MIAMI — San Francisco based Virgin America is consistently noted to be the “best” domestic airline in the America. With excellent onboard service, new aircraft, and superb integration of technology, travelers consistently rate Virgin America as providing a top class travel experience. Yet for all the plaudits, Virgin America has not been able to translate its product appeal into consistent financial results. As it charts another round of expansion this year, after taking a year off, the time has come to examine Virgin America; its finances and its business model.
Pursuing an aggressive expansion
Amidst the hubbub earlier this year surrounding the merger between American Airlines and US Airways, low fare boutique carrier Virgin America announced new services between its largest hub in San Francisco and Anchorage, Alaska and Austin, Texas. The new daily year-round service to Austin began May 21st , while six times per week red-eye service to Anchorage will run from June 6th to September 9th. The schedules for the new routes are as follow; both services will utilize Airbus A320 equipment.
Almost immediately following Virgin America’s announcement, JetBlue struck back at Virgin America, seasonally doubling its existing daily flight between San Francisco and Austin for the summer of 2013, and, adding a second daily red-eye flight with schedules as follow:
San Francisco (SFO) to Austin (AUS):
Austin (AUS) to San Francisco (SFO):
|Depart – Arrive||Depart – Arrive|
|5 p.m. – 10:24 p.m.||8 a.m. – 9:57 a.m.|
|11:39 p.m. – 5 a.m. (next day)*||8:59 p.m. – 10:54 p.m.*|
– Flights operate daily effective May 21 through Sept. 2, 2013 –
– *New service –
– All times local –
JetBlue also added a second daily flight between San Francisco and Fort Lauderdale after doubling to twice daily between Los Angeles and Fort Lauderdale on January 7th. Schedules for Fort Lauderdale-Austin are as follows.
San Francisco (SFO) to Fort Lauderdale (FLL):
Fort Lauderdale (FLL) to San Francisco (SFO):
|Depart – Arrive||Depart – Arrive|
|2:25 p.m. – 10:56 p.m.*||10:40 a.m. – 1:34 p.m.*|
|11:25 p.m. – 7:44 a.m. (next day)||7:15 p.m. – 10:32 p.m.|
– Flights operate daily effective May 21, 2013 –
– *New service –
– All times local –
Meanwhile, legacy rival United also increased its frequencies on San Francisco-Austin for the peak summer period, moving from 4 daily flights to 6 for June and July, and 5 for May, August, September, and October. United also increased the mix of mainline aircraft versus regional jets on its San Francisco-Austin services.
However, the competitive response from two rival carriers didn’t significantly phaze Virgin America, who launched services to Austin amidst great fanfare. “Austin and San Francisco share deep cultural and economic ties, so it made perfect sense for us to expand our network into this area that deserves not only increased flight options, but a better brand of service,” said Virgin America President and CEO David Cush. But will passengers trade price for quality, especially on the short-medium haul routes when the airline’s superior passenger experience product is optimized for more medium-long haul routes. More importantly, will business passengers trade schedule flexibility for the inflight product?
Indeed Virgin America has pursued an aggressive path of expansion during the spring of 2013. Since the start of April, Virgin America has already launched new flights from both San Francisco and Los Angeles to Newark, from San Francisco to Austin, and from Los Angeles to Las Vegas, and San Jose with San Francisco-Anchorage coming soon. Some of their expansion doesn’t seem particularly risky or expensive due to existing economies of scale, market, awareness, and under-utilized aircraft. These include Anchorage which is seasonal and uses red-eye flights to increase utilization, as well as Newark and San Jose which are just new stations as opposed to complete new cities. Other markets are riskier given the airline’s strategy, however. Austin is an example according to noted travel analyst Henry Harteveldt of Hudson Crossing where Virgin America misses the boat on appealing to the high-yield, loyalty program driven business customer: “Despite their true product benefit, Virgin America lacks a confidence in opening up new routes. They leave money on the table by not having the most optimum schedules and, in the case of San Francisco-Austin, just 1 flight per day.” Harteveldt classifies the airline’s current market position as one appealing to the “Premium Leisure Traveler” because the lack of optimum scheduling exists across the system which “hurts their utility, making them less viable for corporate accounts (outside the San Francisco Bay Area). They don’t offer the first and last flight of the day and they generally don’t offer particularly strong frequency.” The expansion during the course of the second quarter came after capacity (in available seat miles [ASMs]) fell 4% year over year in the first quarter of 2013.
