Let's Make a Deal

A newly rehabilitated--and temporarily stabilized--Northwest Airlines is poising itself for the next round of industry mergers and acquisitions.

Al Checchi and Gary Wilson--the "Fly Boys" who bought Eagan-based Northwest Airlines in 1989 and nearly ran it into the ground, earning themselves titles such as "Barbarians at Gate 31" from local media--are back in the news. This time, though, they are likely to be painted as savvy investors whose hard work and determination will net more than $1 billion in profits for themselves and those who invested with them.

Northwest is being dressed for sale. And Checchi and Wilson have just jockeyed their way into the catbird seat, tossing out the only element that could have stood in the way of making a clever deal--longtime partner KLM Royal Dutch Airlines.

Or so goes the perception in the industry. Of course, Northwest's formal response to whether it is discussing a possible sale or merger is always the same: "We don't comment on rumors." And the company naturally describes its battle with KLM very differently.

But recent moves by Northwest's board and top management--as well as the company's financial position and the condition of the industry generally--have led a number of Northwest employees, former executives, and industry analysts to believe that management is prepping the company to fetch an attractive price as the industry enters its next round of consolidations in the coming year.

"Many of us believe Northwest has been operated for about the last 12 months as though it's being prepared for sale," says a senior Northwest pilot active in company affairs, adding that the most likely suitor is American Airlines. NWA, he points out, "has done little by way of capital expenditures; market opportunities, especially in the cargo area, have been let go; and no plans are being made to replace our older Boeing 747s, even though we frequently can't carry a full load of passengers across the Pacific because of fuel capacity constraints."

"What we've been doing," counters Northwest representative Jon Austin, "is simply trying to operate efficiently and profitably. The last nine consecutive profitable quarters indicate we've had some success at that."

Vince Bazzachini, the president of Local 1833 of the International Association of Machinists (IAM), says he doesn't believe management is actively trying to sell the company. "But I do believe there's a backup plan that has been prepared in the event there is another round of industry mergers," he says. "Is there a plan B [to be acquired]? Sure there is."

In essence, Northwest's position seems to be that "if we're going to go up for grabs, we have to do some things to make sure we're well positioned to take advantage of it," says Barbara Beyer, president of the Arlington, Virginia-based airline consulting firm Avmark Inc. "Northwest set up a poison pill, has cleaned up its act financially, has a solid domestic route system, has the Pacific routes, and has a good relationship--despite the recent conflicts--with KLM. Those things make it an attractive buy."

The matter of who has the power to decide Northwest's course has been the subject of intense infighting and legal maneuvering between KLM and NWA. In recent weeks, the struggle has spilled into the courtroom, where KLM is trying to reverse the actions of Northwest's board of directors. At issue are certain rights granted to KLM when it agreed to help the airline out financially in 1989 and again in 1992-93.

According to Austin, Northwest has no secret agenda: "The company's management and board is doing what it thinks is in the best interest of the company, its employees, and its shareholders."

Others say it's doing only what's best for Checchi and Wilson. "KLM was the only one that controlled Checchi and Wilson," counters one industry official with ties to Northwest's upper management. "Those two now have $6 billion in market-valued assets to play with, and KLM keeps them from doing things that are not in the interest of either airline."

By way of illustration, the airline official points out some interesting details surrounding Northwest's recent adoption of a "poison pill" shareholders' rights plan.

Northwest accused KLM of trying to slowly buy a large enough position in Northwest to take control of it. Such a claim seems absurd given that U.S. laws prevent foreign ownership from exceeding 25 percent of a carrier's voting stock and 49 percent of its overall equity; KLM owns around 20 percent of Northwest's voting stock and was hoping to acquire up to an additional 4 percent. It had no plans to go any further, KLM company officials claim.

But laws can be changed, cautions Austin. "As it's prudent to put a lock on your door even though the police are out there protecting you," he says, "it's prudent to change the bylaws even though laws are out there."

Austin also says that Northwest officials discovered a KLM representative had requested that the U.S. law be changed. He wouldn't elaborate, except to say that "It was at a level sufficient to provoke our extreme concerns." KLM denies the claim. And the industry insider notes that Checchi and Wilson--who boast ties to the leadership of both major parties and to officials of the Department of Transportation--have more political clout than their counterparts at KLM.

Northwest's board nonetheless used concern over KLM's potential encroachment to justify amending an agreement that was formed in 1989 between the original six investors who financed Northwest's leveraged takeover: KLM, Checchi, Wilson, investor Richard Blum (the husband of U.S. Senator Dianne Feinstein, D-California); longtime Republican insider Fred Malek; and the New York-based Bankers Trust Co. These six had agreed in 1989 that if any one of them, or a combination of them, wound up owning 40 percent of the holdings that the original shareholders had started out with, that investor--or a combination of them--could block the board of directors on major corporate transactions, such as mergers or sales of Northwest assets. Bankers Trust recently sold off 4.2 million shares, leaving only two entities with enough stock to block a major board-approved transaction: the Checchi/Wilson team and KLM.

The recent amendment does away with all that by eliminating the 40 percent blocking rights. It also kills an agreement whereby KLM was to be given first right of refusal on any stock sold by the original shareholders. And as if those moves weren't enough, there's the poison pill. Northwest's pill protects the company from an unwanted party buying more than 19 percent of its stock (and restates KLM's ownership at 18.8 percent on a fully distributed, fully diluted basis).

In getting rid of KLM's veto power and freezing its ownership position, the board no longer faces the threat of any outside interference, "especially from KLM," Northwest has stated.

One question remains: Without KLM's influence, who will counterbalance the influence held by Checchi and Wilson?

Four of Northwest's 14 board members (Malek, Blum, a director of Blum's firm named Thomas Kempner, and Northwest President and CEO John Dasburg) are close allies of Checchi and Wilson and would very likely vote as dictated by them. Two others, including Bankers Trust's George Vojta, also are likely to vote in accord with Checchi and Wilson's wishes. That's more than 50 percent of the board poised to go along with them.

Of the six other directors, three are union representatives. All of Northwest's union contracts come up for renegotiation in 1996 when a three-year-old concessions deal expires, and employees are supposed to have wages restored to 1993 levels. As the unions face a new round of negotiations with management, there could be pressure for a quid pro quo in the form of solidarity with Checchi and Wilson on board votes.

The recent board moves are bad news not only for KLM but for anybody who might argue that a company's shareholders are best served by a diverse group of directors. But put yourself on the other side of the table, says Avmark's Beyer: "If you're Checchi and Wilson, would you want KLM to have the first right of refusal on your stock when somebody like American comes along and says it's interested in buying it?"

Despite the company's refusal to comment on rumors that it will be up for sale, there are considerable advantages to the present managerial regime in following that course as opposed to pursuing its other options: carrying on independently or trying to leverage the purchase of another carrier.

In 1989, Checchi, Wilson and partner Fred Malek invested $42 million to buy 44 percent of the voting stock in Northwest at the time of its takeover. Today, Checchi and Wilson own about 20 percent, or roughly 23 million shares. Should Northwest be sold anytime soon, the two would clear a profit of $1.1 billion (including the $100 million they already made), based on its current trading price. Not bad for a seven-year investment.

Then there are the stock options, which allow managers who receive them to buy stock at below-market prices during a certain period of time.

A look at Northwest's 1995 proxy statement suggests that if the airline were acquired at its recent high-range trading price of about $46.50 a share, John Dasburg, Northwest's president, could make a profit of about $26 million by exercising all the options he held as of December 31, 1994. Michael Levine, the executive vice president in charge of the airline's marketing and international operations, would make $11 million (a figure that includes redemption of 45,000 shares he already owns). Levine has a little added incentive: According to the proxy statement, he will receive $1 million if the company is sold and he resigns as a result before July 1, 1998.

The power struggle between KLM and the Checchi/Wilson team comes at a time when Northwest is sitting in its best financial position since before the 1989 leveraged buyout.

Indeed, it was only a few years ago that Northwest was on the verge of going bankrupt. In December 1991 NWA management bullied the state of Minnesota into giving the airline a $280 million bailout loan to keep things going until December 1992, when it was able to get suppliers, lenders, and shareholders to allow the company to refinance. As part of that refinancing, KLM agreed to write off its entire original $400 million investment in Northwest and to defer dividend payments on its preferred stock, and contributed $50 million to a $250 million emergency loan to keep Northwest out of bankruptcy court.

