(FORTUNE Magazine) – NOW THAT THE AIRLINES have become the flavor of the month on Wall Street, it's worth taking a hard look at whether an industry that has been only marginally profitable over the past decade ought to be taking on the huge debts that can result from takeovers. The business has been wildly cyclical, exposed to the kind of downturn that many economists foresee as the inevitable end of today's long-running expansion. And the carriers need piles of cash: They must soon spend billions to replace aging planes whose reliability has suddenly seemed questionable. The latest takeover target is UAL Corp., owner of United Airlines, the No. 2 U.S. carrier (behind American), which transported 56 million passengers last year. The contest for UAL comes hot on the tail of the NWA buyout, in which fourth-ranked Northwest Airlines was swallowed by California dealmaker Alfred Checchi. The UAL battle illuminates both the logic behind the takeover movement and the dangers in it. UAL has one of the oldest fleets in the air, and as recently as 1986 earned only $11.6 million. Yet before the bidding is over, its shares could wind up costing more than $300 apiece, up from $120 just a few months ago. To pay top dollar for airline stocks, buyers must assume that high fuel prices, serious labor unrest, and ruinous fare wars will no longer occur. Says Paul E. Tierney Jr., a principal in the New York investment firm Coniston Partners: ''These prices are based on an assumption that the future is not going to be like the past. That might seem like a reasonable assumption, but it could also be a scary one.'' Are the people bidding for these airlines deranged? Not necessarily. They have been attracted by an intense shakeout that has left the industry to a handful of megacarriers, which have amassed potent market power. By developing hubs at major airports -- Northwest in Minneapolis, TWA in St. Louis, USAir in Pittsburgh -- they have created minimonopolies in which they can maintain some degree of price stability. Using intricate techniques known as yield management to fill airline seats at the best possible prices, these giants have boosted profit margins markedly. Despite all that, some experts question whether airlines will ever be suited to highly leveraged buyouts. Since deregulation, the successful carriers have been those that had the financial wherewithal to exploit market opportunities quickly by taking over new routes or establishing new hubs. Says NWA Chairman Steven G. Rothmeier: ''It's questionable how much debt you can really take on in this business.'' Philip Baggaley, airline analyst at Standard & Poor's bond-rating service, points out that U.S. carriers have placed orders for about $100 billion in new aircraft while the industry's cash flow for 1988, a very good year, totaled less than $5 billion. Highly leveraged carriers will no doubt have to finance their purchases by piling on even more debt. ''The crunch comes in a downturn,'' says Baggaley. ''The industry is more stable than it used to be, but it is still cyclical.'' The battle over UAL will no doubt continue to rage despite such cautionary signals. Anyone who followed the NWA fracas, in fact, might well be experiencing serious deja vu, since many of the same faces have reappeared. West Coast investor Marvin Davis put both carriers into play with big opening tender offers, and the early list of alternative suitors for UAL included most of NWA's rumored aspirants: Pan American Airways, the Bass brothers of Fort Worth, and the Kohlberg Kravis Roberts buyout firm. Watchful industry experts were betting that UAL would end up private, in a leveraged buyout led by current Chairman Stephen M. Wolf. Takeover imam Saul Steinberg, a close friend of Wolf's who at last count owned about 6.8% of UAL's stock, would likely end up with a large chunk of the company, and United's labor unions would probably be brought in under some sort of ESOP. A foreign airline might get involved. KLM, the Dutch national carrier, provided about $400 million in equity for NWA's new owners; British Airways, which has various marketing agreements with United, could fill a similar role for UAL. WHATEVER the outcome, Wolf seemed likely to remain at the controls. Before coming to United last year, the 48-year-old chairman had earned a solid reputation as a turnaround specialist at Republic Airlines and at Flying Tiger, the cargo carrier. According to industry insiders, however, he was not the lone contender to replace ousted boss Richard Ferris. Robert Crandall, American's chairman, and Frank Olson, current chairman of Hertz Corp., both turned the job down. Since coming aboard, the workaholic, 6-foot-6 executive appears to have won the confidence of the directors by reshaping the company's structure and shaking up what had been a somewhat sleepy corporate culture. ''He has a way of making absolutely sure people come in early and stay late,'' says a top UAL executive who departed after Wolf arrived. He tore down the last ramparts of Ferris's travel empire with the sales of Hertz and the Westin and Hilton International hotel chains. He then completed an $80-per-share buyback. He was also burdened with about $2.8 billion in long-term debt, and he moved quickly to squeeze cash from United's vast route structure. Wolf has proved adept at defending the carrier's market share in the crucial computer- reservations business. He has also built up United's lucrative business in Asia. UAL's Pacific routes, which Ferris acquired from Pan Am in 1986, now account for 20% of revenues and nearly 35% of operating profits. UAL has an undeniably attractive array of assets, some obvious and some less so. The carrier owns outright about 80% of its 416-plane fleet, vs. 50% for most of its competitors. A new owner out to reduce leverage could sell a large part of the fleet at a huge profit and then lease the planes back. United's gates and other ground facilities have also increased