MIAMI — Alaska Airlines has beaten out low-cost carrier (LCC) JetBlue and won a bid to acquire Virgin America, the nation’s ninth largest airline. Alaska’s bid for Virgin America is reportedly to be around $2.6 billion in cash, against a current public valuation for Virgin of $1.5 billion. The combined airline would leapfrog JetBlue to become the nation’s fifth largest airline by capacity (available seat miles) while lagging slightly behind JetBlue in terms of passengers carried.
All-cash deal poses little financial risk for Alaska
According to the latest reports, the deal for Virgin America is entirely in cash, along with the assumption of roughly $200 million in debt. Virgin’s current lead investors (Cyrus Capital and the Virgin Group) apparently wanted to wash their hands of equity holdings in the airline altogether and eschewed shares in the new Alaska Airlines for a cash payment. Alaska had roughly $1.5 billion in cash and cash equivalents prior to the merger, so it will have to take on additional debt or liability to finance the transaction.
The exact details of how Alaska raised the additional cash have not yet been disclosed, but given that the airline has the best balance sheet of basically any U.S. carrier, it would not be hard for Alaska to raise a debt offering at very favorable interest rates.
Alternatively, Alaska has a fleet of more than 80 Boeing 737 Next Generation (700s, 800s, and 900s) that can be used to raise cash via a sale and leaseback transaction. Either of these options would allow Alaska to bring on Virgin America without harming its excellent credit rating and balance sheet or drawing down operating cash reserves to risky levels. Despite the size of the transaction, it poses very little financial risk for Alaska.
Virgin isn’t worth $2.6 billion
The risk for Alaska is more of the intangible strategic variety. The $2.6 billion price tag is reflective of a lot of things, very few of which have anything to do with the underlying value of Virgin America itself. That $2.6 billion figure is more than 20 times Virgin America’s adjusted 2015 net profit (excluding a positive one time event), and the $150-200 million in profits on $1.5 billion in operating revenues at the absolute peak of the current airline earnings cycle and a historically aberrant low-fuel environment, are certainly not worth a 20x multiple.
The fleet of 60 newish Airbus A320 family aircraft would certainly have value if Virgin owned any of them (in fact it only owns five), though the manageable lease rates gives the fleet some value. Most of Virgin’s assets are instead tied to airports, a mixture of gates (which are starting to become a constraint at various airports around the country) and slots at certain slot restricted airports.
The big prizes in terms of overall value are probably the gates at Terminal 2 in San Francisco and Terminal 3 in Los Angeles (Virgin’s hubs) but the most valuable assets on a unit basis are the two gates at Dallas Love, the 12 daily slot pairs at New York La Guardia, and the eight daily slot pairs at Washington Reagan. All of these things are assets – but their collective value is nowhere near the asking price
Alaska becomes the third player in the Bay Area
Regardless of whether Alaska overpaid for Virgin, it is unquestionable that the merger instantly creates a third player in the booming Bay Area air travel market behind United Airlines (with its hub and Transpacific gateway at San Francisco converging rapidly on 300 daily departures), and Southwest (which operates 239 daily departures across the Bay Area’s airports – including 116 at Oakland). The new Alaska will operate close to 80 daily departures at San Francisco International (SFO – the region’s dominant airport) with pre-merger Virgin America contributing 60 of the 80. The combined carrier will operate out of by far SFO’s nicest Terminal (2) and will add on nearly 30 daily departures at its San Jose focus city and 10 more at Oakland.
Virgin America has carved out a nice niche in the Bay Area, and at least some of that is due to its distinctive brand presence. Assuming the combined carrier decides to drop the Virgin moniker (more on this below), it will lose at least a portion of its customer base at its main hub. But the gate space will allow Alaska to create a true focus city at SFO and it will be able to redistribute some of the frequencies to its core strength markets in the Western U.S. and maintain overall profitability. The potential loser in this merger is San Jose – any hopes of its ascension to 60-70 daily departures and quasi hub status for Alaska is now dashed. But there is no question that the merged carrier will be a powerful force in the Bay Area.
Merger creates more of a logjam at LAX
The merger also creates instant scale down the road at Los Angeles International Airport (LAX), where the combined airline would offer nearly 80 peak day departures with a good mix of regional and long haul, transcontinental flights. LAX is beginning to verge on a bloodbath, but each airline has managed to carve out a niche in one of the nation’s most competitive airline markets. The merged carrier will gain additional gate space at LAX (where gates are at a huge premium), but that could be more of a curse than a blessing. Right now, Alaska operates out of Terminal 6 at LAX while Virgin operates from Terminal 3. Neither terminal has the space to accommodate an additional 40 daily flights, and while Delta’s eventual move to the north side of the airfield will open up space in Terminal 6 to combine, the new Alaska will have to deal with split operations and busing of passengers at LAX for some time to come.
Alaska becomes a Western Powerhouse
The immediate scale in Los Angeles and San Francisco help turn Alaska into a power in the western United States while further diversifying the network away from the Pacific Northwest. Alaska now has a hub or focus city in Seattle, Portland, San Francisco, Los Angeles, and San Diego (you can also throw in Anchorage if you’d like) which is absolutely blanketing the West Coast of the US. In fact no other airline can match the breadth of Alaska’s coverage (Southwest comes closest but is weak in the Pacific Northwest) in the region.
The one piece of this transaction that is of questionable value is the two gates at Dallas’ gate constrained Love Field (DAL). Alaska’s five daily flights at nearby Dallas Fort Worth International Airport could certainly fit into the gates at DAL and replace some of the unprofitable point to point (p2p) flights that Virgin currently operates. But those gates may well be more valuable in the hands of another airline (Delta in particular covets them) and they could represent an interesting way to claw back some of the cash spent on the deal (could Alaska get $30, 40, or even $50 million for the pair)?
Alaska’s victory is also JetBlue’s loss, as the latter carrier will have to continue to muddle along with its orphan operation at Long Beach. A JetBlue – Virgin merger would have instantly created a third competitor to Alaska and Southwest in the Western U.S. (and created a new national airline threat), and defense against a strengthened JetBlue was certainly a driving factor behind Alaska’s winning bid in the auction.
The Airbus A320 question
The merged airline’s fleet will also pose a quandary, as Virgin’s fleet of A320s and order for A320neos are a direct contrast to Alaska’s fleet of 737s and orders for the 737 MAX. At least initially, Alaska will have to operate a new type as it would be unrealistic to replace all of the A320s on day 1. It would also behoove Alaska to give the A320s a shot or at the very least use them as leverage in negotiations with Boeing. Airbus will try to use the opportunity to get a foothold at an airline in Boeing’s backyard, but ultimately Alaska is expected to cut some sort of sweetheart deal with Boeing for a mix of 737-800s and additional 737 MAX orders in return for having the A320s taken off their hands (similar to the deal Air Canada enjoyed with its Embraer E190s). We also expect Alaska to move to auction off Virgin’s ultra-valuable early delivery slots for the A320neo to other airlines (another way of clawing back cash from the transaction).
The merger is actually good for consumers
As with any merger, the Alaska – Virgin tie up will of course come under scrutiny from the media and the U.S. Department of Justice (DOJ) alike. And there is a kernel of truth to the notion that the spate of mergers in the U.S. airline industry have constrained competition and raised fares for passengers. But Alaska and Virgin compete head to head on just three routes (Seattle to SFO/LAX and Portland to SFO), which means that the DOJ doesn’t really have grounds to block the merger.
And for whatever competition is lost on those routes, consumers in the Western U.S. will gain overall from having another airline with the scale and network up and down the West Coast to provide credible competition to the big four U.S. airlines (American, Delta, Southwest, and United). Sometimes it takes scale to compete (this is particularly true for business travelers and corporate contracts) and paradoxically, this merger may well boost competition and result in broadly lowered or constrained fares for consumers overall.
The only losers will be those who particularly value the Virgin brand and its distinctive onboard experience. The combined airline will certainly adopt best practices from both parents but as Alaska’s management team will be the surviving one, certain elements of the Virgin brand will be jettisoned. The Virgin name itself is also likely to suffer the same fate, as the merged airline would be required to pay 0.7% of its annual revenues as a licensing fee in order to keep it. Instead we will get the new Alaska Airlines, a newly minted powerhouse in the Western United States.