September 29 2004 DBN telephone conference

[The economy]
It’s starting to be a custom to open the hour by taking the temperature of the economy.

Just like last month, the stock market continues moving sideways, and that’s important because the market is one of the better leading economic indicators.

Since our last teleconference in July, the market has moved true to form. August, as usual, was an “up” month, and September, as usual, has been a “down month.” In sum, the average are almost exactly where they were when we were last together. Looking back five years, the Dow has changed less than 1%, and that’s amazing.
Consequently, the market continues telling us almost nothing.

The most interesting development comes from the Federal Reserve, and I don’t mean the increase in the discount rate. I refer to how the Fed, in its latest announcement last week, no longer used the word “transitory” to describe higher energy costs. Chairman Greenspan must believe that higher energy costs are here to stay.

Statistics from the consumer are interesting. In July, consumer spending grew 0.8%, although personal income rose only 0.1%. As a result, personal savings fell to the lowest level of the year, prompting an investment banker to comment that the “rebound in spending . . . is coming because of consumers’ continued willingness to borrow.”

Let’s look at some other factors. There are fewer jobs in America now than there were 41 months ago, and some folks are concluding that newly created jobs offer wages and benefits lower than the jobs being lost.

What we have, in result, is an increasingly squeezed consumer, just on the jobs front. Add higher energy prices, and the future does not look good for consumer spending which represents two-thirds of the economy.

Now let’s look at inflation. In the face of it all, we have the government and some analysts telling us that the core inflation rate is a modest and manageable 1.7%. Core inflation excludes food and energy, but I personally don’t know anyone who can live without food or energy. (might as well try to live without oxygen) And we have Mr. Greenspan implying that the higher cost of energy is no longer “transitory.” CEO of Wal-Mart is saying publicly that the Wal-Mart customer is being squeezed by higher energy prices.

I am pleased to say that I can now identify the first victim of inflation coupled with constricted consumer spending. I refer to Interstate Bakeries, the country’s largest baker, which filed chapter 11 last week in its hometown of Kansas City.

Interstate was suffering from higher energy costs needed to fuel its ovens and delivery trucks and also from higher raw material costs. On the other side of the business, retailers are either unwilling or unable to pass higher costs along to the consumer. And here’s what’s important. Interstate cannot blame its problems on low cost foreign competition.

It’s pretty clear to me that real wages have declined over the last few years. In consequence, consumers just aren’t going to pay more for Twinkies, even if the cost of making them and shipping them has risen.

I predict we will find other food businesses in the same bind. Where consumers can now obtain a 0% loan to buy a car, there isn’t much evidence that people will run up debt to buy groceries.

The survivors in the food business will be those who make money through having an efficient distribution operation. Interstate’s was antiquated, and it was killing them. Just look at Wal-Mart, it’s as much a distributor as it is a retailer. Wal-Mart can make a big buck because it reputedly has the world’s best distribution system. I also like businesses where the product is not your major cost, because you can better adjust your spending.

Now let’s move to another part of the food chain, namely, the farmer.

So far, farming has been little disturbed by globalization. But it’s my view that the situation is about to change. The rest of the world is complaining bitterly about government subsidy for farming, both in the U.S. and in Europe. We’re seeing ourselves being dragged before World Trade Organization to respond to complaints that our subsidies are crushing the farmer in under developed countries.

So, over time, I see shrinking subsidies which will hurt both the family farmer and even the corporate farmer. On balance, however, I doubt it will help the poor farmer in an under developed country because, sadly, they lack the capital and the efficiency to compete in the world market. After all, in an efficient farming operation, labor is a very small part of the cost. Instead, I predict that the corporate farmer will go abroad, buy or lease land, and end up profiting from the troubles that will ensue for farmers in the U.S.

I also note that consumers world wide will benefit through lower food costs, although savings will be less dramatic in the U.S. where food is highly processed and raw material makes up less of the cost to the consumer.

I’d like to add a couple of footnotes before we end our discussion of the economy. For the first time, I’ve seen a prediction of a recession next year, on account of the squeeze on the consumer and higher energy prices. I’m skeptical, however, because recessions usually occur as a result of some major, unforseeable event. Increasing energy cost is very foreseeable. I also should note that former Fed Chairman Paul Volker sees a 75% chance of a financial upheaval within five years. I tend to agree with Mr. Volker because our deficit spending both by consumers and by government is being financed with loans from Asia. But we talked about that at great length in July.
I also note that the Nobel prize winning economist Paul Samuelson has decided to disagree with the long held notion that free trade is always beneficial. Arguably, we are already seeing what Mr. Samuelson predicts through globalization which reduces costs for consumers but may be at the initial stages of either decreasing the number of jobs in the economy or lowering wages. If we live long enough, we’ll find out if Mr. Samuelson is correct.

