I have been asked my opinion of the Delta/Northwest deal by several students and friends. Quite frankly, I do not know enough about either firm to comment in great detail. But that has never stopped me before. So here goes…

Provided that regulators and the employee unions at both firms allow this deal to go through, the success of this merger hinges on two specific factors:

1. The ability to wield increasing market power - restricting supply and eliminating routes in an effort to gain more pricing power, raise fares, and generate additional profits.
2. The ability to generate cost saving synergies - in fleets, gates, reservation systems, maintenance, management, etc. - thereby raising profits.

With respect to the former, there will no doubt be opportunities for the combined firms to exercise some pricing power. Moreover, with gasoline prices at an all time high, this rationale for their combination makes economic sense.

With respect to the latter, both of these firms are struggling. Each has recently emerged from bankruptcy, and both have cost structures that are too high relative to the competition. I have never been a big proponent of the idea that bringing two bad firms together suddenly yields one good firm. This deal is no exception. I am therefore skeptical about their ability to generate meaningful synergies by combining forces.

All told, although I believe that the potential for pricing power is there, the additional pricing power will not address the fundamental problems that each firm faces. Moreover, the synergies will not make up the difference. For this reason, my off-the-cuff priors would be to expect the combined firm to fail, …as would either firm left to its own devices.

The real question though is whether Delta and Northwest have more of a fighting chance together or separately. Unfortunately, my answer is that in this case, it likely doesn’t matters much either way.

The most recent issue of the Economist has a nice analysis of the deal (see Trouble in the Air). They write:

Darkening economic clouds, oil at $114 a barrel, cut-throat competition and disappearing credit lines are confronting airlines with their biggest crisis since the dark days after September 11th 2001. It is a measure of the panic sweeping the industry that Delta and Northwest said this week they would push ahead with their $3.6 billion merger to create the world’s biggest airline by traffic…[T]he two airlines have decided to take the risk of a potentially long-drawn-out and fractious integration of their operations because they calculate that a merger is their best chance of survival as the industry’s woes deepen.

Delta and Northwest…having only recently emerged from Chapter 11 bankruptcy protection themselves…know that time is not on their side. After a strong recovery by America’s airlines in the past few years, profitability has fallen fast this year. And balance sheets are still weak, even at the big network carriers.

Delta has 117 McDonnell Douglas MD-88s with an average age of 18 years; Northwest soldiers on with more than 90 DC-9s with an average age nudging 40 years. These planes are up to 40% thirstier than their more modern counterparts, a crippling burden given the price of fuel. They are also more difficult to maintain—as last week’s grounding of American Airlines’ similarly elderly MD-80s highlighted.

Delta and Northwest have little scope to cut front-line staff or replace their ageing fleets any time soon—production lines at Boeing and Airbus are fully booked until 2012. But they think they can secure cost reductions of about $1 billion a year by centralising their back-office operations and cutting management jobs. They also hope to boost revenue by combining route networks and strengthening their appeal to lucrative corporate customers.

So there you have it. My opinion on the deal given what limited information I have on each firm.

I don’t know how many of you saw yesterday’s article in the Times (see Retailing Chains Caught in a Wave of Bankruptcies). Although the story is not new, there were some interesting nuggets in the article. Michael Barbaro explains:

The surging cost of necessities has led to a national belt-tightening among consumers. Figures released on Monday showed that spending on food and gasoline is crowding out other purchases, leaving people with less to spend on furniture, clothing and electronics. Consequently, chains specializing in those goods are proving vulnerable.

Retailing is a business with big ups and downs during the year, and retailers rely heavily on borrowed money to finance their purchases of merchandise and even to meet payrolls during slow periods. Yet the nation’s banks, struggling with the growing mortgage crisis, have started to balk at extending new loans, effectively cutting up the retail industry’s collective credit cards.

“You have the makings of a wave of significant bankruptcies,” said Al Koch, who helped bring Kmart out of bankruptcy in 2003 as the company’s interim chief financial officer and works at a corporate turnaround firm called AlixPartners.

“For years, no deal was too ugly to finance,” he said. “But now, nobody will throw money at these companies.”

This is consistent with what I’ve been saying for a long time now, that businesses are getting hit especially hard on both the supply side and demand side of the ledger at once. This makes for a very difficult environment.

But the retail story is just a warm up.

Moving forward, the real action will be in how these effects reverberate throughout our economy, and then spillover to the broader world economy. Outside of housing and financial firms (the epicenter of this crisis), the next obvious lurch downward, which we’ve already begun to see, is in durables (autos, appliances, etc.); retail; and travel. In essence the recession is now beginning to impact those businesses closest to the struggling consumer. From there, just follow the supply chain upstream to the manufacturers of intermediate goods and providers of intermediate services. And as it so happens, many of those providers of intermediate goods and services are foreign. 

And this is how a U.S. recession effectively turns into a worldwide recession.

In my opinion, the world is just too interconnected, and the U.S. such a large part of the world economy, for it not to happen.

Just one question: Have we hit the first intermission in this show yet?

Several more bankruptcies to report this week - Skybus, Frontier Airlines, and Linens n’ Things.

I’m a week behind on Skybus (a friend pointed that out to me); but in my defense, Skybus was a tiny operator that had been in business for less than one year (see Skybus Airlines Files for Bankruptcy). Although Frontier Airlines was considerably larger and more established than Skybus, their business models were similar - both low cost, short-haul operations. Now Frontier is similar to Skybus in another way - it too has gone the way of the Dodo (see Frontier Airlines Files for Bankruptcy Protection).

