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The airline industry just got a little smaller.
The latest news is that Alaska Air (NYSE: ALK) is buying up the Richard Branson-backed airline, Virgin America (NYSE: VA). It’s the same airline that’s known for mood lighting and robust media entertainment on its flights.
It’s the first airline industry merger since 2013, when US Airways and American Airlines (NYSE: AAL) combined.
Alaska Air is the No. 1 servicer of the state of Alaska. It runs various full-service flights along the Pacific Coast, including a big new bet on Hawaii. Of note, Virgin also just started a route to Hawaii.
Virgin America primarily operates in the U.S. and Mexico, helping further grow Alaska Air’s presence in the more stable U.S. airline market. In particular, the move solidifies Alaska Air’s dominance on the West Coast.
Alaska Air is paying $57 a share for Virgin America, a near 50% premium to where shares traded last week. It’s a sizable premium to pay, but for good reason.
The Big Benefits
Virgin America is a prized asset, and the purchase could mark one of the last M&A moves in an industry that’s seen rapid consolidation over the last decade.
Both Alaska Air and JetBlue (NASDAQ: JBLU) were bidding for Virgin America, the ninth-largest airline. The buyout allows Alaska Air to overtake JetBlue as the fifth-largest airline in the U.S.
The move would have given JetBlue a much-needed boost to its West Coast operations. Virgin America has a loyal following in Silicon Valley, and the buyout gives Alaska Air a chance to get into two very important West Coast cities: Los Angeles and San Francisco.
Meanwhile, Alaska Air has one of the best returns on invested capital in the business. It clocks in at 27%, thanks to cost discipline and labor streamlining. Virgin America also has a solid ROIC of 31%. Both companies have similar low-cost structures as well.
What to Expect
With the addition of Virgin America, which posted record earnings last year, Alaska Air should be positioned to become a formidable foe against major airlines. The deal is expected to close by the end of the year and would be immediately accretive to earnings, while also boosting annual revenues by nearly 25%.
What’s more is that Alaska Air offers a 1.3% dividend yield – which is just a 15% payout of earnings. Its dividend yield doesn’t seem like much, but it’s one of the highest in the industry.
Plus, Alaska Air has a strong balance sheet – with more cash than debt – so the company shouldn’t have any problem financing the deal. Of note, Alaska Air is one of the few airlines to not have declared bankruptcy.
If the deal does fall apart, possibly because of regulatory oversight, Virgin America would have to pay Alaska Air a close to $80 million breakup fee.
Alaska Air isn’t necessarily moving away from being a specialty airline. It will still have a stronghold on a few niche markets. With the Virgin American deal it’s merely expanding its reach and eliminating a West Coast competitor. And when the two companies cut costs and eliminate excess routes, there should be more money left over for the airline stock to boost its dividend.
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