Wednesday, December 07, 2011

Interesting opportunity in AMR 7.5% 2016 Senior Secured Notes

American Airlines (NYSE:AMR) recently filed for Chapter 11, following a standoff with its pilots union over wage negotiations. American is the only one of its peer group (aside from Southwest-LUV) to have maintained its expensive legacy liability structure, in the form of expensive union contracts, onerous work-rules, and large unfunded pension (>$5Bln underfunded).

Currently, most items on the McDonald's Value Menu are more expensive than AMR stock and its unsecured debt obligations have fallen precipitously to $.20. The secured bonds for AMR trade mixed, with 1st-lien secured (newer aircraft) bonds trading near 8% or par, 2nd-lien bonds near 10%, and older-aircraft deals in the mid-50s to yield 15-20%. American is expected to reject a number of leases on its 85 older MD-80 planes (45% of leased portfolio, which should result in significant cost-savings and additional  unsecured claims. The estimates of unsecured claims range from $13-25Bln and is difficult to estimate, given significant issues like lease rejections on facilities, planes, engines and the potential for American to dispose of pensions to the PBGC. 

While the newer secured plane deals are probably money-good, they offer unappetizing returns near 8% that do not meaningfully compensate for the potential headline risk and volatility that can occur in a bankruptcy. The unsecured debt at twenty cents offers significant upside in the bull case (200-300% return possibility), but there are massive uncertainties with respect to how aggressive AMR management will be on the union contracts, pensions, etc. If the restructuring and pension/cost-cutting is significant, it will incur sizeable unsecured claims that dilute bondholder recovery. In the bear-case, it could result in loss of principal and/or negligible return over the expected 18-months that the bankruptcy case may take to fully resolve.

My preferred security is the 7.50% Sr Secured Notes Due 2016, currently trading at $74 (near 17% YTM). The security package on these bonds is exceedingly attractive, as it is comprised of American Airlines profitable international routes to China, Japan, and London. The full security package also includes highly sought-after slots and gates in Heathrow and Japan, both of which would likely have strong demand from third-party buyers. My understanding of the indenture is that if American chooses not to affirm this bond and continue payments, then bondholders can force the trustee to seize each of these slots, gates, and routes which would effectively destroy American's international business (including their decade-plus relationship with British Airways, as their gateway partner into Europe). There are numerous reasons American would not commit such folly:

1) The most recent appraised value of the collateral package (gates, slots, route authorizations) was approximately $1.526Bln as of 09/30/2011. This exceeds the outstanding amount of 1st Lien Notes by a factor of 1.5x, which suggests strong over-collateralization and that American would be wiping out potential equity value that exists above the lien.

2) American's international business is currently profitable, their domestic US business is not. Disrupting the only profitable part of its operations would cripple the business and also damage international traffic that is being fed into its US network

3) Future access to capital will be needed- American just priced this deal in March 2011, at a time when its ratings were below investment-grade and potential restructuring seemed possible within the next few years. This deal was structured to protect investors during any likely restructuring, by providing them with collateral that was previously a part of its bank credit facility until 2009

4) Access to routes in Asia and London are highly sought-after, with London/Japan being the most slot-constrainged airports in the world. American would have a tough time ever regaining a foothold in international markets and jeopardize billions in enterprise value if it attempted to impair bondholders of this issue. This seems like a silly thing to do if the only upside was to squeeze bondholders out of a couple hundred million dollars. It would be much easier to squeeze costs by eliminating workers, pensions, excess facilities, and older planes. That is where the real fat seems to be.

5) American has left foreign trade creditors and suppliers out of its US bankruptcy filings. They have not cancelled flights or suspended frequent flyer miles, along with indicating an intent to remain a going concern. American is entering bankruptcy at a time of strong industry "cooperation" on flight capacity and pricing, along with having a cash hoard of $4Bln that ensures adequate liquidity during its restructuring. Based on this, they appear to have given every intent on maintaining current hub-strategy and international partner alliances (particularly British Airways alliance). As such, it would negate the possibility of American walking away from their leases and their note obligations.

What could go wrong?- Although there seems to be strong likelihood of AMR surviving and affirming payment of the 7.50% Notes, there is the risk that a significant economic contraction (i.e- European economic meltdown) significant decreases travel demand and the value of the underlying routes. If such an event caused American Airlines to liquidate prior to 2016, the value of the collateral may be negligible because the leases and authorizations would likely have no bidders and zero recovery value.  We believe an AMR liquidiation is unlikely and that this scenario is remote, but worth considering given the severity of the recovery value.

Summary- Buy the 7.50% 2016 notes, believe bonds will trade up to par (35% near term upside) once the Notes are affirmed by the bankruptcy judge (in my estimation, 99% probability given the Trustee report that has been published).