Shorted Stock May Hint At Looming Merger

Hedge fund investors have put Delta Air Lines Inc.'s pilots on alert, by shorting Delta stock... just as CEO Richard Anderson (right) renewed speculation the airline could combine with a rival.

Delta pilots -- who met recently to get an analysis of industry trends, specifically on mergers -- are discussing rebuilding a $1 million "merger assessment" fund they could use to hire legal representation in the case of new merger talks, according to a story in the Atlanta Business Chronicle.

"Institutional investors -- including many hedge fund investors -- see opportunity," Lee Moak, head of the Delta branch of the Air Line Pilots Association, wrote in a September 24 letter to fellow pilots outlining his concerns.

An investor who shorts a stock hopes to profit from slipping prices. The investor borrows shares from a broker, agreeing to replace them at a later date, and then sells them hoping their price will decline.

The pilots have watched as institutional investors and hedge funds helped grow their share of Delta stock by 39 percent in the second quarter.

The airline's stock traded between $18 and $20 per share, and trading volume declined, hedge funds shorting Delta stock increased their holdings to 8.9 percent of Delta's more than 240 million outstanding shares.

Instead of keeping the Delta properties together new investors may be looking at breaking it up into pieces, according to the story.

Those investors may be speculating that Delta's strong returns after emerging from bankruptcy are temporary.

Moak wrote, these investors are looking for a "transaction" that could include a "forced" sale of Delta's frequent-flier program, reservation system or even a wholesale merger.

As of September 28, hedge funds shorted 8.9 percent of Delta stock, for a total of 26.9 million shares. Bloomberg reports an 84 percent increase in the number of shorted shares since June 15.

"It's kind of like having a shark in your swimming pool in the backyard," said Rick Miller, a corporate governance attorney with Powell Goldstein LLP.

"At some point, the shark has to be fed," he said of the hedge funds.

As ANN reported, last week Delta reported better-than-expected profits with net income of $220 million for the third quarter, the highest in company history. Delta's cost and debt structure was re-engineered during bankruptcy, leaving the airline with a lean balance sheet.

Delta is now taking on more long-term debt by spending on airplanes by adding employees and expanding its worldwide presence.

CEO Anderson said last week consolidation could be in the cards for the third-largest US airline, which is based in Atlanta.

"This industry, including Delta and candidly all network carriers, are the products of consolidation," Anderson said. "We firmly believe this evolution will continue."

He emphasized, however, that Delta wants to be "in control" as an "acquirer."

That tune bolstered analysts who have long rallied for consolidation in the airline industry as a means to take out extra capacity, or airline seats, in the domestic system, and boost airline profits by tempering low fares.

Industry analysts say Anderson's comments are peaking interest and are, "rekindle investor confidence in hoped-for industry consolidation," said Jamie Baker, an analyst with JPMorgan Chase.

Baker wrote that he believes Delta would be looking for "larger, more ambitious efforts, rather than smaller, more labor and regulatory-friendly JetBlue [Airways] or Alaska [Airlines]-type acquisitions."

Speculation that Delta and Northwest Airlines might try to merge -- as their pilots unions and airplane fleets are similar -- erupted after Anderson was selected to succeed Jerry Grinstein as CEO in August. Anderson is the former CEO of Northwest.

Hedge funds could apply pressure for a merger.

However, Anderson and President and Chief Financial Officer Ed Bastian continually told investors October 16 they are considering ways to strengthen Delta's cash flow... especially whether to sell subsidiary Comair, one of the airline's regional carriers.

"It's the only one we own out of our nine regional carriers," Anderson said.

Moving forward, Anderson said Delta wants to pay down debt, and will not order more jets, thus taking on more debt with aircraft orders.

Proof of this is that Delta paid down $1 billion in debt, such as bankruptcy obligations to the Air Line Pilots Association and Pension Benefit Guarantee Corp in the third-quarter.

Still, Delta also invested $400 million in capital improvements at its hubs in Atlanta and New York, as well as deposits on aircraft, in the third quarter.

At some point, however, Delta will have to renegotiate a contract with its pilots union, which could increase employee costs. And fuel prices have been stubbornly high.

Delta spokeswoman Susan Elliott wouldn't comment specifically on hedge funds, saying only that the airline has "ongoing discussions with our shareholders, including hedge funds, about a variety of topics, but we don't comment on specific conversations."

Delta's stock has not produced what it projected coming out of bankruptcy.

Delta avoided the merger with US Airways Group Inc. by saying Delta's value coming out of bankruptcy would be $9.4 billion to $12 billion, after an offer by US Airways of $10.3 million to buy Delta.

"Frankly, having snubbed last year's cash-rich offer from US Airways, it is no surprise that management and the Delta board are beginning to feel the heat."

FMI: www.delta.com, www.delta.com/about_delta/investor_relations/index.jsp