Source: New York Times
Author: Jeff Bailey

Pardus Capital Management, a New York hedge fund, has sent a letter to management of Delta Air Lines asking it to seek a stock-for-stock merger with UAL, the parent of United Airlines, in a deal that would create the world’s largest airline and could prompt sweeping consolidation in the airline industry.

Gordon M. Bethune, former chief executive officer of Continental Airlines, is working with Pardus, the hedge fund said in the letter. And consultants have identified $585 million in savings the two big airlines — currently Nos. 2 and 3 in the country — could realize by combining operations.

Pardus said in its letter, sent Tuesday night, that it owns seven million Delta shares, about a 2.6 percent stake.

The proposal comes one year after a bid for Delta by US Airways that ultimately failed. That offer raised hopes among investors that airlines, long reluctant to merge because of expected labor problems and other factors, would finally consolidate and make the industry more efficient.

The US Airways bid also, however, attracted opposition from Delta workers, who feared widespread job losses, and from some who expected that the deal would reduce air service in some cities both carriers served.

The recent rise in oil prices, pushing jet fuel to record levels, threatens to snuff out the airline industry’s nascent recovery and send carriers back into the red. That has led to increased speculation in recent weeks that mergers would again be seriously discussed.

Most airlines remain heavily in debt and highly vulnerable to fuel prices or any economic downturn.

Karim Samii, president of Pardus, and Shane Larson, a principal, said in the letter to Delta’s top executives and its chairman that “we believe it is imperative that you seek to enter into a merged transaction with another carrier given the rapid rise in fuel prices and the increased risk to the business as a stand alone entity.”

Estimates of Delta having $1.5 billion in free cash flow for 2007 suggest, with higher fuel prices, that cash flow “would be more than eliminated if fuel prices remain at current levels for full year 2008,” the letter said.

The letter goes on to evaluate potential merger candidates for Delta, including Northwest Airlines and Continental Airlines, but concludes that United is the best fit.

Pardus said in the letter that it had written to Delta management on Sept. 7 recommending a merger but at that time had not named a particular partner.

Since then, the hedge fund consulted with Mr. Bethune, the former Continental chief, and with consultants at Simat, Helliesen & Eichner.

It concluded that United and Delta together would offer the broadest network of routes to business travelers, and substantial savings.

A combination with Northwest would offer more savings — $1.5 billion a year, mostly from combining smaller hubs — but would not create as expansive a network, Pardus concluded. Northwest has a hub in Detroit, and Delta has one in Cincinnati; Northwest has a hub in Memphis, and Delta a giant one in Atlanta.

And a combination with Continental would deliver no savings, actually raising the combined airlines’ costs by $171 million a year, and also present difficult management succession issues, the hedge fund concluded.

Pardus recommended that Delta acquire United in a no-premium stock merger. Based on recent trading prices, Delta could swap 2.395 of its shares for each United share, Pardus said. Pardus said it would back Richard H. Anderson, Delta’s chief executive, to run the combined airline, with United’s chief, Glenn R. Tilton, United’s chief executive, sticking around as chairman “for the next year or two to help facilitate integration.”

Though Delta might get a better exchange rate by waiting and hoping its stock rises, Pardus recommended seeking a merger immediately. Fuel prices are one factor. And the regulatory climate — the Bush administration may be considerably more tolerant of big mergers than a potential Democratic White House — is another.

As of early today, Delta was trading at $18.64, giving it a market capitalization of roughly $5 billion. UAL, the United parent was trading at $42.92, giving it, too, a market capitalization of roughly $5 billion.

That would suggest owners of the two carriers, if they combined, would split the company roughly in half. Pardus recommends a stock-for-stock exchange with no premium for United holders.

Mr. Tilton has publicly advocated industry consolidation, and is known to have engaged in discussions with Continental Airlines about a combination. Continental has said it prefers to remain independent but that, should the industry begin to consolidate, it would not stand idly by.

At Delta, Mr. Anderson has also spoken in favor of consolidation in recent months. A former chief executive of Northwest Airlines, who then took a job at UnitedHealth Group for a few years before being hired at Delta, he was the choice of Delta’s creditors committee, a group that wanted the carrier’s management open to the potential of a merger.

If fuel prices remain as high as they are today, there will be tremendous pressure on airlines to merge and cut their costs. Delta and United, having just recently emerged from bankruptcy, where workers took a beating on wages and benefits, have little opportunity to further reduce labor costs or increase productivity.

In fact, United faces an angry work force that, seeing the carrier profitable and Mr. Tilton receiving a big paycheck, wants to reopen contract talks early and extract a raise.

And raising fares to remain profitable — something airlines are trying mightily to do these days — is difficult, too. Low-cost carriers like Southwest Airlines, AirTran Airways and JetBlue Airways, which operate across much of Delta and United’s networks, help keep fares lower. And consumers resist, too, shopping diligently online for low fares and making it difficult for airlines to increase their revenue.