Before I leave the subject of the economy, I want to offer an editorial, or, more properly, I want to go out on a limb with a prediction.

At our last teleconference in July, I spoke about how Asian central banks are sustaining our economy and the American consumer by lending us unprecedented billions of dollars. As I said, the Chinese and the Japanese are lending us money so we can buy their products.

Since we were last together, the statistics have gotten worse. Within the last ten days it was announced that the current account deficit hit almost 6% of GDP.
There’s never been anything like that before in the history of the world. This country has become the world’s biggest banana republic.

No other country on earth could borrow even one quarter of what the US borrows abroad. For some reason, the US can suspend the laws of physics.

Just imagine what would happen if the Asian central banks decided not to lend us so much money. Imagine what would happen if the world reduced our economy by 6% because they didn’t want to lend to us so much. A 6% chunk out of the economy would be much worse than a recession.

Grant’s Interest Rate Observer cheerfully admits being wrong for several years, but Grant’s is still predicting, and I quote, a “disorderly drop in the dollar exchange rate.” Maybe that’s what Paul Volker means when he predicts a financial upheaval within 5 years.

Grant’s is not alone. The senior currency strategist at a major New York bank says, and I quote, “No country has ever sustained this level of external imbalance without eventually succumbing to currency depreciation.”

Frankly, I am worried. And I’m worried because few other people seem to be worried. Needless to say, politicians don’t say a word. And the Federal Reserve is virtually silent on the subject, although on occasion a Fed Reserve Governor will say a word or two to show that they’ve got the problem in sight. It’s possible that the Fed doesn’t to speak on the topic publicly for fear of touching off a panic.

So, for now, we’re sitting here ignorant but happy, just like Argentina before it’s economy blew up a few years back. Argentina hit the skids because their vibrant economy had been pumped up by dollars loaned from abroad, but one day the spigot got shut off.

Here, the unraveling will take a different course because the dollar is the world’s reserve currency. If we need to pay off foreigners, the Fed can simply print money or create dollars. Any way you slice it, the result will be a dramatic drop in the value of the dollar versus other currencies.

From here on, you can fill in the details yourself. Besides thinking about inflation, think about the consequences if the dollar is no longer the exclusive reserve currency. Also consider the consequences if interest rates on government debt are pegged to the euro or a bundle of currencies. In other words, what if our government has floating rate debt just like credit cards.
Enough of that pessimism. Let’s go on to something else equally depressing.

[11:50]

[Pension Benefit Guarantee Corp]
I refer to the Pension Benefit Guarantee Corporation, because I predict it will be much in the news over the next three years.

The Pension Benefit Guarantee Corp. which was set up by Congress in the 1970s to guarantee at least a portion of a worker’s defined benefit pension.

The PGBC is funded by premiums paid by employers. Of course, when a company goes bust, the PGBC takes over the assets in the pension fund and becomes liable to pay up to $44,400 per year to each worker.

As recently as the end of 2001, the PGBC had a surplus, but the surplus turned to a $3.5 billion deficit by the beginning of 2003, largely as a result of the bust in the steel industry. By the first of this year, the deficit had ballooned to $11 billion.

So, what’s next. Well, the termination of the pension plans at United Airlines by itself will add another $6.2 billion to the deficit. By a factor of nearly two to one, UAL will be the single biggest loss that the PBGC will have assumed. Although I don’t know which would terminate first, the pension plans at US Air will cost another $2.1 billion.
In other words, UAL and US Air alone will raise the deficit from $11 billion to $20 billion.

Once US Air and United terminate their plans and enjoy a markedly cheaper cost structure, I’ll bet that will set off a domino effect in the airline industry. The next to fall presumably would be Delta, where the cost to the PBGC will be $5.7 billion.

Wrap up the pension plans among all the network carriers, and you’ve got a combined deficit in the range of $21.5 billion. The General Accouting Office says the airline deficit could be even larger, but the airlines alone will bring the combined shortfall above $30 billion.

But that’s not all. In the auto industry, legacy expenses are costing domestic auto makers several thousands dollars per car more than Asian manufacturers. The GAO calculates that the auto industry could bring a $60 billion deficit on its own, pushing the total deficit above $100 billion. Now, you’re talking real money.

By way of comparison, the savings and loan bailout cost somewhere between $150 billion and $200 billion.

But there’s more problems facing the PBGC. The executive director told Congress last year that single employer plans across the country are under funded to the tune of $400 billion.

Clearly, we’re facing a bailout. How large, I can’t say. If we have runaway inflation, the problem will disappear because higher interest rates will make up the deficit. But even so, the cost to the country will be horrible because fixed pensions won’t be worth squat in inflated dollars.