In short, Virgin America has survived from a tumultuous beginning to develop into a solid, if still financially tenuous airline, and a major competitor on the west coast, particularly against United and Alaska, and to a lesser degree Southwest. Their fleet numbers 53 Airbus A319 and A320 mainline jets, serving 23 destinations from 2 hubs, and carrying 6.2 million passengers and surpassing $1.3 billion in total revenue per year.
Finances don’t hold up on inspection
Yet despite the growth, Virgin America continues to struggle financially. For the most recent fiscal year (2012), Virgin America reported a net loss of $24.99 million, down from $30.83 million in 2011, but still a third consecutive net loss during the most profitable 3-year stretch for the US airline industry since the late 1990s (2010-2012). Passenger revenue per available seat mile (PRASM) was a positive sign, growing 7.3% year over year to 10.26 cents, but that was offset by a 4.1% rise in cost per available seat mile (CASM) to 11.17 cents, and more disturbingly, a 6.0% rise in CASM excluding volatile fuel prices (CASM ex-fuel) which are beyond the carrier’s control. The rise in revenues came despite a 27.3% increase in ASMs for the full year, while passenger traffic in terms of revenue passenger miles (RPMs) grew 23.4%, enough to drop Virgin America’s load factor by 2.5 percentage points to 79%. PRASM for the first quarter of 2013 grew and even more robust 16.5% despite a 4.2% decrease in ASMs and an 8.1% decline in RPMs.
Admittedly, there were some positive signs for Virgin America. It reported its first ever fourth quarter operating profit ($5.11 million) in Q4 of 2012 and its operating loss for the first quarter of 2013 (typically the weakest quarter for airlines) was a modest $15 million, down $33.6 million, or 69% year over year. Virgin America also managed to eliminate $290 million dollars in debt by December 31st, 2012, which will have a roughly $20 million positive effect every quarter for Virgin America moving forward. They also secured $75 million in additional debt financing to boost liquidity.
“With the strong improvement in first quarter 2013 financial performance, we are on track for a significant operating profit for the full year,” said David Cush. “The agreements reached with our investors enhance the improvements we are seeing in our business, and are a first step in modifying the Company’s capital structure to one more in line with public companies. With this solid improvement to our capital structure, we now expect to achieve a net profit in the second half of 2013, and are well positioned for sustained healthy financial performance in 2014 and beyond.“
But these small signs of hope do not change the reality of Virgin America’s financial performance. This is a carrier that recorded an operating loss of $31.73 million and a net loss of $145.39 million both significantly worse than their corresponding 2011 figures. Virgin America had an operating margin of -2.38% and an atrocious net margin of -10.91%, which is contextually bad in an industry where each and every one of its competitors had a positive operating margin and a better net margin. Even bankrupt American Airlines parent AMR made a slight operating profit of $107 million on revenues of $24.86 billion, and recorded a net margin of -7.54%. All of the balance sheet improvements in the world can’t hide the fact that Virgin America still hasn’t found a way to make money with its existing business model. This is an airline that hasn’t recorded an operating profit, let alone a net profit, in its entire existence dating back to the August 2007 launch. It has spent the past 3 years in the best airline financial environment in years, posting lukewarm financial results and underperforming its peers.
But what all of the balance sheet improvements can do is; make Virgin America look better as a candidate for an initial public offering (IPO). A loss-making business with high debt totals doesn’t look good as an IPO candidate and that’s what Virgin America was. But once you get the debt levels down, the narrative can shift. Cush and co. are moving themselves into a position where Virgin America is a fast growing business with low debt levels and a strong asset base (at least so long as the narrow body aircraft pricing bubbles persist). Despite the tenuous financial performance, that sort of framing makes Virgin America an attractive IPO target in the same vein as businesses like Groupon, Twitter, and dare I say it; Facebook.
