06/06/2016

Alaska’s merger with Virgin America will be expensive but will aid growth

Alaska’s merger with Virgin America will be expensive but will aid growth

Alaska Airlines and Horizon Air’s parent firm, Alaska Air Group, Inc., is set to acquire Virgin America, Inc. Despite the limited commonalities, Ishka believes that this merger makes strategic sense for both the airlines, especially in a consolidating US airline market.  However fleet integration, Virgin’s shareholders and the increased leverage could still challenge Alaska’s attempt at expanding its market share beyond the Pacific Northwest.


Inorganic expansion
 

Alaska Airlines (Alaska) is a strong player in the Pacific Northwest through its bases in Anchorage, Seattle and Portland, however, it has limited reach in rest of the US domestic market. Acquiring Virgin America (Virgin) gives Alaska access to Virgin’s bases in California thus helping to consolidate against competition on the West Coast and also expand operations on the East Coast by getting access to the slot controlled airports in New York, New Jersey and Washington. Any attempt to expand organically in these areas would have put Alaska in direct competition with Virgin and therefore Ishka believes it makes strategic sense for Alaska to merge with Virgin as it seeks to increase its market share.

In addition, the proposed merger is in-line with the trend of consolidation in the US aviation market. The following graphic demonstrates the level of consolidation over the course of the last 35 years. As of 2015 both Alaska and Virgin sit in the cramped space of the US low cost carriers and this merger is Alaska’s attempt at growth in a competitive environment. Compared to jetBlue and Hawaiian Airlines, both of which have a low cost premium product offering similar to Alaska, Virgin is the smallest airline in this group, making it more feasible for Alaska to acquire and to expand its reach and increase its market share in North America.


Downgrade in investment grade credit rating?

 

 

Alaska Air Group, Inc. (Air Group) is among a handful of investment grade airline companies in the world. Lean operations have contributed to consistent profitability and have allowed the airline to maintain an extremely healthy balance sheet with very limited debt. As can be seen from the table, Air Group’s fundamentals are in an extremely healthy state. However, the acquisition will clearly impact the capital structure and result in an increased leveraged position for the company.

 

 

As per Ishka analysis, Air Group’s adjusted net debt will approximately rise from a negligible $198 million at the end of 2015 to a significantly higher $3.7 billion as a result of this acquisition. This will certainly lead to higher interest expenses as a result of the higher leverage and will also lead to higher contractual obligations in the future. Ishka’s views are corroborated by the fact that S&P recently put both Air Group and Alaska on ‘CreditWatch Negative’ on the Virgin acquisition. In addition, there is a possibility that the offer price would have to be revised upwards as Virgin’s shareholders were yet to approve and accept Alaska’s offer.

 

Pressure on short-term profitability

 

Ishka estimates that there could be pressure on the bottom line in the short-term. Air Group anticipates it could incur between $300 and $350 million towards integration and merger related expenses before it starts to realize annual synergies of $225 million. If the deal goes ahead as planned and Virgin becomes part of Air Group by 1st January 2017, the synergies are expected to be realized as shown in the chart. As a result, before it realizes any benefits, there are integration costs in the short-run which could impact profitability. In addition, as mentioned above, the increased debt burden will lead to higher interest expenses which could further impact the bottom line.

                                                                     Estimated realization of synergies

Alaska estimates the full $225 million synergies to be realized starting only from 2020.


Hurdles towards the merger

 

In Ishka’s view the integration of the different fleet types is a critical factor in this merger. While Alaska mainline operates an all-Boeing fleet, Virgin operates an all-Airbus fleet. Operating a single fleet type allowed Alaska to avoid fleet complexities in its operations, especially in training, crews and maintenance and this has helped to keep the operating expenses down. It will not be the same post Virgin’s acquisition and may have an impact on margins, at least initially. In its defense, Air Group successfully integrated Horizon into its portfolio, even though Horizon operates a different business model and fleet type to Alaska. Consequently, Ishka believes that, notwithstanding some initial teething issues, Air Group should be able to handle the fleet integration reasonably well.

While the merger clearly seems advantageous to Alaska, the benefits to Virgin are not immediately clear.  Virgin’s board believes that going forwards they will be in a better position to face competition by consolidating with another airline, however, Virgin’s shareholders may think otherwise. Ishka believes that commercially this is an ideal time for Virgin to execute this deal as it has generated a positive turnaround in the last 2 years and is now in a strong position fundamentally to negotiate an attractive price for its shareholders.

While obtaining regulatory clearance on such deals can be a challenge, Ishka does not expect the merger to face any major regulatory hurdles as currently there is limited overlap between their routes, therefore any potential competition implications do not arise. Secondly, while this merger would allow Alaska to expand its market share, it does not create a situation in which Alaska will be able to achieve any market dominance.

 


What if the merger fails to happen?

 

If the merger fails to happen, we return to the question as to how Alaska will achieve growth. It is likely that the carrier would have to invest in additional aircraft but would also be forced to hunt for attractive airport slots. In a saturated market a significant increase in capacity could put pressure on Alaska’s yields.  Consolidation is likely to happen among the low cost carriers in the US even if this deal fails. Alaska itself successfully defeated a rival bid from jetBlue for Virgin. If this transaction fails to go through, it could open the doors for jetBlue to attempt to acquire Virgin again. Due to its size and business model, Alaska may also become a possible takeover target for larger airlines.


Ishka’s Insight
 

  • Both Alaska and Virgin exhibit strong fundamentals. Alaska has not recorded an annual loss for the past 11 years, while Virgin has crafted an impressive turnaround in the last 2-3 years. This augurs well for the Alaska management in acquiring a profitable airline.
  • The fundamental strengths of both the airlines should help overcome any short term pressures on the bottom line, however, the likelihood of a rating downgrade will remain.
  • Fleet integration may be a challenge, however, Alaska has demonstrated that it can be done effectively.
  • As demonstrated by all the previous cases of airline consolidation in the US, the coming together of two airlines in a tight market will help rationalize capacity, consequently contributing to higher yields and profitability.
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