Congress is already beginning to hold hearings on the subject. When US Air, United, and Delta all dump their plans, the demand for reform will be deafening. And if Interstate Bakeries tries to terminate its plans, Congress will see that the threat to the PBGC is not just from specific industries facing peculiar problems. If our low interest rate environment persists for long enough, pension plans all around the country will be in trouble.

Now why do I bother to waste your time in a bankruptcy conference talking about the PGBC. The PBGC is not going to bankruptcy the federal government. Well, here’s the reason.

Today, when a pension plan terminates, the PBGC only has a general unsecured claim for the deficiency. Sure, it dilutes the pot for other unsecured creditors, but any smart vulture investor can calculate how much stock the PGBC might end up receiving, so the vulture can determine how much to pay for a distressed company’s bonds or debt.

In this country, the ultimate unknowable is always Congress. What will Congress do when it gets its teeth into the PBGC? Congress can’t simply require a company to pay its pensions, because most troubled companies would just liquidate, so the PGBC would end up with the liability in any event.

Here’s what I’m afraid of. Taxes have a priority over unsecured creditors under the present bankruptcy scheme. At present, the PGBC has no priority. What if Congress gives the PBGC a priority claim?

If you’re a vulture investor and Congress is talking about a priority claim, how do you price a distressed company’s unsecured debt? And how can we be sure that Congress won’t require secured creditors to make some kind of a contribution?

In other words, I see the potential for disrupting the secondary market in distressed debt. So, if I were a vulture investor, I would start paying very close attention to Congress. In addition, it’s also not beyond imagination that Congress could require the buyer of assets to make contributions on account of terminated pension plans. That likewise would prompt buyers to pay less for troubled assets.

For Congress, the question will be this: Shall the taxpayer and the PGBC pick up the tab when someone who buys a bankrupt business can make a profit because the pension plan has been terminated?

If any of you in the audience has any ideas on the subject, please call me or send an Email. I think the PGBC is a really big story affecting the future of the bankruptcy industry and what we pay for assets.

[18:00]

[Airlines]
Let’s move on to a subject I’m frankly getting tired of talking about. Unfortunately, I don’t’ see any relief in sight. I refer to airlines.

The only good news I have to report is that US Air did not file chapter 11 in August and did not louse up my summer vacation for a second time in two years. You’ll remember that US Air filed its previous 11 case in August of ‘02. This time, the only difference is that they waited until September to file. Otherwise, it’s the same airline, only the problems are worse now than they were two years ago.

US Air’s problems are more severe because the company filed with only $745 million in unrestricted cash and no DIP financing because the federal government has a lien on everything to secure the guaranteed loan which had been reduced to $711 million when the filing occurred.

I’ve been asked whether US Air will survive, but I don’t know because the decision will be made not by the usual handful of creditors whose actions are relatively predictable. Instead, the life or death decision for US Air will be made by thousands upon thousands of travel agents who will decide whether or not to book their customers on another airline.

You and I could make an educated guess about US Air’s survival if we knew how their advance booking are holding up, but I haven’t seen any statements on the subject since the day after filing. Actually, if bookings are holding up, the company would be well advised to say so publicly, otherwise skeptics might start concluding that bookings aren’t good and that survival is tenuous. In that regard, skepticism becomes a self fulfilling prophecy.

A recent action by US Air implies that their condition is tenuous. Last Friday US Air filed an emergency motion to be heard on October 7 asking the bankruptcy court to impose temporary wage cuts immediately. To avoid liquidating this winter, US Air says it needs to generate $200 million in cash by saving $38 million a month on the backs of its employees.

US Air is caught between a rock and a hard place. To qualify for an emergency cut in wages, the airline must prove to the judge on the one hand that the company will shut down absent relief on wages. On the other hand, the company’s rhetoric could scare travel agents and depress bookings. I guess we’ll find out in the next few weeks.

Meanwhile, US Air’s ability to survive is not being helped in the least by an intramural fight among the pilots’ union leaders. In that regard, how US Air got into bankruptcy speaks volumes about the future.

A majority on the leadership council of the pilots’ union wanted to send the company’s offer to the pilots for a vote. However, voting is weighted by the number of members in each representative’s local. Consequently, the four representatives from Pittsburgh and Philadelphia, although a minority in number, represented a voting majority and by themselves blocked sending the offer out for vote. The company filed chapter 11 the same weekend. Notably, the pilots in Pittsburgh are from an airport that is being demoted from hub status while the pilots in Philly are facing upstart competiton from Southwest Airlines. You will recall that Southwest several years ago virtually drove US Air out of Baltimore. Therefore, the pilots in Pittsburgh and Philly may have already begun to assume that their jobs are a lost cause and thus have little incentive to save the company.

Consequently, I’d have to assume that the union leadership won’t be able to muster a vote in favor new concessions. The unions don’t have any reason to be happy because each offer from the company is worse than the last. Just before the bankruptcy filing, US Air was asking for a 19% wage cut from its pilots. Last week, the company demanded a 23% wage reduction. Remember also that the employees took stiff wage cuts in the prior bankruptcy.

Even if the unions refuse to grant more concessions, the bankruptcy court has power to throw out the old contract. Nevertheless, the court can’t make people work if they want to strike, and an airline is a service business. By driving away customers, grumpy, dissatisfied workers can hurt an airline almost as much as high fuel prices.

Consequently, it’s my opinion that US Air’s future also lies in the hands of its employees and travel agents.

So, the question is, what can US Air do to enhance survivability. Why not sell assets?

After all, US Air owns the very valuable Boston-New York-Washington shuttle which has about the highest seat mile yield in Creation. They also have very valuable gates and slots at La Guardia and Regan National where they’ve got their own terminals. In fact, US Air has the largest number of operations of any airline at La Guardia.
So, how about selling some of those gates and slots or maybe the shuttles?

But if they do sell the crown jewels, is there enough left around which to build a business, or would US Air just be a glorified regional airline with a very high cost structure?

As for me, I don’t see any important asset sales if the airline is to survive as anything significant. Thus, if US Air announces it’s looking to sell selected assets, ask yourself whether it’s the beginning of an orderly liquidation.
So, whether it’s by a sudden failure or an orderly sale of assets, what will US Air’s demise mean?

First, the loss of US Air won’t be lamented even by some people who lease them aircraft or finance their planes. If you’re a major institution with a large portfolio of aircraft, you might be happy to see US Air go out of business, figuring it will enhance the value of your aircraft being operated by other airlines. Furthermore, major aircraft owners have probably already taken their hickies on their financial statements with regard to United Airlines and US Air, so the liquidation of either of them might not have any balance sheet effect on the aircraft lessors.

In short, US Air’s demise could come quickly and without advance warning. We could wake up some morning to find that management has shut down the operation because advance booking weren’t generating enough cash to make the numbers work.

The loss of US Air will be the single most important event to date in the history of the airline industry, because I’ll bet that low cost carriers will get their hands on most of the gates and slots at La Guardia and Regan National. Just imagine how the competitive picture will look everywhere east of the Mississippi if low cost carriers become the dominant operators at La Guardia and Regan National.
Next, let’s go take the temperature over at United Airlines.

In our last teleconference, I recommended that an airline in chapter 11 should plan to stay there for three years, until the rate of change in the industry slows down. In another three months, UAL already will have been in chapter 11 for two years. Right now, they are effectively beginning their second reorganization.

Until now, the changes at UAL have been modest. They’ve battered their employees and their aircraft owners, but the business plan is pretty much the same and their costs are still among the highest. Until now, their reorganization had been based on the idea of a huge government loan. With Uncle Sam no longer in the picture, we can now expect UAL to take out the knife and make some serious changes. If they don’t, I question whether the airline will survive.

In terms of emerging from chapter 11, I had assumed that UAL would look around for an equity investor who would have a controlling position in the stock, much like Air Canada and US Air in its prior bankruptcy. Much to my surprise, UAL said recently that it intends only to obtain exit financing in the form of debt. At the behest of the creditors, United is now attempting to reorganize so that the stock won’t be diluted. After all, stock is the only thing that United can distribute to its creditors.

However, I have a major question about whether someone is going to put 1 or 2 billion dollars at risk where the best outcome is to recover your principal and interest. Furthermore, if you’ve got that much money at risk, you typically want some control over how the money is spent. In short, it’s my guess that the investment community will demand equity for the kind of bucks that United needs. We’ll just have to stand by and see what happens.

On another front, two unions have a motion up for argument in October to appoint a trustee over at United. The efforts by the unions to remove management should not be dismissed out of hand. In addition, other creditors may be critical of management for spending nearly two years in pursuit of government loan guarantees based on business plans that were fundamentally flawed. In any event, replacing management would not be easy. Who from the outside with substantial airline experience would want the job? Given how top management at network carriers have been taking pay cuts, becoming UAL’s CEO would mean working 18 hours a day for comparatively low compensation with the possibility of taking the blame if the company fails. Anyway, good people have already been leaving the industry. The CFO at American Airlines left more than a year ago, and Delta’s CFO left this spring. Both went to other industries. That in itself doesn’t say much good about the airline industry.