America West bounces on buy of US Airways, but concerns loom; Delta sees convertible arbs make exit

By Ronda Fears

Nashville, May 20 - America West Holdings Corp.'s acquisition of bankrupt US Airways Corp. sparked a spree of activity in airline convertibles, with the America West issue trading up as the merger is expected to kick in a change-of-control put. Other airline issues, however, were mixed as the impact on the merger as well as the transaction details stirred debate.

On whole, traders reported that the convertible market was still feeling a bit firmer with decent bids.

"Today has been really weird, today and yesterday," commented a fixed-income portfolio manager who historically has allocated a good portion of assets under management to convertibles, albeit admittedly at a smaller level in recent months.

"On the positive side of the ledger, valuations are looking pretty darn cheap. On the negative side of the ledger there are the hedge fund redemptions, plus the breakdown in broker/dealers' ability to provide liquidity to the market. That really broke down in April, so probably for four weeks straight the market has been trading in the hole, until a couple of days ago."

During the last half of the week there have been better buyers around, but participants are still hesitating to call it an out-and-out turnaround. Biotechs have been popular lately, sellsiders say, and on Friday there were a few tech names mentioned as well. Small buying continued in the General Motors Corp. and Ford Motor Co. convertibles, too.

aQuantive a 'cheap' tech pick

aQuantive Inc. was turning heads following a nice earnings report earlier this month and an announcement this week that the online advertising company is expanding into digital television.

The 2.25% convertible moved up 2 points even as the underlying stock slumped.

"Here is one that seems to be active. I like the story and the bonds, and I hear a few other places like it," said a sellsider.

He quoted the aQuantive convertible at 127 bid, 128 offered with the stock at $14.40. aQuantive shares closed at $14.24, off 55 cents on the day, or 3.72%.

The bonds have takeover and dividend protection, the trader pointed out.

"The company is doing everything right. The credit is solid," he added. "Growth and income buyers, I'm seeing more of them coming in. Why not? The bonds are cheap if you like the story, and people seem to like aQuantive."

On Thursday, Seattle-based aQuantive announced it has created a new division known as Atlas On Demand to tailor its internet technology for on-demand television broadcasts, aiming to help advertisers plan commercial time inserted into video on demand programming, target specific audiences and track viewer response.

Even at 127, for terms of roughly 1.75%, up 15%, the trader said he sees the bonds about 5 points cheap on a hedged basis, using a 40% volatility and credit spread of 400 basis points over Treasuries.

America West flaps upward

There was plenty of flap in the airline space Friday, too, in the wake of America West's announced merger with US Airways. Several issues were taking off, including the America West 2.4912% cash-to-zero convertible that is expected to have a change-of-control put triggered by the transaction.

The issue was quoted moving up to 27 on Friday from 23.5 bid on Thursday. America West shares gained 36 cents on Friday, or 7.5%, to settle at $5.17.

At the tail end of America West's conference call Friday, management said that holders of the convertibles will have the right to exercise the put if the proposed merger with US Airways is consummated as planned. The company also indicated the put would be paid in the America West common shares.

Merrill Lynch convertible analyst Tatyana Hube recommended that holders exercise the put, based on information so far available. She pointed out that the put price is 34.361.

Artful deal, but must function

About $1.5 billion in private financing has been arranged for the deal, the companies said, with Canada-based ACE Aviation Holdings and PAR Investment Partners putting up capital as well as Airbus with a $250 million loan.

America West is actually acquiring US Airways with financing provided by vendors and other interested parties; with only $150 million in fresh equity, analysts observed.

"The airline industry now fully embraces 'Pay to Play.' Vendors have to put up cash to get the business," said CreditSights analysts Roger King and Glenn Reynolds in a report Friday.

"It is truly amazing that this whole deal was done in about one week with only $150 million of semi-unconnected equity - the lead hedge fund is an investor in AWA."

Success will hinge on the ability to cut losses before cash runs out. More specifically, cost-cutting at the old US Airways, which is in bankruptcy, is key.

The new airline will operate as US Airways but will be run by America West chief executive Doug Parker and is purported to be capable of earning a profit even with oil prices above $50 a barrel. The combination of a near-liquidation airline with a liquidity-constrained airline is not a recipe for success.

Airline mergers not panacea

Indeed, S&P credit analyst Philip Baggaley cautioned in a report Friday that while consolidation could improve the health of the U.S. airline industry, past airline mergers have had a dismal track record.

"America West faces significant risks in acquiring a bankrupt airline twice its size and integrating the new employees with its own work force," Baggaley said. "Still, significant new equity investment and loans, plus revenue and cost synergy opportunities should mitigate those risks somewhat."

Airline mergers differ from those in most other industries in that they can generate added revenue, but often result in a net increase in operating expenses, the report notes. The added revenues come from diverted traffic from competitors and increased pricing power. However, airline merger cost implications have been less favorable, given the typically higher labor costs that follow and the costs of operational disruptions, according to the report.

As with any merger, part of the credit effect in airline combinations is determined by the acquirer's means of financing the purchase.

S&P does not expect the America West/US Airways combination to trigger a wave of airline mergers in the near term, though eventual consolidation to fewer participants remains likely.

Delta fares favorably in deal

In addition to the perception that the America West merger with US Airways will lead to some reduction in capacity, onlookers say it could bode well for Delta Air Lines Inc. as it strives to avoid bankruptcy.

"The new willingness to invest in a distressed credit without security could help Delta avoid bankruptcy a second year in a row as it lines up its own set of 'Official Suppliers,'" the CreditSights analysts said.

But, time is of the essence for the America West/US Airways combination to cut costs. And analysts say there is zero room for error.

"Given the difficult state of the industry, better financed competitors, a cash sink at US Airways, and a step-up in weight class for America West management, we would say that the odds of a successful merger are not high," CreditSights' King and Reynolds said.

"For the industry, it will keep pressure on transcon yields. For Delta, there is no rest for the weary. A lower cost competitor along the east coast will keep yield pressures in tact."

Convertible players reacted in mixed fashion, with the 8% issue described as slightly better bid while there was heavy selling by convertible arbitrageurs in the 2.875% issue. Delta's junk bonds were seen solidly higher, while the stock slipped 7 cents, or 2.15%, to close Friday at $3.18.

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