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How Will The Virgin America Merger Impact Alaska Air's Cost Of Capital?

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The amalgamation of Alaska Air and Virgin America in an all cash deal of $2.6 billion is expected to create a low-fare carrier offering a premium product and quality service to its passengers. Apart from enabling Alaska Air to expand its footprint in California and complementing its superior customer service, the merger will have a notable impact on the Seattle-based airline’s cost of capital.

Alaska Air is neither a full-blown legacy carrier nor a low-cost carrier. Hence, the airline has been expanding its operations to compete with the legacy carriers, while maintaining its low cost advantage against its competitors. Consequently, the airline has managed to deliver industry leading operating margins over the years. However, the market is unsure of the implications that the airline’s proposed merger with Virgin America will have on its overall results. This has resulted in a 20% fall in the airline’s stock price since the announcement of the deal. The major cause of investor concern is that the transaction requires Alaska Air to assume almost $1.4 billion worth of long term debt and lease obligations from Virgin America, which is likely to alter the airline’s capital structure significantly. In our previous analysis, we had shown how the Virgin America merger will impact Alaska Air’s capital structure. While it is clear that the company’s capital structure will become highly levered post the merger, we believe that it could work in the airline’s favor in the long term.

Here we explain, how the merger will result in a lower cost of capital for Alaska Air, which will boost the airline’s valuation in the long term. The table below clearly depicts that Virgin America’s cost of debt (before tax) is notably lower than that of Alaska Air. As a result, even after assuming a significant portion of Virgin America’s debt, Alaska Air’s cost of debt is likely to drop to 6.3% post the merger. Further, Virgin America had net operating losses (NOLs) of over $1 billion at the end of 2015. Thus, Alaska Air’s pre-tax income (post merger) can be easily set off against these NOLs, resulting in zero tax obligations in 2016. Overall, Alaska Air’s cost of debt (after tax) post merger is estimated to be around 6.3% in 2016. This, coupled with the airline’s debt-to-capital ratio of almost 60% post the merger, will reduce Alaska Air’s overall cost of capital from 8.4% before the merger to 7.9% post the merger.

Thus, we believe that despite resulting in a highly levered capital structure, the Virgin America deal will have a positive impact on Alaska Air’s cost of capital.

Have more questions about Alaska Air ? See the following link:

For more data and our model and valuation, please refer to our complete analysis for Alaska Air Group

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