At the same time, Northwest was allowed by its bankers to defer debt payments of $337 million for another year. And it saved an estimated $3.7 billion in future costs by killing its fleet modernization plan, opting instead to keep the oldest assemblage of planes of all the major U.S. carriers in the air despite their fuel inefficiencies.

The moves paid off. Six months later the company's unions agreed to $886 million in concessions over three years in exchange for stock. Fuel prices dropped and Northwest's competitors started suffering due to competition with lower-fare airlines such as Southwest--a factor Northwest has not yet had to face in its Detroit and Minneapolis hubs.

"I think Northwest is the best-managed airline in the business today. Their relationship with labor is without parallel," says Paul Davner, an airline industry analyst with BDS Securities in New York. Three years ago he doubted Northwest's chances, but today, he says, "Their marketing strategy is the envy of the industry. And their financial position is solid."

Beyond its rehabilitated fiscal reputation, the company also boasts enviable assets. Two weeks ago, Northwest announced a clever plan whereby it shifted a $758 million Japanese mortgage into a different form of ownership, allowing it to be accounted for as "minority interest in an affiliate." In so doing, it wiped $758 million worth of debt off its balance sheet. NWA management then announced they would use $537 million in cash and $300 million from a new unsecured bank loan to pay off $837 million worth of debt.

This chunk of old debt is the last portion of the original financing used to buy Northwest through a $3.65 billion buyout in 1989--which means new freedom for the Checchi/Wilson regime. Until now, most of the airline's chief assets were committed as collateral to the leveraged buyout financing; they included Northwest's prized Pacific routes, currently listed with a book value of about $4.7 billion and a market value of about $6 billion, according to news reports and inside sources who attended a recent Northwest presentation at Salomon Brothers Inc.

That means, in theory, that Northwest could re-leverage those assets into a financing deal that would allow it to buy another airline. Or it could sell off the assets to the highest bidder. Industry analysts say, for example, that American Airlines would be willing to pay much more than book value to buy Northwest's Pacific routes. In yet another scenario, some unknown suitor could come along and put Northwest through another leveraged buyout by using its assets to help finance a purchase.

As for rumors about Northwest selling the Pacific routes separately, the company breaks from its usual "no comment" posture. "The rumors are absolutely false," says Austin, "and anybody who would say that has no understanding of the company or its strategy."

Meanwhile, the industry is rife with speculation over who may be looking to buy whom. United Airlines made a serious run at picking up USAir until talks broke down two weeks ago. That possibility sent several other airlines into strategic planning meetings, searching for their own possible merger partner to combat what would have become the world's largest airline.

As Beyer points out, a deal between Northwest and American would be even bigger. But she and all the other people contacted for this story say they don't know what Northwest may be planning at this point.

Adding to the mystery is Northwest's unique position in the industry. "The people who have the ability to buy other airlines are United, Delta, and American. Then there's the other group, those carriers such as Continental, USAir, and TWA that are in the area of likely being acquired," says Dan Aikens, vice president of the aviation consulting firm Airtrans Inc. "Northwest is in the middle and can go either way."

The hottest bet on the street is that Northwest will be acquired by American, or become part of a new parent company that merges Northwest with Continental or Delta. But there are several potential variations:

§ American and Northwest

"The best merger would undoubtedly be between Northwest and American," said BDS's Paul Davner, echoing several other industry observers. "In one fell swoop, American would get a European ally through KLM and the largest bloc of U.S.-Japan routes."

Northwest and United own most of the routes between the United States and Japan/Asia. The Pacific routes give Northwest great strategic value because of their profitability relative to domestic and Atlantic routes. At the same time, Northwest isn't taking full advantage of its route authorities; it has more than a dozen routes into Japan that it cannot afford to use at present, and industry observers say the company is continuing to lose ground to United when it comes to Pacific market performance. American, through buying Northwest, could finally compete with United on a level playing field.

Others disagree. "Anybody who thinks that's possible has too much time on his hands," says IAM official Vince Bazzachini. "The two have been arch enemies for a while now. I also think the government would take a serious look at a merger of that size before allowing it."

"With its cost structure, I don't think American is anywhere near positioned to go after and acquire Northwest," says a former high-ranking Northwest executive. "[American Airlines CEO Robert] Crandall may just be so charged up that Northwest would look like the deal to do. But Northwest's pilots are under a different union than American's, and that would be tough to deal with."

