Clearing the last regulatory hurdle means Alaska is close to consummating its eight-month-old agreement to buy Virgin America and form the nation’s fifth-largest airline. Even when that’s done, such mergers pose many challenges. “They have a lot of wood to chop,” says one expert.
The Department of Justice on Tuesday approved the $4 billion acquisition of Virgin America by Alaska Airlines, clearing the way for creation of the fifth-largest U.S. airline. The combined company should fly more passengers out of West Coast airports than any other carrier.
However, to curb the potential anti-competitive effects of this latest consolidation in the airline industry, the DOJ’s antitrust unit imposed conditions that will limit Alaska’s collaboration with American Airlines on key routes.
Alaska told investors the restrictions will affect how it operates in 45 markets, and will initially reduce its annual revenue by $15 million to $20 million.
Despite that, “we remain confident in the merits of this transaction,” Alaska Air Group Chairman and Chief Executive Brad Tilden said in a statement. “With this combination now cleared for takeoff, we’re thrilled to bring these two companies together.”
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Antitrust officials singled out Alaska’s cooperation with American because Virgin competes fiercely with that carrier on about 20 nonstop domestic routes, forcing American to lower prices and to offer better service on those routes.
To keep that competition alive, the DOJ required the newly enlarged Alaska to agree not to collaborate with American in so-called code-sharing agreements on certain routes.
Code-sharing allows Alaska to market and book passengers on American flights, and vice versa. It allows a smaller carrier like Alaska to greatly enlarge the network of routes its passengers can choose. However, it also provides an incentive for the two carriers not to compete head-to-head.
A DOJ official on a teleconference call Tuesday said limiting the code-share will ensure that the merger does not reduce competition and will reduce by about half the volume of American passengers on Alaska flights.
Alaska said that so far this year it derived about $190 million in revenue from its code-share with American, just less than 4 percent of its total revenue of $5.1 billion.
Of that, about $60 million would be affected by the new restrictions.
However, Alaska said it believes it can recover 70 percent of that by replacing lost revenue from American passengers transferring to its flights with its own direct bookings on the same routes.
The DOJ agreement did not require Alaska to divest any assets such as airport gates.
Different style airlines
The merger was originally expected to be completed in September, but as the DOJ gave the deal extra scrutiny, negotiations were extended.
Alaska and Virgin shareholders approved the deal in the summer and the DOJ’s consent is the final regulatory hurdle.
Before the acquisition can finally close, a lawsuit in federal court in San Francisco will also have to be resolved. In that case, 42 plaintiffs representing Virgin passengers are challenging the merger as harming the interests of the traveling public.
“Lawsuits of this kind are not uncommon with mergers,” Alaska said Tuesday. “The company believes the plaintiffs’ claims are without merit and plans to defend its acquisition of Virgin America accordingly.”
The proposed merger was announced April 4, with Alaska paying a premium price of $57 per share for the smaller San Francisco-based airline. When speculation that Virgin might be sold began in late March, Virgin’s shares were selling for less than $35.
In addition to the roughly $2.6 billion Alaska will pay to Virgin shareholders, it will assume existing Virgin America debts and aircraft operating leases of $1.4 billion, for an aggregate transaction value of approximately $4.0 billion.
The two airlines have very different styles.
Virgin, a smaller airline with a limited route network, differentiated itself by offering a unique product. Passengers enjoyed a fun-filled service vibe and technological innovations such as ordering food on their seat-back touch screens and mood lighting.
Alaska is more mainstream, relying on an efficiently run regional network to attract passengers.
Yet as Seattle’s hometown airline, known for good quality passenger service, and with a popular mileage-rewards program and a linked credit card with extra perks, it also has a very loyal following.
Merging is hard to do
In June, Alaska Chief Executive Tilden suggested that it’s an option for the two airlines to continue as separate brands.
However, most industry experts expect that the two airlines will eventually operate as a single entity, with Alaska branding.
Yet that will take a considerable time.
In the meantime, they’ll continue to fly as two fleets of aircraft — Alaska’s all-Boeing and Virgin’s all-Airbus — manned by separate crews and painted with different liveries.
Merging of two airlines is a difficult process, and often it hasn’t gone smoothly. The 2010 merger of United and Continental is a notable example.
“They have a lot of wood to chop,” John Reardon, an airline-industry expert with Pasadena, Calif.-based investment firm Western International Securities, said of Alaska and Virgin. “This is going to be a work in progress for a couple of years.”
Among the biggest challenges will be integrating the two airlines’ computer systems so that passengers can book seamlessly on either fleet at one website.
And employees of Virgin have to become Alaska employees. In addition to adjusting the work culture, all the details of seniority, pay and benefits have to be resolved.
Alaska will likely see total wage costs rise as it hikes the pay of Virgin employees, especially pilots, to match its own employee pay scale.
Alaska took in $5.6 billion in revenue last year, carrying 32 million passengers on a fleet of 152 Boeing 737 mainline jets, plus 71 smaller regional airplanes. It has more than 15,000 employees.
Virgin had 2015 revenue of $1.4 billion from 7 million passengers flown on a fleet of 63 Airbus A320 jets. The airline has about 3,000 employees.
Alaska management estimates the one-time integration costs at between $300 million and $350 million.
Inevitably, glitches will arise that cost more than expected to fix.
“I suspect there’ll be a few earnings surprises on the negative side,” Reardon said.
Still, he thinks that if any team can prevent the merger from becoming “a millstone around the necks of shareholders,” it’s Alaska’s top-notch management.
Alaska’s ability to thrive in the past two years, despite a massive competitive assault from Delta at its main Seattle hub, shows the airline is in a healthy state, Reardon said.
Cool vibe vs. mainstream airline
As the integration of Virgin proceeds, Alaska’s leadership has to make some big calls.
What will it do about the disparate Airbus and Boeing aircraft types? Will it retain both A320s and 737s or get rid of the Airbus planes as they gradually come off lease?
How will it market the new combined airline to retain loyal Virgin America fliers?
Reardon contrasted the broad Alaska passenger base with the typically younger hipsters who choose Virgin for its cool culture.
“That hipster, viva Las Vegas vibe is going away,” said Reardon. “How are they going to appeal to customers who enjoyed riding Virgin because it was cooler than any other airline?”
Alaska will likely depend less on retaining the hard-core Virgin passenger base — a portion of which may well migrate to other carriers such as JetBlue — than on attracting a broad range of fliers in California and beyond to its enlarged route network.
The addition of Virgin now gives Alaska a more significant presence all along the West Coast, with a dense network connecting all the major cities from Anchorage, through Seattle and Portland to the Bay Area, greater Los Angeles and San Diego.