Alaska Airlines (NYSE:ALK) on April 4, 2016, officially announced the acquisition of Virgin America (NASDAQ:VA) for $57.00/share in an all-cash offer. At that time, the companies reported that the deal was expected to close by January 1, 2017.
From April 4, 2016 until September 21, 2016, Virgin America's stock traded in the $55-$56/share range, at a slight discount to the offer of $57/share. Then, a much larger discount developed on September 22, 2016, when Virgin America's stock dropped about 5% on the day. A few days later, on September 26, 2016, Alaska Airlines confirmed rumors with a press release that the U.S. DOJ had requested an extension from September 30, 2016 until October 17, 2016 for regulatory review.
Source: Yahoo Charts
Two Competing Views
Until late September 2016, the prevailing view in the market coalesced around a "low-risk" deal. From the market close on April 4, 2016 at about $55/share, the expected return (assuming a close on January 1, 2017) hovered at just under 5% (annualized).
With the DOJ delay announcement, however, the expected return (assuming a close on January 1, 2017) has increased to about 35% (annualized), with the current share price at $53/share.
The key to determining the profitability in this opportunity hinges on two points:
- Will the deal be consummated?
- When will the deal be closed?
Will the acquisition occur, or will the DOJ block it?
Predictions involving the DOJ, especially in an election year, always involve some risk in misreading the situation. But, in this case, what is the likelihood that the DOJ will add conditions that would effectively block the merger?
Looking at recent airline mergers of much larger companies, such as American Airlines (NASDAQ:AAL) with U.S. Air, the DOJ conditions have revolved around concentration at key airports, especially airports with landing slot constraints. The remedy has typically involved the divestiture of landing slots and/or gates.
Assuming that the DOJ will follow the same reasoning as in recent airline mergers, the central question would be if any key airports will result in a significant change in concentration, especially if the airline will be in a dominant position, when these two airlines merge.
Although the acquisition of Virgin America by Alaska Airlines has been characterized as creating a "West Coast powerhouse", this characterization is only true because Alaska Airlines is already a Pacific Northwest powerhouse, pre-acquisition. Pre-merger, Alaska Airlines already has a dominant share in the states of Alaska, Oregon and Washington.
Source: Alaska Airlines' Investor Deck (April 4, 2016)
The primary reason for Alaska Airlines' acquisition of Virgin America is to buy expansion into California. Post-acquisition, Alaska Airlines will be the second largest airline at SFO (San Francisco International) and fifth largest airline at LAX (Los Angeles International)--a meaningful presence in each market, but not dominant in either. Since Alaska Airlines will only be a distant second to and a third of the size of the SFO-dominant United Airlines (NYSE:UAL), it is highly unlikely that the DOJ will seek remedies such as slot or gate divestiture at SFO. Similarly, due the combined companies' fifth place at LAX, it is almost inconceivable that the DOJ will require remedies there.
Source: Alaska Airlines' Investor Deck (April 4, 2016)
Excluding California airports, that leaves the Alaska Airlines dominated airports of SEA (Seattle-Tacoma International), PDX (Portland International) and ANC (Anchorage International) as the possible concern of the DOJ.
The only airport of the three with any significant overlap between Alaska Airlines and Virgin America is Seattle. For that reason, the DOJ may seek some concessions, such as gate divestitures at Seattle-Tacoma International, for approval of the merger.
Overall, any divestiture requirements would be minor and unlikely to scuttle the planned acquisition. Therefore, the likelihood of consummating this merger is extremely high.
When will the merger occur?
As news of the DOJ concerns first broke, The Seattle Times reported on September 22, 2016:
Virgin America Chief Executive David Cush said Monday at an aviation conference that the federal review of the merger is "going according to plan" and the two airlines still expect to complete it in the fourth quarter.
What if the DOJ demands result in extended negotiations that extend the timeline? How will that change the expected return?
I've calculated the following scenarios myself, based on the current Virgin America price of $53/share, with the assumption that the $57/share cash offer is completed with varied delays in the timing of its completion.
- No delay (close by end of Q4/2017): >35% (annualized)
- 90 day delay (close by end of Q1/2017): >16% (annualized)
- 180 day delay (close by end of Q2/2017): >10% (annualized)
Therefore, as long as the merger closes by mid-2017, the return profile is quite profitable.
What could go wrong?
The critical decision point for this investment is the decision of the DOJ within the next week. If the DOJ decides to block the acquisition in court, then the possibility of an abandonment of the acquisition by Alaska Airlines may occur.
However, past cases in the same industry, strongly suggest that this outcome is highly unlikely. Moreover, Alaska Airlines has shown a high commitment to completing this merger which will greatly expand the scale of the combined company across the West Coast.
This special situation opportunity makes a strong return, uncorrelated to the market, possible with a long position in Virgin America's stock.
Disclosure: I am/we are long VA.
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.