-- This article was written by Lou Whiteman of The Deal
The airline business for years had a notoriously woeful M&A track record, with a history littered with transactions that mostly destroyed value and helped breed toxic labor relations. Recent deals have largely reversed this trend, but there is reason to worry Alaska Air Group (ALK) might be hard pressed to keep that winning streak going.
Seattle-based Alaska on Monday agreed to acquire Virgin America (VA) for $4 billion including debt and leases, a stunning 47% premium to Virgin's Friday close. Alaska is paying a premium for a company that had experienced considerable turbulence as an independent, buying scale in an effort to transform itself from a regional powerhouse into a national competitor.
But combining the two brands will be no easy task. Unlike recent M&A successes, including Delta Air Lines' (DAL) purchase of Northwest Airlines, this transaction offers no opportunity to close overlapping hubs or expand into markets that are difficult to penetrate without help.
Virgin's pilots and other workers are likely in for a substantial raise as union deals are combined, cutting into potential cost savings, and the target's fleet of Airbus aircraft are not only something new for Alaska to manage but are also mostly leased at what industry sources say are above-market rates. The merger also makes Alaska's existing labor deals open to renegotiation, with unions likely to seek out raises for their memberships in return for signing off on the transaction and integration plan.
Jamie Baker of J.P. Morgan notes that there is reason to be skeptical of promised cost savings. In a note Baker writes that the first rule of airline consolidation is that "fuel remains the same while labor costs escalate, and collectively these represent a majority of operating costs." Over time the larger combined airline should enjoy a better credit profile and with it improved lease rates and insurance terms, but those benefits are small.
"If the merged entity were to shut down a money-losing hub like Memphis or Cleveland and/or consolidate expansive real estate, that could be meaningful," Baker wrote, referencing Delta's action at Memphis post-Northwest and United Continental's (UAL) drawdown at Cleveland post-deal. "No such opportunities appear relevant in this transaction."
While there is little route overlap between the two airlines an increasingly hesitant Department of Justice must also weigh in on the transaction, creating additional uncertainty.
Despite the potential issues, Alaska management appeared to feel that a merger was a risk worth taking. Alaska was motivated at least in part by a multi-year confrontation with Delta, an erstwhile partner that has waged a bruising battle with Alaska as it built its own domestic hub in Seattle. Alaska weathered that fight admirably, in part due to its strong cost structure and nimble management but in part due to luck that Delta came calling at a time when Alaska was enjoying labor harmony and when Seattle could soak up the expansion without devastating airline margins.
With Seattle's airport in expansion mode a second wave of Delta growth could be coming, and one lesson Alaska apparently took from the initial fight was the importance of diversification. Virgin America brings that, with an avid following in markets like New York and San Francisco and strong appeal with the Silicon Valley business flyer.
Alaska would appear to have some levers to pull to help make the deal work financially. The company has a strong working relationship with Boeing (BA) and the aerospace firm will likely be eager to see the combined airline dump jets made by arch-rival Airbus as soon as possible. Boeing Capital worked with Southwest Airlines (LUV), another of its most loyal customers, to place smaller 717 aircraft after that airline's purchase of AirTran Holdings and will likely be motivated to take similar actions to help Alaska get higher cost Virgin jets off of its books ahead of lease expiration dates.
Virgin America also has firm orders for additional Airbus jets that could be monetized should Alaska wish to remain all-Boeing, as well as landing rights at Dallas's in-town Love Field that would be of interest to Delta and other airlines should they become available.
The deal for Virgin America is a bold move that, if successful, should silence the skeptics and end the constant industry discussion over whether little Alaska Air can make it on its own. But there are dangers to navigate before Alaska arrives at that destination.
-- This article was originally published by The Deal, a sister publication of TheStreet that offers sophisticated insight and analysis on all types of deals, from inception to integration. Click here for a free trial.