Northwest Airlines is no longer the highly leveraged, unprofitable carrier of a few years ago, but the carrier faces some tough hurdles in 1996. Jane Levere reports.The scourge of the investment community less than three years ago, Northwest Airlines is now the darling of Wall Street, having streamlined its operations back to profitability. Last year Northwest had the highest system-wide load factor among the US majors, and one of the lowest cost structures, and posted record net profits of close to $400 million. Its growth plan for 1996 is also winning plaudits, as the carrier focuses on further strengthening its hub and spoke operation.

However, Northwest's future progress on the road to recovery may well face some obstacles if its labour costs escalate significantly once the wage snapbacks, negotiated with unions in 1993, begin to take effect in the second half of the year.

The carrier's highly publicised legal dispute with 22 per cent shareholder and marketing partner KLM Royal Dutch Airlines also could take its toll. The bad blood generated by KLM's law suits late last year over corporate governance issues has apparently created a feeling of distrust, particularly from KLM's perspective, that could prevent the carriers from significantly expanding their cooperation and fully exploiting all opportunities for revenue growth. And if the rift gets ugly enough, KLM could well ditch Northwest for other potential partners, either in the US or Europe.

Finally, Northwest will have to buy new aircraft - including replacements for its refurbished DC-9 fleet - and these purchases could put increased pressure on its already fragile balance sheet.

However, today's good times are in marked contrast to the tumult back in 1989, when investors Gary Wilson and Al Checchi led a $3.1 billion leveraged buyout (LBO) of the airline made possible, in part, by a $400 million loan from KLM.

Between mismanagement, over-expansion, global recession and the general industry downturn, Northwest's fortunes plummeted dramatically thereafter, bringing it to the brink of bankruptcy in mid-1993. To stave off bankruptcy, the airline obtained $886 million in wage concessions from its labour unions, to be phased in over a three-year period in exchange for stock and three seats on the board. As part of the bail-out, KLM lent Northwest $50 million and also helped it arrange for an additional $200 million loan, in exchange for stock options and various constraints on merger and sale activities.

Since then, under president John Dasburg, chief financial officer Mickey Foret, and Michael Levine, executive vice president of marketing and international, Northwest has charted a deliberate, disciplined course. Helped by the wage caps, the management team has attacked and reorganised every aspect of Northwest's operations.

On the marketing front Northwest has cut unprofitable routes and hubs - including the Washington, DC mini-hub, a larger hub in Seoul, Korea and service to Australia. The airline's entire network has been repositioned to focus on profitable flights to and from the remaining hubs in Minneapolis, Detroit, Memphis and Tokyo, while a major expansion of service has been launched to secondary cities in Canada.

Northwest has also embarked on an ambitious codesharing programme, hooking up with: Asiana Airlines to maintain a presence in Korea; Alaska Airlines to feed Northwest in the Pacific Northwest; and German regional Eurowings in Amsterdam. Northwest has radically revamped its ground and in-flight service and upgraded its business class product in 1994. The success of these combined efforts can be seen in the carrier's 1995 US industry leading system load factor of 71.5 per cent, while 1995 revenue per ASM climbed 7.3 per cent to 9.58 cents, and yield rose 2.6 per cent to 12.42 cents.

Meanwhile Northwest has opted to refurbish and hushkit over half of its 174-aircraft DC-9 fleet instead of buying newer, noise-compliant equipment. According to Foret, this action should save the carrier $1.4 billion in current dollars over a 15-year period beginning in 1995. Hushkitting of Northwest's 106 DC-9-30s is slated to be completed by the end of this year. Other cost-cutting and revenue-enhancing measures have focused on improving employee productivity, yield management, fleet scheduling, maintenance procedures and distribution. These steps have put Northwest's operating costs in the forefront of the majors: according to estimates by Standard & Poor's, the carrier's operating cost per ASM for the nine months ended September 30, 1995 was 8.1 cents, compared to 8.5 cents for United, 8.6 cents for Delta and 9 cents for American.

On the financial front, the airline passed a significant milestone towards the end of last year, repaying or replacing its outstanding $837 million LBO debt with a mixture of internal cash and a $300 million unsecured loan. This step, according to Foret, will help Northwest improve its credit ratings, reduce the cost of subsequent financing, 'and allow the capital markets to stop looking at us as an LBO. Now that we've paid off our LBO debt, there are no more LBO restrictive covenants'.

Northwest's 1996 game plan includes: a 6.9 per cent increase in system-wide capacity through additional flying on existing routes and extra seats on aircraft, the substitution of B757s for 727s, and the launch of new thrice weekly nonstop service from Detroit to Beijing. There will also be an additional $150 million in savings from new maintenance procedures; greater efforts to recognise and reward high yield business travellers; and, to complement the new Detroit-Beijing service, a new codeshare with an unidentified Chinese airline. In addition Northwest is looking into making extra savings by copying efforts by Federal Express to convert B727s and DC-10s into two-pilot operations.

About the only immediate visible cloud on the airline's otherwise bright horizon is its labour costs, which will climb by at least $260 million when wage snapbacks - which would return unionised employees to their 1993 pay scales - go into effect starting in August. Although the carrier's profit and loss statement will improve by an estimated $240 million once the snapbacks are in place, because employees will no longer receive stock in lieu of wages, the extra $260 million wage bill will reduce cash flow. The unions are also likely to seek cost of living increases on top of the snapbacks. 'Almost certainly there will be a large increase in Northwest's cash costs and there is little prospect this can be fully offset by productivity improvements,' says Standard & Poor's aviation analyst Philip Baggaley.