He also echoes a point raised by other observers: "Could you imagine Crandall and Checchi and Wilson trying to negotiate?" Both sides have been publicly open about their disrespect for each other. "On paper, American and Northwest would make sense. But look at the egos involved and the labor issues."

But at least one Northwest pilot thinks the labor issues could actually be a benefit. "Our pilots would jump at the chance to switch to an independent pilots union," he said. "If American's and Northwest's pilots got together and had an election, that's what would happen."

§ Northwest and Continental

A merger between Northwest and Continental "is what the boys are fighting KLM over," claims the former Northwest executive. "They could probably combine the two carriers and create an even greater value for their stock. Whether your stock is $45 a share or $55 a share makes all the difference when you go to sell millions of shares."

Continental is doing much better financially than in previous years. Parts of its system would complement Northwest well: its hub in Houston, its operation in southern California, its European presence. It has a lower employee cost structure than Northwest's. And, four years ago, Checchi and Wilson were interested in buying Continental. So there's some degree of familiarity.

"Most of the upper management folks at Northwest come from Continental," Davner adds. Checchi is well-acquainted with the current chairman of Continental, David Bonderman; he is also friendly with Continental's former chairman, Minneapolis banker Carl Pohlad.

But there are "old labor wounds with Continental that would be hard to heal," according to Bazzachini. "Continental decertified the IAM under Frank Lorenzo, so you'd be asking one labor force of union workers to merge with a labor force of scabs."

§ Selling Northwest piece by piece

"Another consideration is that Northwest may be worth much more piecemeal than as a whole," the Northwest pilot says. "American could buy our Pacific routes. Somebody else--like UPS--could buy our cargo routes, which are severely underutilized right now. And an airline like Delta could buy our domestic routes."

This also might make the most sense from the standpoint of Northwest's investors. "They'll have tax problems if they try to sell it all at one time," says one industry official with ties to Northwest's upper management. "So they'll probably try to cut deals where they sell off parts of Northwest and get pieces of other companies at the same time." For what it's worth, this is the one scenario that Northwest adamantly denies.

Whatever the course Northwest elects to follow, timing will count for a lot. The nation's largest airlines are currently enjoying their best financial performance in nearly a decade; in the process, they're generating a ton of cash. United, American, and Delta each have more than $1 billion in cash available. Wall Street expects even better in the future. Considering the condition of the industry (with its continued low fuel prices) and the economy (steady), analysts figure the only way airlines can continue their recent growth rate is through smart mergers.

But besides the notorious volatility of the airline business, there are other specters on Northwest's horizon. According to industry consultant Aikens, "The thing people should be focusing on is the mid-term impact of the wage concession snap-backs in 1996." Labor concessions saving the airline about $280 million a year "snap back" into the picture in August 1996. (According to insiders privy to the labor situation at Northwest, the snap-back provision is "pretty much set in stone," though it's generally thought that Northwest management will try to offset as much of the $280 million as they can by extracting labor concessions on matters such as pensions, benefits, and workplace hours.)

Northwest will likely end 1995 with close to $800 million in available liquidity and cash on hand. But it faces large debt repayments beginning again with $477 million in 1996 and staying at about that level each year through 1999, according to financial statements filed with the Securities and Exchange Commission.

And if fuel prices should begin to rise again, they will have an inordinate impact on Northwest in view of the fact that the airline still operates the most fuel-inefficient fleet among the major carriers. Consider that Northwest's overall passenger yield--the amount of money on average that it makes transporting one person one mile--is no higher today than it was in 1990, when the average cost of jet fuel was roughly 50 percent higher than it is today.

"The clock is ticking. [The Checchi/Wilson team doesn't] want to be here to deal with the snap-backs or to deal with all the union contracts coming due at once," says an airline industry consultant who asked for anonymity. "The last thing you want is to be in a position where you have to negotiate with everyone all at once. It goes against the traditional rule of negotiating: divide and conquer."

And even if things will continue to go well at Northwest through 1996, there's still the fact that Checchi and Wilson bought Northwest as an investment, not to run an airline. "Remember, these guys are corporate raiders," Beyer said. "Their goal is certainly not to have an established loyalty that is too much greater than the value of their checkbooks."

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