Alaska Air pays through nosecone for U.S. Virgin

April 4, 2016

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Alaska Air is paying through the nosecone for Virgin America. The Eskimo-logoed carrier secures some coveted airport slots with its $2.6 billion deal for Richard Branson’s stateside flier. Cost cuts fall way short of the premium to Virgin’s undisturbed share price, however. It’s a risky bet that the airline industry has changed its destructive ways.

There may be some validity to the thesis from a company with an investment-grade rating and net cash on its balance sheet. U.S. airlines have benefited from a decent economy in recent years and a series of mergers – most of them struck when one or both partners were struggling – that slashed costs. The precipitous fall in the price of oil also saved $18 billion in fuel expenses for the sector last year, two-fifths of which landed right on the bottom line, according to Barclays.

Pre-tax margins are 20 percent or higher for the best among them: Delta, Southwest and Alaska. Laggards like United Continental and American Airlines generate about 12 percent. A few years ago, such results would have been just a pipedream.

Bradley Tilden, Alaska Air’s chairman and chief executive, is only going a short way with this acquisition. Virgin America accounted for 1.7 percent of U.S. air traffic last year. That won’t make up much ground against the big four, which control more than four-fifths of the market. Adding West Coast hubs and bulking up in New York and Dallas could, however, lay the groundwork for later expansion.

The two airlines, though, have little overlap in either routes or planes. Alaska Air flies mostly Boeing and Virgin predominantly Airbus. Expected cost cuts are $50 million after tax. They’re worth $150 million to shareholders, once capitalized and adjusted for the $350 million of merger costs.

To help cover the rest of the nearly $1.2 billion premium, Tilden is relying on a top-line turbo boost from changing which aircraft fly which routes, persuading more passengers to fly Alaska Air and greater income from the company-branded credit card.

These sorts of revenue benefits tend to be harder to realize. There also may be other headwinds. Oil prices are back on the rise. Margins are expected to slide again by 2019, according to analyst forecasts culled by Thomson Reuters. That means Alaska Air’s M&A journey could be a bumpy one.

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