On April 4, 2016, Virgin America agreed in principle to its acquisition by Alaska Airlines. The top four airlines—American, United, Delta and Southwest—currently account for more than 80 percent of available capacity, while Alaska Airlines has a 5 percent share, Virgin a 2 percent share. A merger would turn Alaska into the fifth largest carrier in the U.S., pulling it ahead of JetBlue.
At first glance, the deal looks like the standard template used by the “Big Four” airlines over the last two decades. It’s also expected to lead to further consolidation in the domestic airline industry.
Not Your Father’s Airline Merger
As a bit of background, in 2000 the U.S. domestic aviation sector was dominated by 10 mega-carriers. But through extensive mergers and acquisitions (M&As), fueled by a wave of bankruptcies, they were reduced to just four large carriers. American Airlines, the largest U.S. carrier with a 25 percent share, was created through three separate mergers between 2001 and 2013.
Although the Alaska-Virgin merger could be considered a continuation of this trend, there are some significant differences from earlier deals. Nearly all the M&As in the past 15 years were driven by distressed companies, and the acquirers were more often than not mega-carriers.
By contrast, Alaska Airlines is the most profitable carrier in the U.S. with operations focused on the West Coast, and Virgin America, after years of losses, is expected to generate a net profit in 2016.
In addition, route overlap was often a significant factor in past mergers. The Southwest/AirTran merger, for example, involved 21 overlapping routes, with 15 being covered by only a single airline post-merger. In the case of Alaska and Virgin, however, there are only seven overlapping routes, with no monopolized route post-merger.
The Path to West Coast Domination
As a traditional regional airline, Alaska has remained dependent on its core hubs of Portland and Seattle over the last four decades. Although it’s maintained a market share of more than 50 percent in Seattle, its largest market, a sharp expansion by Delta in Seattle has, over the last two years, threatened Alaska’s share. By summer 2015, the Delta-Alaska overlap on Seattle routes reached nearly 50 percent. A merger with Virgin America, then, seems to be a strategy focused on developing new hubs and consolidating market share in the West Coast market.
Post-merger, Alaska is expected to have the largest market share on the West Coast (22 percent), followed by present leaders Southwest (21 percent) and United (16 percent). The deal should provide Alaska with a strong toehold in California—the largest state by population, gross domestic product and passenger volume. Marked improvement should also be seen in New York.
As there are no overlapping routes and operations, the merger is not expected to result in any dramatic changes in fares. Though we can expect some aggressive pricing from Alaska—especially in California—considering its high margins and strong balance sheet, a full-blown price war is unlikely to be on the table. With a highly concentrated field, pricing discipline can be expected to be sustained.
Case Study: American Airlines and US Airways
The Alaska-Virgin America deal is valued at a price-to-EBITDA (earnings before interest, taxes, depreciation and amortization) multiple of 11.08 times, reflected in a 90 percent premium on its 120-day average price. This is a significantly high multiple, especially when compared to the 2.83 times (as of May 2) applied to American Airlines following its merger with US Airways.
As you can see above, American Airlines experienced a sharp valuation from mid-2014 to mid-2015 in the expectation of a windfall from low oil prices. Now that the impact of low fuel costs has become somewhat exhausted, it can be safely assumed that American Airlines experienced a valuation expansion of nearly 25 percent post-merger. It should be noted that the deal also resulted in a significant dilution for American’s shareholders of almost 40 percent.
What’s more, there has been significant drag on synergy realization—or the potential financial benefit achieved through the merging of companies. At the time of the merger, American Airlines indicated revenue synergies worth $1.5 billion by the end of 2016. However, through mid-2015, only $480 million worth of synergies had been realized. Until late 2015, American and US Airways were still offering different prices on the same route.
That said, despite all the synergy-related problems and equity dilution, the merger has, overall, created value for investors in terms of earnings per share (EPS) and valuation expansion.
The Alaska-Virgin deal could provide a template to be followed by other smaller airlines such as JetBlue, Hawaiian, Spirit and other low-cost carriers. The deal has valued Virgin America at $4 billion, with $2.6 billion as the value of equity. Alaska is financing the all-cash deal with $600 million and nearly $2 billion in debt. Thanks to the investment-grade debt rating of Alaska (the only airline with an investment-grade rating, we should add) and a post-deal debt-to-capital ratio of 58 percent (still below the average of more than 60 percent for the industry), the deal should be accretive for investors on day one.
Alaska has estimated synergies worth $225 million per year to be realized by 2020. Considering that the age of Virgin America’s fleet of planes is much younger and that it already maintains close to the same fuel efficiency as Alaska, operations integration is expected to be smooth. On the other hand, the harmonization of labor costs could create a drag on synergy realization.
Considering the current high concentration of the industry in the hands of the Big Four, further M&A activity by them could hit a regulatory wall. However, in a favorable environment marked by low fuel prices and strong passenger growth, the smaller airlines could still pursue M&A, allowing them to gain market share and compete with the Big Four on a piecemeal basis as we are seeing with the Alaska-Virgin America deal.
With strong balance sheets and historically high margins, M&A could be a compelling alternative to a riskier organic growth strategy for these smaller players. In a highly reduced playing field, the Alaska-Virgin America deal could be the start of one last consolidation wave among the smaller players, which could finally bring to an end the two-decade M&A cycle in the U.S. airline industry.
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The P/EBITDA ratio compares a company’s price to its earnings before interest, taxes, depreciation and amortization. This metric is widely used as a valuation tool. It compares the company’s price to true cash earnings. Lower ratio values can indicate that a company is currently undervalued. A revenue synergy refers to the opportunity of a combined corporate entity to generate more revenue than its two predecessor standalone companies would be able to generate. Dilution refers to the reduction in the percentage equity ownership of a company due to additional equity being issued to other owners. Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability.