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MIAMI — San Francisco-based Virgin America will officially become a publicly traded airline later this morning, after an initial public offering (IPO) raises $305.9 million on the sale of 13.3 million shares at a price of $23 per share. The initial sale values Virgin America, who will trade on the NASDAQ stock exchange under the ticker VA, at roughly $972.9 million.

Valuation is fair but not particularly cheap 

Over the past 12 months – Virgin America recorded a net profit of $70.42 million, meaning that its initial trailing 12 months (ttm) price to earnings (P/E) ratio is 13.8. By comparison, United Airlines has a ttm P/E ratio of 14.2, Delta has a ttm P/E of 13.6, and Alaska Airlines has a ttm P/E of 14.8. In absolute terms, that would seem to imply that Virgin America is fairly priced, and there is certainly some truth to that – especially as the company is expected to record a net profit of more than $80 million for calendar 2014. In an industry where most rival airlines are seen as moderate to strong “Buy” prospect, it would seem as though Virgin America is a reasonable investment.

But Virgin America’s P/E ratio is a somewhat misleading conveyor of its actual value potential as a stock – and that has to do with earnings growth runways (pun intended) and stability – the former will be covered in more depth later on. But for the latter, and this is beginning to verge outside the territory of pure aviation analysis, a component in determining a P/E multiple is the stability and sustainability of the underlying business model.

Which is to say that a company that has a better and longer track record of delivering profitability will be rewarded by investors (in the long run) with a higher P/E multiple. Does anyone think that Virgin America’s track record of profitability matches that of Delta, Alaska, or heck even United? Assume for a second, that stability represents 20 percent of the overall P/E multiple (within an industry) – by that standard Virgin America is not cheap at all. A famous axiom of equity markets is that stock returns are 50 percent market, 30 percent industry, and 20% company. The market and industry are largely constant, so the 20 percent “company” element of returns is the only thing you can really control. And by that standard, Virgin America is perhaps the poorest investment in the industry (Hawaiian and JetBlue the other two candidates for the moment).

Financial Improvement Driven by Debt Restructure and Capacity Control

Virgin America was profitable in 2013 and it will be profitable in 2014. In a vacuum, that is substantial progress for an airline that lost money in each of its first six years of existence. But if you dig into the numbers, almost all of the improvement was driven by two key factors – capacity control, and debt restructuring. In May 2013, Virgin America restructured its (substantial) debt load and accordingly by year end 2013, Virgin America’s interest expenses declined 38 percent YOY (the airline would not have recorded a net profit without the $43.2 million reduction).

(Credits: Chris Sloan)
(Credits: Chris Sloan)

In the first, second, and third quarters of 2014, interest expense declined 70.8 percent, 48.1 percent, and 8.2 percent YOY respectively, with the cascading decline reflecting the debt restructuring. YOY so far in 2014, Virgin America has improved results by a cumulative $60.3 million, of which reduced interest expense represented $32.3 million, or 53.5 percent of the YOY improvement. This raises questions as to whether Virgin America’s underlying business has truly turned the corner towards profitability (on an operating basis), or (as is the more likely scenario) accounting and capitalization calisthenics have been arbitrarily used by large institutional investors to artificially boost the company in advance of this IPO, after which these investors can cash out a substantial percentage of the realistically retrievable portion of their investment into Virgin America.

And the other key factor driving Virgin America’s profitability has been substantial revenue growth. A portion of that is cyclical (the airline basically launched into a recession) and driven broadly by the U.S. and California economy (which recovered later than the U.S. on average), a portion of that is industry-related (capacity discipline by competing airlines and consolidation in the industry driving up fares),  a portion of that is situational (the sizzling San Francisco and Bay Area economy and market due to tech and Silicon Valley), and a portion of that is driven by Virgin America itself.

Assume for a second that the non-Virgin element of that is 60 percent, a back-of-the-envelope estimate that probably overstates Virgin America’s ability to drive revenue growth based on its actual product (i.e. its route network and schedule). But to isolate Virgin’s own contribution, it is abundantly clear that the most important factor has been capacity discipline. Cost per available seat mile (CASM) excluding fuel was flat in 2013 versus 2012 and is up thus far in 2014, and accordingly, cost discipline hasn’t been a driver of profitability for Virgin America. So turning to capacity discipline, capacity measured in available seat miles (ASMs) fell 2.2 percent YOY from 2012 to 2013, grew 3 percent in Q1 2014, fell 1.6 percent in Q2, and fell 0.8 percent in Q3.

In March 2013, Virgin America became the second airline in the US to introduce fuel saving Sharklets following JetBlue. (Credits: Bill Abbott)
In March 2013, Virgin America became the second airline in the US to introduce fuel saving Sharklets following JetBlue.
(Credits: Bill Abbott)

For an airline that doubled ASMs between 2009 and 2012 alone, this represents an almost ascetic level of capacity discipline. And that discipline has paid off in two ways to boost Virgin’s financials and indicators. In a direct sense, the lack of capacity addition and expansion into new markets helped improve fares in existing markets, and without the addition of expensive new flights, margins improved accordingly. And in terms of market mix, mature markets increased as a share of total markets (through natural spool-up and the relative paucity of new additions), which boosted both PRASM and profitability through compositional effects.