And it’s easy to see why Virgin America is being pushed towards an IPO. There are two ways for investors to make money in a business. One is for that business to make steady profits and for investors to take a share of those profits each quarter. Despite Cush’s promise of ‘significant’ operating profits and a net profit for Virgin America in 2013, it is clear that Virgin America is not at that stage today and unsure that they will ever reach it given the shaky fundamentals underlying their business. The second is by making their money back through an IPO – the investment will push up Virgin America’s valuation, giving investors a viable return on invested capital (ROIC). For investors who have already poured millions into Virgin America and still have money tied up in the airline, an IPO might be the only way that they make their money back. Thus it’s little wonder that investors are making the little moves that temporarily make Virgin America a more attractive IPO candidate; forcing debt reduction and reducing interest on outstanding debt to push down Virgin America’s net losses. If the US economy continues to perform reasonably well through 2013, housing recovers, and Virgin America is able to show further financial “progress,” they just might be able to time an IPO correctly and make their money back for investors.
Is Virgin America’s business model flawed beyond repair?
Even if Virgin America is able to pull off a successful IPO, their business model and future prospects still look highly uncertain. At its core, Virgin America is an airline that tries to sell itself on superior service, as well on being “hip and cool.” At the bottom of every press release, the airline proudly declares that it “was named “Best Domestic Airline” in the Condé Nast Traveler 2008, 2009, 2010, 2011 and 2012 ‘Readers’ Choice’ Awards and “Best Domestic Airline” in Travel + Leisure’s 2008, 2009, 2010, 2011 and 2012 ‘World’s Best’ Awards.” Virgin America operates from a sleek new terminal at San Francisco, its aircraft are outfitted with industry leading in-flight entertainment and connectivity (IFEC – featuring both in-seat video and lightning fast, at least by airplane standards, WiFi) and power outlets in every seat, and the airline’s marketing highlights the quality and unique service provided on Virgin America’s flights. Much as quasi-parent Virgin Atlantic introduced a new gold standard in service on long haul flights, Virgin America “offers guests attractive fares and a host of innovative features aimed at reinventing air travel.” That last phrase is key; reinventing air travel. Much of what Virgin America does can certainly be considered innovative in the domestic market; their embrace of IFEC has pushed legacy carriers into tentative, if unwilling investments in their own IFEC. They certainly are the new standard for passenger service on domestic flights; they’ve even taken to referring to passengers as “guests.” In fact, their balance sheet refers to passenger revenues as “guest revenues,” and passenger traffic as “guests,” indicative that Virgin America is applying a hospitality industry mentality to the airline business. Harteveldt sees this as a good and bad thing “Virgin America is like a boutique hotel. You look forward to staying there but it lacks the scale and loyalty programs of a big chain where you have multiple properties in multiple locations. They lack strong, viable hubs with connecting opportunities, even at SFO and LAX where the bulk of their flights are concentrated, and potential for business accounts. You can’t be a boutique airline and succeed. You have to have scope and utility.” Legacy carriers such as American, United, and Delta are catching up to Virgin America’s inflight product with stylish new cabins, personal IFE’s, and wi-fi. In some cases are starting to exceed it in premium cabins such as by offering flat-beds on transcontinental flights and in the case of American’s new A321 fleet, an even more rarified first class experience with 1-1 seating. Arch-rival JetBlue is getting into the game as well with its new premium cabin “suites” on its upcoming A321 transcon runs.
But airline flying has evolved into almost a commodity business; where seats are a commodity like oil or gold. Virgin America had banked on consumers paying a premium for its service, but in today’s airline market the only premiums that exist are those for superior networks, better schedules, and frequent flyer benefits. Virgin America has a network and schedule that are replicated by multiple competitors at its two core hubs, and a relatively stingy frequent flyer program that lacks global reach. So Virgin America is at a disadvantage relative to not only its legacy competitors, but even hybrid carriers JetBlue and Southwest Airlines, both of whom have far superior networks to Virgin America, which is reflected in its poor unit revenues, which are consistently amongst the worst in the industry.
