Alaska Air Group (ALK) is the somewhat surprising "winner" in the bidding process for Virgin America (VA). It has been very clear that the bidding process has gotten quite competitive, forcing Alaska to pay a very fat premium in order to become a greater powerhouse on the West Coast.
The strategic rationale behind the deal makes perfect sense. Alaska will gain scale, obtain a better network, gain improved access to key airports, while it adds a customer-oriented business with a relatively new fleet. The only drawback is the high price being paid for Virgin, something which will limit accretion in the near to medium term.
That being said, the real strategic benefits should translate into real financial benefits in the years thereafter as well. This follows the improved positioning of Alaska Airlines versus market-leading nationwide competitors.
The Deal Terms
Alaska Air announced that it is willing to pay $57 in cash for each share of Virgin America. This marks a huge +46% premium compared to the share price on the day before the deal was announced. It should furthermore be remarked that shares of Virgin have already risen on the back of takeover speculation in recent weeks. As a result, the final price represents a +100% premium from the recent February lows.
What is somewhat remarkable is that Alaska has elected to acquire in an all-cash deal, as the deal does not include a stock component. This is somewhat remarkable given the very strong performance of the stock, certainly over long time frames. Including debt as well as the present value of operating leases on planes, Alaska is valuing Virgin at roughly $4.0 billion.
The Rationale Behind A Deal?
So what is Alaska getting for its $4 billion investment? The company is notably looking to improve access to California, while it obtains very valuable slots at airports in New York as well. These routes and slots allow Alaska to gain greater scale and benefit from related network effects in order to compete more effectively with the major nationwide and international carriers.
Notably, Virgin America has been at the forefront of technology developments, low fares and good customer service. As a matter of fact, the airline was formed in response to the frustration about fares and customer service. Its high-profile founder Richard Branson was actually very frustrated with the fact that he had to sell the business, given that he owned non-voting shares.
The only good thing for Branson might be the fact that Alaska has a very solid reputation in terms of employee and customer satisfaction. Despite the solid track record, Alaska will certainly be able to learn a few best practices from Virgin America.
The Price Looks Pretty Steep
The $4.0 billion price tag is quite steep, with the equity component amounting to $2.6 billion. This means that the actual premium being offered for Virgin amounts to $800 million if you compare the purchase price with that of the day before the deal was announced. If you would include the run-up in the shares of Virgin in the days and weeks ahead of the deal, the premium number would come in much closer to a billion.
For the $4 billion price tag, Alaska will obtain ownership in an airline which reports sales of $1.5 billion and generates $200 million in pre-tax earnings. This translates into a 2.7 times sales and 20 times operating earnings multiple, both being quite elevated within the airline sector. That said, Virgin has real advantages which include valuable slots, while it flies over 7 million loyal customers through its relatively new and fuel-efficient fleet.
Alaska is much bigger as it generates $5.6 billion in revenues by transporting over 32 million passengers each year. Pre-tax earnings amount to $1.3 billion and this shows the importance of scale in the airline sector. Alaska's pre-tax margins of 23% are roughly 10 points higher compared to those reported by Virgin America. This margin gap can in part be closed by both cost and revenue synergies.
Alaska believes that cost savings come in at roughly $50 million per year, as the network effects should boost revenues by $175 million. Achieving these synergies does come at a relatively high price, estimated at around $300 million. If you take into account these synergies, the purchase price comes in at roughly 2.4 times sales and 13 times operating earnings.
Alaska itself held $1.3 billion in cash and equivalents at the end of the fourth quarter. The company had just $700 million in regular debt outstanding, although leverage stood at $1.7 billion if you include the present value of operating leases. Even in that case, the net debt load was quite limited at around $400 million. Given the all-cash deal, leverage will increase towards $4.5 billion, although the balance sheet remains relatively strong.
The company had 125 million shares outstanding which traded at $82 ahead of the deal, for a $10.2 billion equity valuation. If you take into account the net debt load ahead of the deal, Alaska was valued at $10.6 billion as a stand-alone entity. This is equivalent to 1.9 times annual sales and 8 times operating earnings. Both of these multiples are much lower compared to the multiples being paid for in the Virgin deal, even if you take into account the anticipated cost and revenue synergies.
Final Thoughts: Strategically Sound But Too Expensive
Deals typically have quite a few angles which need to be discovered. It goes without saying that Alaska will gain scale, access to great operational expertise, as well as very important slots at key airports in Los Angeles, New York and San Francisco. Network effects and a relatively young fleet create additional advantages, as Alaska is looking to compete more effectively with the large legacy carriers.
So far so good. The problem is the high price being paid for Virgin America, even after taking into account the anticipated cost and revenue synergies. To put it bluntly, Alaska is paying a sum which is equivalent to 37% of its enterprise value in order to expand sales by 27%. It should furthermore be stated that Virgin's margins are much lower, thereby severely limiting earnings accretion in the short term.
The good news is that Alaska is using cheap cash and its strong balance sheet in order to pay for Virgin. Somewhat remarkable is that no equity offering is taking place after Alaska's shares trade at richer multiples. As a matter of fact, shares have seen a huge multi-year run, having risen from just $4 in 2009 to levels in the $80s at the moment!
The high valuation multiples and the $800 million premium being offered for Virgin America are putting off some investors in Alaska. Unlike management, shareholders do not believe that they are the "winner" in this competitive bidding process as shares lost roughly $400 million in terms of market value. The fact that this decline is less than the premium offered suggests that shareholders see real benefits of the deal, although they think that the premium offered is simply too big.
All in all, I see reasons to be upbeat although most benefits take quite some time to materialize. The combination will post adjusted earnings in excess of a billion, (before considering the financing costs of the deal), translating into earnings of roughly $8 per share. After taking the financing costs into account, earnings accretion will be limited, at least in the short to medium term.
The real financial, but certainly the real strategic, benefits are only expected to be seen in the long run. An improved network, combined with strong operational excellence, should improve the positioning of the airline versus that of legacy carriers over time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.