Let us begin by giving credit where credit is due – adopting capacity discipline, which has powered much of the rebirth of the U.S. airline industry, was absolutely the right move for Virgin America. This column has been a vocal critic of Virgin America’s capacity management in the past, and accordingly seeing them opt for such a prudent strategy is certainly heartening. And there are two possible stories, or narrative arcs that might explain Virgin America’s shift in strategy.

Story one is that Virgin America itself, after years of trying to grow its way into profitability, realized that given market realities, the limitations and strengths of its inflight product, and the state of the US airline industry, that prudent and disciplined capacity management would allow it to boost financial results, and perhaps finally deliver the profitability that had been so elusive.

Story two, which is admittedly cynical, says that Virgin America’s investors, after years of financing a loss-making airline, said enough-is-enough – we want to make some of our money back, and since the underlying business doesn’t seem like it will do that anytime soon, the best way for us to do that is through an IPO. At that point (likely somewhere in 2012) the investors realized that conditions were ripe for them to make money off of improving views on the airline sector in finance circles and the cyclical and situational factors noted above.

(Credits: Virgin America)
(Credits: Virgin America)


But to allow Virgin to profit off of that, it had to make some cosmetic changes to the airline’s finances, and so through the accounting calisthenics noted above, it boosted the net profit figure by reducing interest expenses. Then, to add the capacity discipline to the mix, it deferred several aircraft orders to give Virgin a two to three year window of capacity control (by keeping fleet growth flat and pushing management to reduce utilization). This would boost Virgin’s profitability through mid-2016 (coincidentally when the financial community projects US airline earnings to peak), and between the initial float during the IPO and subsequent liquidation over that period, the initial investors would cash out.

Between strong appetite for Virgin stock amongst retail investors in its core California markets, and buoyant general industry and market sentiment, Virgin investors would be able to cash out before cyclicality and forced growth (A320neos) pushed down earnings from 2016 onwards.

Now the true narrative arc of Virgin America over the last couple of years is probably a blend of both stories, but in evaluating where Virgin America’s profitability will go moving forward it may not even matter which story is true – because the one element of Virgin America’s underlying business improvement that it controls – capacity discipline, will have to be reduced as the carrier takes on ordered aircraft that it has locked itself into. The 10 additional A320s and 30 A320neos will make sure of that. And if Virgin America falls back into the same pattern of over-expansion – then it will continue to underperform industry peers.

Costs Set to Rise Due to Aging

For a low cost carrier, Virgin America has a higher than ideal cost base, though the downturn in fuel prices in the second half of 2014 defrays that somewhat. But over a medium-length time horizon of three to five years, Virgin will likely run into the same troubles that have plagued larger peers JetBlue and Southwest.

As its workforce and initial fleet age, labor expenses and aircraft maintenance costs will rise, eating into margins substantially. Labor expenses rise as airline workforces age due to the compounding effect of annual raises (made possible by unionization or the threat of it) and increased benefit costs (primarily health care) for older employees.  And the rise in maintenance costs is self-explanatory, even if Virgin does have 26 aircraft coming off lease in the next few years.

Where is the (Profitable) growth?

And it’s not even clear that Virgin America has profitable opportunities for growth. The Love Field operation, while great for marketing purposes, is capped at perhaps 18 daily flights at best, and it’s unclear what the scope for profitable growth is at either Los Angeles or San Francisco. Both operations are constrained by gate space (in the theoretical doubling of size sense, or even increase by more than 60 percent of frequencies), and the Los Angeles market is rapidly turning into a bloodbath as both Delta and American expand rapidly.

Virgin America notes that it only serves 15 of the 50 largest markets from each of these two airports, but how many markets are left where Virgin America could break even, let alone preserve current margins? Even with a better economy, that number isn’t more than four or five in a best-case scenario. San Francisco is a bit better, but not exactly devoid of competition itself. What is the scope for Virgin America to grow to 1.5 times it current size and preserve margins (thereby generating a strong long run return)? Our view is that it is almost negligible.

First class seats on a Virgin America A320. (Credits: Virgin America)
First class seats on a Virgin America A320. (Credits: Virgin America)

First class seats on a Virgin America A320. Image courtesy of Virgin America

The problem lies in the type of market that Virgin America needs to make a base work – the market needs to have a large volume of travelers under 35 (preferably millennials) who have disposable income and follow a certain lifestyle, as well as a volume of business travel that isn’t tied down by corporate contracts. Of the markets that fit those criteria, Seattle is a bloodbath, New York and Boston already have JetBlue and lack space, Washington D.C.’s preferred airport is closed off (Dulles suffers from too many drawbacks domestically for a Virgin operation to work), Austin is still too small of a market (with a huge Southwest presence), Chicago has too much competition (and barely fits the required characteristics), and Portland has Alaska.

So with few growth prospects and an uneven business model, Virgin America’s potential to deliver Delta, United, Alaska, American, or even Hawaiian/JetBlue-esque returns (from the past two years) over the next few years is severely limited. This is not to say that you can’t make money on the stock, especially in the near term. And even, long term, there are ways to make money on a share price decline. But despite the IPO and improved financials, America’s * best * airline has yet to prove the sustainability of its operation and the viability of its underlying business model.