitoring tools. It could fetch about $3.5 billion, one of the people said, or about 10 times the revenue it generated last year. It's a small part of 3M's overall business so it's hard to read too much into this, but it would continue the company's pruning of its portfolio over the past few years as it focuses on higher-growth areas like health care. And hey, every extra bit of cash helps in a pandemic. In other divestiture news, Carrier Global Corp. is selling a portion of its stake in Swedish refrigeration and air-conditioning company Beijer Ref AB through an equity offering. The transaction won't affect the companies' distribution agreement and Carrier will continue to be a major Beijer Ref shareholder. But the recent rally in Beijer's shares makes this a good time to start the process of cleaning up Carrier's myriad holdings and joint ventures, Barclays Plc analyst Julian Mitchell wrote in a note. 

Spirit AeroSystems Holdings Inc. is scrapping its deal with airplane-wing supplier Asco Industries, adding to the pile of purchases canceled amid the pandemic. The transaction was initially valued at $650 million when it was announced in May 2018 but the price was later reduced to $420 million after Asco was hit by a cyberattack, complicating the companies' efforts to secure European regulatory approval. With that signoff still not yet in hand, Spirit said this week it's officially terminating the transaction. Walking away saves Spirit cash it can ill afford to spare as the combination of Boeing Co.'s still-grounded 737 Max jet and the upheaval of the pandemic wreaks havoc on its financials. But the purpose of the deal was to help Spirit diversify away from its former parent company Boeing and take on more work for Airbus SE and the defense industry, so it's a strategic loss. A separate transaction for certain Bombardier Inc. airplane-structure operations for cash consideration of $500 million is still pending. The companies have until Oct. 31 for all the conditions to be met, one of which is the absence of a material adverse change to the Bombardier business. 

Bonus Reading

Harvard's Chetty Finds Economic Carnage in Wealthiest ZIP Codes
Banning Gas-Guzzling Cars Can't Come Soon Enough: Chris Bryant
How Diligent Was GM About Its Deal With Nikola?: Timothy O'Brien
Unilever, Consumer Giants Push Suppliers to Rescue Seafarers
How Harley-Davidson Lost Its Rumble in India: Anjani Trivedi
GE to Stop Selling Equipment for New Coal-Fired Power Plants
Michigan State Walk-On Becomes Billionaire by Making Mortgages

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