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Here's how the airlines can bounce back

James Gellert, RapidRatings CEO, joins Yahoo Finance with a look at how his company is rating the big airlines and what each needs to do to bounce back from impact of the COVID-19 pandemic.

Video Transcript

[RINGING BELL]

ADAM SHAPIRO: Welcome back to "On the Move." both Delta and United have reported the CEOs from both companies talking about the road to recovery-- Scott Kirby this morning saying they see light at the end of the tunnel. Really? Let's invite into the stream our next guest. That would be James Gellert. He is the CEO of Rapid Ratings.

This is a firm that does risk assessment for major corporations worldwide to help them understand the risk and management going forward. James, good to have you here. And you've done a recent stress test, year-end stress test, for all the airlines. So let me go-- show the viewer some graphics before I ask you this first question.

The first graphic I want to show everybody has to do with a score you have called the financial health rating. A score of 40 or lower on a financial health rating, which you use to measure liquidity and leverage and earnings performance-- 90% of companies that were 40 or lower wound up defaulting at some point. You also do a core health score, but that's much longer sustainability.

Now let's look at some of the results. At the end of the second quarter, United and Delta had moved into a high-risk category with American Airlines. Southwest was not yet there. But your year-end stress test is telling a very dire warning for the airlines. What is that?

JAMES GELLERT: Well, the stress test, Adam, was trying to predict what the revenue impact could be for the year and then a whole variety of flowing-through factors through the income statement and the balance sheet to try to get a perspective of what the financial health rating could look like on these names. And we took about a 49% haircut on revenue for the year. And right now, given the reporting over the last couple of days, that might have been too conservative or too generous. So the stress test may actually be high-- be producing higher numbers than it could have.

But basically what it was showing is that all the major airlines in the US are falling well into that 40-and-below area with American falling the most to 16. And again for perspective, over the last 20 years 90% of companies that have failed have been rated 40 and below, and the highest incidents of failure have been rated in that 22-to-23 range.

So it doesn't mean a company will absolutely fail. There are a lot of things that go into the decision to file for bankruptcy or being forced into bankruptcy. But companies in this sector, in this risk zone, are very high risk and have a-- and all institutional investors and other companies that work with them buying and selling to them need to be paying really close attention to their products.

ADAM SHAPIRO: But one of the things you've pointed out to me in previous discussions is a lot of this is about liquidity and that it's a waiting game. In fact, I'm going to quote you. "It's a waiting game as to whether the recovery and traffic for the airlines comes back before liquidity runs out." Delta has got $21 billion in liquidity. United, we learned from their earnings, has more than $19 billion. We've got American and Southwest on the 22nd of October. What do you think those liquidity positions are telling us, or is your stress test telling us not enough?

JAMES GELLERT: Well again, it's about time. And time is a fact-- is a function of a number of things. The time frame-- the fuse life, if you will-- is extended if traffic spikes back up if we don't have a new surge in coronavirus, if we get a vaccine sooner rather than later, if the CARES Act gets out of the political malaise that it's in and we have more stimulus funding and the airlines want to take that stimulus funding.

But they're all trying to reduce their daily costs and making some good progress in doing that. American is the one that is probably the most at risk because it really has liquidity to get through roughly the first quarter of 2022. And if it does not have a material uptick in traffic and these factors move in its favor before then, then it's subject to whether the capital markets will continue to bail it out. And if things are looking bad, that's pretty speculative and that's when they really have some serious problems on their hand. And that's when people are really going to start talking about bankruptcy.

JULIE HYMAN: And so, James, it's Julie here. So all of what you're describing has a lot of ifs in it-- if coronavirus cases don't go up, if traffic comes back, if Congress does manage to pass some sort of aid for the airlines. I mean, how-- are you handicapping all of those various ifs? And do you think that they are likely, and therefore do you think that the likes of American is going to avoid, say, running out of cash and a bankruptcy filing?

JAMES GELLERT: Well, look. There are so many ifs. The likelihood is that they don't all work. So the-- so in our stress test we are assuming a-- we're not assuming that there is any improvement in traffic and for the balance of the year. And that's what's yielding these more-- these relatively tough assessments and American going to a 16. But American, naturally right now after Q2, is at a 24. So with the Q3 numbers they may very well approach that 16. Delta after Q2 was a 39, and its stress test number was a 30, and it's dropped to 28 after we rewrited it this morning from yesterday's numbers.

So the stress test numbers are, you know, kind of right on at the moment, irrespective of all of these ifs. I happen to think we will see some uptick in traffic, but keep in mind the airlines can't bounce back by themselves. They have to bounce back by having more traffic from business travelers, more traffic from consumers, non-business travelers. Many of them have switched to loads of freight, and they've got to be able to sustain those freight routes. And then the overall economic environment has to be conducive, not just from a capital markets perspective, but also from a GDP perspective, an unemployment perspective, all of which are intertwined back with whether we're going to see more business travel and whether supply chains are using freight on these carriers as well.

ADAM SHAPIRO: James, I want to point out too to our viewers the seriousness of the work you do. Past discussion in May, you pointed out McDonald's, Unilever were among clients. You have various clients worldwide, and your business since the pandemic has hit, assessing risk for the supply chain at these companies, is up 73% year over year. You also pointed out that there's significant degradation in the financial health and a potential for doubling of companies in your high-risk and very risky zones. Can you give us some insight into what industries that may cover outside of the airlines?

JAMES GELLERT: Well, it really covers all industries. And, Adam, I'm gratified that we've become the go-to for companies and banks doing financial assessments of suppliers and third parties. And that's really driven by the fact that our algorithms allow us to rate private companies-- and private companies and the accuracy of the ratings themselves.

Private companies represent around 75% of most companies' supply chains, and that means it is a tremendous risk if companies don't have insight into what those companies are doing, how they're faring, and how their risks are migrating. And in our stress tests we see in public and private companies the potential for a doubling of companies entering our high-risk and very-high-risk zones this year and a halving of companies in our very-low-risk zone.

This does not mean all of these will happen because all companies are in triage mode doing everything they can-- gaining more liquidity, issuing debt where they can, borrowing where they can, shedding assets when they can. But financial health is the best measure of understanding how these companies look going forward, and that is something that the most sophisticated supply chains, and the banks for their own risk management, have been leaning into more to try to have more insight into the suppliers across every industry-- not just whether there is an immediate risk, but whether there is a destabilization in those companies that will evidence itself and a risk of companies either failing in the next year to two years or degrading to the point where they can't perform to the standards that they need to perform to in terms of quality, delivery, timing, cybersecurity, insurance, all of the things that people are concerned about in and out of just whether a company is going to succeed or fail in your supply chain.