greatly in value. The carrier's landing slots at airports where the FAA restricts traffic during peak hours -- Chicago's O'Hare, Washington's National, JFK and LaGuardia in New York -- have acquired significant value. So has its roster of orders and options with aircraft manufacturers. Such is the scramble for new planes that a carrier strapped for cash can sell its place in line at Boeing, McDonnell Douglas, or Airbus Industrie. Pan Am sold some of its orders for $100 million this year. Altogether, UAL's assets are probably worth $5 billion to $6 billion. ALL OF WHICH made almost inevitable the gang of corporate raiders now circling the company. The problem is that most seem to be focusing on UAL's considerable strengths without paying too much attention to the potential downside. While selling planes and leasing them back would certainly provide a quick dose of cash, for example, United or any other carrier hoping to stay competitive has no choice but to continue flying as many planes as possible. Under these circumstances, the leasing agreements become a permanent off- balance-sheet drain on revenues. Says Baggaley of Standard & Poor's: ''They are debt instruments in everything but name.'' Baggaley points out the scarifying results when leases are added to some of the big carriers' debt loads. Northwest showed 36% debt to total capital before its takeover last spring, about average for a nonfinancial U.S. corporation. Adding its leases, the carrier's debt soars to about 55%. UAL may soon be facing annual interest payments ranging anywhere from $250 million to $500 million and would be forced to join the leasing game in a big way. UAL's other costs could easily balloon too. Fuel prices have been creeping up of late. Edward Starkman, an airline analyst at Paine Webber, estimates that a 10-cent-a-gallon increase would slice $1.3 billion from the industry's operating profits, which are about $3 billion this year. United's labor unions are no lap dogs. The pilots have been feuding with management for years. They engaged in a bitter strike in 1985 and were instrumental in shattering Ferris's dreams of a three-part travel conglomerate. Relations have warmed slightly since Wolf arrived, but the two sides have yet to reach agreement on a new contract. The pilot group still does its best to bedevil management whenever possible. Wolf was wisely conferring with the pilots as he plotted his next move in mid-August, and he would probably include them in a management buyout if he were to choose that route. Frederick Dubinsky, head of United's pilots' union, has indicated his group's interest in joining a buyout deal -- or any other transaction involving a change of ownership. But even if the pilots are mollified, Wolf has no guarantee of labor peace. A source close to United's machinists' union indicates that the group might be inclined to scuttle any deal that excludes them. ''Our view is that Mr. Wolf allowed the company to be put into play for his own aggrandizement,'' the source says. ''All this could have been handled in a much better way from the employees' standpoint.'' Even if all the breaks go his way, Wolf could have trouble handling heavy leverage in a faltering economy. George James, president of the Washington consulting firm Airline Economics Inc., estimates that U.S. airlines' operating profits will drop by about half in 1990 because of a sluggish economy. Signs of a slowdown have already begun to appear: The number of passengers on U.S. carriers tumbled from 212.7 million in the first six months of 1988 to 208.3 million in the same period this year. Slumping traffic has often produced fare wars, and there are no guarantees heavy price cutting won't break out again. Skirmishes have begun between TWA, Continental, and American. The result for UAL, or any other big carrier bearing mountainous debt, could be disastrous. ''These takeovers are < potentially very destabilizing,'' says Mark Daugherty, airline analyst at the Dean Witter Reynolds brokerage firm. ''If carriers subjected to buyouts cut back on capital spending, they could jeopardize their future growth. In a rough economic period, these companies might get into serious financial problems.'' IN WASHINGTON an increasing number of officials have come to agree. Legislation has surfaced in both the House and the Senate that would give the Department of Transportation broader authority to review airline mergers or changes in ownership. Transportation Secretary Samuel Skinner, meanwhile, has been issuing stern statements about takeovers; aides say he is working closely with Justice to discourage bidders with weak financing. Without doubt, the Bush Administration has taken a far tougher line with the airlines than did Reagan's. Officials at the Transportation and Justice departments are especially concerned that the industry's growing consolidation will eventually result in decreased competition, to the detriment of customers. They have taken a couple of dramatic steps to make themselves felt. The government turned down American's proposal to merge its computer reservation system with Delta's and prevented Eastern from turning over some gates in Philadelphia to USAir, which was already dominant there. To these officials, a dismal outcome of airline buyouts would be the economic failure of one or more of the remaining big carriers. Just eight airlines control 94% of U.S. traffic, and megacarriers with a stranglehold on particular routes have demonstrated considerable pricing power. Competition has been further restrained by limited ground facilities and landing slots at many U.S. airports. Government officials worry that carriers facing huge debt loads might be tempted to delay buying aircraft, scrimp on maintenance, or otherwise jeopardize safety. Their fear is that the flying public, in the end, could be the ultimate loser once Wall Street's latest craze has run its course.

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