And upon further rumination, it is unsurprising that Virgin America has been relatively unsuccessful in making its business model work. Carriers that try to sell themselves on service have an abject record of profitability and sustainability. The last carrier to try it – Milwaukee based Midwest Airlines – wilted during the post- 9/11 LCC boom, folded into Frontier Airlines in 2009, and saw its network dismantled under the Frontier umbrella within 2 years. Airline history is littered with the carcasses of airlines that tried and failed to make money off of their service (eos, Legend Airlines, MaxJet, et. al). That strategy led Virgin America to post a cumulative net loss of $671 million, and an operating loss of $447 million since its inception.
But to its credit, Virgin America appears to have recognized the pitfalls of relying solely on its service reputation to garner profitability, and appears committed to developing and diversifying its network with recent rounds of expansion. But the US airline industry has increasingly diverged into two strategic extreme; ultra low cost carriers (ULCCs) with completely unbundled product offering targeting passengers with extremely low base fares; and network carriers offering a partially unbundled base product with some sort of premium option, and competing on network strength and connectivity. Virgin America is stuck in limbo between these two factions; its costs (with a CASM of 11.17 cents) are too high to effectively compete with ULCCs, yet its network is too weak to compete effectively with network carriers. The following chart shows the PRASM of US network carriers as well as Virgin America for Q1 2013, and clearly shows the gaping PRASM disparity faced by Virgin America.
At the same time, two things bode poorly for Virgin America’s ability to grow PRASM and improve profitability. The first is the intense competition it faces at its two core hubs in San Francisco and Los Angeles. Admittedly, Virgin America has begun to build out its network in these two markets, serving 15 destinations on roughly 45 daily flights from Los Angeles, and 18 destinations on around 54 flights per day from San Francisco during this summer’s peak schedule. Yet the airline faces immense competition on every single one of its routes from both hubs; as the following tables show. The first table is for San Francisco and the second for Los Angeles; schedules are for a week in mid-July, after Orlando service is dropped from San Francisco.
San Francisco SFO Weekly Departures
Los Angeles LAX Weekly Departures
The competition in Los Angeles is particularly fierce, and has only gotten worse for this upcoming summer; Delta added 18 new daily flights (equivalent to more than 1/3 of Virgin America’s entire operation!) to 7 new destinations, while American countered with 8 new flights to 7 new destinations.
Both of these are large markets to be sure, and San Francisco has seen significant personal income growth (which is correlated with increased air travel demand) while Southern California’s economy finally appears to be recovering. But Virgin America is the second and fourth/fifth largest players in these markets, and the competition is slowly bleeding it dry. Sure Virgin America can keep adding destinations and building that all-important network, but it will bleed money while doing so; investor pressure likely will not allow that.
Another problem is that Virgin America has a maturing workforce and ageing fleet. For the former, older workers cost more than younger ones due to increased health costs and contractual wage increases, while the ageing fleet puts pressure on maintenance expenses. And these costs grow exponentially with age; meaning that Virgin America’s 6% increase in CASM ex fuel in 2012 might be a harbinger of worse things to come.
So in short, Virgin America has an unproven business model that has yet to make money; and is squeezed on either side by competitors with lower costs and/or better networks. It operates from two of the most competitive markets in the US, with no other clear avenues for expansion (the markets in the US that can support 50+ flight full service operations already have them), and faces a rising cost base. With their unique customized fleet, and inflight product and lack of strong corporate accounts, the airline doesn’t make the strongest acquisition target or alliance member either. It’s almost a similar situation to sister-carrier Virgin Atlantic, except Virgin America is less desirable as an acquisition target. Their salvation was the 49% of acquisition by Delta. The real value of VS were access to the Heathrow slots to combat the AA/BA OneWorld Alliance at LHR. Virgin’s LAX and SFO slots aren’t worth strategically anywhere near as much. It really is a shame, but the airline that legitimately has one of very the best, if not the best, on-board domestic services in the US faces a troubled and uncertain future.