The most impressive bankruptcy of recent vintage (Bear Stearns aside) has to be Linens n’ Things. Should it file for bankruptcy tomorrow as expected (see Linens n’ Things Weighing Bankruptcy), it would represent the most consequential bankruptcy so far this year. Linens n’ Things is not only a household name, but it received a fair amount of notoriety when it became a portfolio company of the private equity firm Apollo Management (see Apollo Struggles to Keep Debt from Sinking Linens n’ Things).

So this makes the new running list of notable 2008 bankruptcies:

• Wickes Furniture (retail)
• Sharper Image (retail)
• Lillian Vernon (retail)
• Sirva (moving services)
• Blue Water Holdings (auto)
• Buffets Holdings (restaurants)
• Aloha Airlines (airline)
• Bear Stearns (banking)****
• The Education Resource Institute (insurance)
• ATA (airline)
• Skybus (airline)
• Frontier Airlines (airline)
• Linens n’ Things (retail)

This list is threatening to get long enough for me to create a separate graphic.

Separately, I have to say, I’ve been somewhat troubled by this recession so far, and the bankruptcies that have accompanied it. Although bankruptcies and recessions go hand in hand, I cannot remember the last time so many well-known names had disappeared so quickly. Sure, the post dotcom recession brought us many a flop. Data from Bankruptcydata.com reveal that there were 289 bankruptcies in 2000 and 383 in 2001, …far more on a SAAR than this year’s 53. But what’s different to me about this recession is that unlike the dotcom era, many of these businesses were viable at one time, certainly much more so than firms like Pets.com or Webvan, …remember them??

And in an additional piece of corroboratory information, I had a conversation with the CEO of a turnaround/restructuring company this weekend who confirmed my worst fears - that this year has been terrible thus far, and is threating to become downright awful. As I’ve discussed on this blog before, he seemed to agree that firms are getting hit pretty hard on both sides of the ledger - on the supply side by financial institutions that abruptly cutoff access to money and credit, and on the demand side by a seriously impaired consumer, whose purchases seem to be falling off a precipice. He told me that this recession feels worse than any he can recall in his 29 year history in the industry. Moreover, he mentioned that he hadn’t been this busy since at least 1992.

He obviously wasn’t complaining. Business for them is going gangbusters.

Although I wish him well as a friend, I hope things don’t go as well for him as he expects, or as I fear they might. Is that bad to say???

Since I updated my blog last week, there have been two more bankruptcies of note (see Updates on Bankruptcies and M&A Activity). Wow, that was fast! If bankruptcies continue at this pace, in a couple of weeks I’ll be unable to keep up with them.

But for now, to make good on my promise, I will continue to keep a running list of noteworthy 2008 bankruptcies. So we can add ATA (see ATA Files for Bankruptcy) and the Education Resources Institute (see Big US Student Loan Guarantor Files for Bankruptcy) to the list.

The new and (un)improved list:

• Wickes Furniture (furniture retail)
• Sharper Image (retail)
• Lillian Vernon (retail)
• Sirva (moving services)
• Blue Water Holdings (auto)
• Buffets Holdings (restaurants)
• Aloha Airlines (airline)
• Bear Stearns (banking)****
• The Education Resource Institute (insurance)
• ATA (airline)

I’ve gone ahead and included Bear Stearns in the tally. I decided that Bear qualifies because Bernanke acknowledged in his testimony that it was within 24 hours of formally declaring bankruptcy (see Bernanke…Defends Bear Bailout).

Please feel free to take issue with my inclusion of Bear Stearns, or to point out any additional noteworthy bankruptcies that I’ve missed.

Two interesting articles to point your attention to this week. The first is from this week’s edition of The Economist (see Waiting for Armageddon). As I’ve been anticipating for more than a year:

After several heavenly years, in which bankruptcies fell to record lows, going bust is back.

Also, The Economist comes to the same conclusion that I did regarding analysts’ predictions about defaults and bankruptcies (see Analysts Formally Predict Uptick in Defaults). That is, they’re way too optimistic.

…most forecasters expect it [the default rate] to rise sharply over the coming months. For instance, Moody’s, a ratings agency, predicts that the default rate will rise to 5.4% by the end of this year…That is a relatively optimistic prediction, for it would merely return the bankruptcy rate close to its long-term average after an abnormally trouble-free period, and it assumes only a mild recession in America.

So far, this recession looks anything but mild to me.

In another corroboratory piece of evidence that the financial climate for businesses is challenging (to say the least) right now, I add a recent CFO magazine article about how M&A activity is quickly grinding to a halt (see How Weak is M&A).

First quarter lethargy in the U.S. reflects…a 71-percent plunge in deals by financial buyers…volume in the first quarter has now fallen to the lowest level in four years.

Private equity firms, for example, seem to have nearly evaporated in the market due to the credit crunch. In fact, many seem busier trying to rework or walk away from previously agreed upon deals…Meanwhile, strategic buyers, suffering from their own slowdown, seem unwilling to step up and buy one of their rivals. That was the case this weekend, in fact, when Aloha Airlines [was] unable to find a qualified buyer or win financing to keep aloft.

These stylized facts are consistent with the sentiment that I’ve expressed on this blog for months now (see M&A Activity on the Decline and Masters of the Obvious). Obviously, it’s not just the private equity jig that’s up (see Private Equity: The End of an Era), but strategic buyers are few and far between these days too.

And speaking of increases in bankruptcies, from the CFO magazine article, we can add Aloha Airlines to this year’s illustrious list of bankrupt firms. This makes my going list of notable bankruptcies so far in 2008:

• Wickes Furniture (furniture retail)
• Sharper Image (retail)
• Lillian Vernon (retail)
• Sirva (moving services)
• Blue Water Holdings (auto)
• Buffets Holdings (restaurants)
• Aloha Airlines (airline)

Just one question: Does Bear Stearns belong on that list???