Northwest's management says it is too early to reveal its negotiating strategy. However Duane Woerth, first vice president of the national Air Line Pilots Association, and the union's representative on Northwest's board, predicts 'a pragmatic conclusion to the negotiations, as long as Northwest recognises its employees like to work for a profitable company and treats them as an asset, and employees recognise that the golden goose has to be kept alive to grow.'

Northwest's other unions - including the International Association of Machinists, and the International Brotherhood of Teamsters for the flight attendants - insist they will not give management any new wage concessions. Echoing the sentiments of the labour groups, Bill Scheri, general vice president of transportation for the IAM, says he hopes 'the company realises it's their turn now to cough up. We feel we gave them enough concessions to turn around the company. Now it's their turn to repay the employees.'

Although Northwest so far has staved off significant competition from low-cost carriers like Southwest or ValuJet - which, Dasburg points out, find serving Northwest markets like Hartford, Connecticut to Fargo, ND, less than attractive - more challenges are likely longer term.

'So far, there's been no rush by the competition to move into Northwest's markets, because the markets haven't been large enough to support two competitors. But with the profits North-west generates, there's the risk someone could try to take advantage of that,' says Moody's Renee Shaker.

The need to re-equip - and the problems of borrowing money at good rates for new aircraft because of a relatively weak balance sheet - are other challenges Northwest must deal with in the long term. Since the early 1990s, Northwest has cancelled orders worth $4.5 billion and deferred delivery of an additional $2.7 billion in aircraft to 1999-2006. Northwest 'does not need the new aircraft that were deferred for a long time to come', says Foret, adding the carrier will not order a replacement for the aging, refurbished DC-9s until 'after 2000'. 'Although there's been a relative lull in Northwest's capital spending, it will have to ramp up over time,' warns Baggaley. 'Improvement in their balance sheet should continue, but it will flatten out if they order new aircraft.'

While another recession could stymie Northwest's efforts to rebuild its balance sheet, one analyst says it is 'disappointing that North- west, in the current market, is not moving to raise equity. They're not doing it because Checchi and Wilson don't want to dilute what they own, because they want to make a boatload of money. But if they did, it would further improve their balance sheet, and give Northwest a decent shot at an investment grade rating.'

Perhaps the most intractable problems Northwest faces involve its marketing and investment partnerships with KLM, and the two suits KLM filed late last year. One, filed against Checchi, Wilson and other original investors, concerns a move by these investors to change a 60 per cent supramajority approval provision in the original agreement to a simple majority for mergers, acquisitions, and asset sales. KLM says this step has unfairly taken away its right to veto deals by Checchi and Wilson. The second suit, filed against Northwest Airlines Corporation, concerns a 'poison pill' plan adopted by Northwest in November which KLM claims was implemented to keep it from exercising its option to buy stock from Checchi, Wilson and the original investors.

According to Northwest management and union officials, the suits, which are still pending, have had no negative impact on the two airlines' marketing alliance, which the US General Accounting Office estimates generated between $125 million and $175 million in revenues for Northwest in 1994. Northwest says the alliance added $50 million in operating profit in 1995.

KLM managers see the situation differently and say that, although marketing cooperation between the two companies continues, distrust of Northwest's management is beginning to colour KLM's attitude. 'Although there's still a decent benefit for both,' says Jack Pheifer, KLM's vice president of strategy and commercial cooperation, 'we cannot deny there has been an impact on the enthusiasm with which a lot of people work.'

Sources familiar with the alliance further suggest that the distrust felt by KLM is preventing it from developing common systems with Northwest, which could create further cost savings. 'Each company would have to surrender its own systems and share them with the other. But the suits, and the dispute, are preventing them from doing this, and from going more deeply into their relationship,' one observer says. Former plans by the two companies to expand their cargo cooperation, or add airline partners in previously untapped regions of the world, cannot be explored because of the bad blood generated by the suits.

If the lawsuits lead to a termination of the alliance, 'Northwest would lose a potential source of back-up support which, while not needed now, could prove useful in a severe downturn,' says Baggaley.

Although KLM admits it is talking to other airlines, it still insists its partnership with Northwest is 'basic, an integral part of the global alliance KLM is trying to put together,' in Pheifer's words. It would 'not be in KLM's interest to drop [it]; it's not like you would change a pair of shoes.'

However, the alliance musical chairs game among the world's leading airlines could resume at any time and upset the shaky Northwest-KLM alliance. 'The fact that KLM is having problems with Northwest has not gone unnoticed,' notes one European airline executive, in a reference to BA and American. If BA's alliance with USAir collapses, BA and KLM could yet hook up with each other, pulling in American and leaving Northwest out in the cold.

The issues raised by KLM's suits against North- west's board, and Checchi and Wilson in particular, 'bring to the surface again the suspicion that they're more interested in maximising their investment than in building a successful airline, that they're financial engineers and not airline-owners/managers,' says one Wall Street executive. Their attitude could scare off other airlines from contemplating a combination with North- west, should it eventually be led to branch out on its own. As the industry contemplates the next round of musical chairs, this prospect is not a pretty one for Northwest.

Source: Airline Business