Fitch Ratings has placed Alaska Air Group (ALK; 'BBB-') on Rating Watch
Negative following the announcement of its acquisition agreement with
Virgin America (VA). ALK has agreed to purchase Virgin America for $2.6
billion. ALK expects to fund the transaction by raising roughly $2
billion in new debt. The $2.6 billion purchase price is not inclusive of
the $321 million that VA had on its balance sheet at the end of the
year. ALK targets closing the acquisition by the end of 2016. The
closing requires regulatory approvals, a Virgin America shareholder
vote, and satisfaction of other closing conditions.
KEY RATING DRIVERS
The Rating Watch Negative reflects the expected increase in leverage at
ALK from the incremental debt raised to finance the transaction and the
risks involved in integrating the two airlines. However, Fitch notes
that ALK's credit metrics prior to this merger were strong for the
'BBB-' rating, and there is a chance that ALK will be able to absorb the
additional debt while maintaining an investment grade rating, depending
on several factors. Fitch expects to resolve the Rating Watch after
meeting the company and obtaining additional information about the
expected financing of the transaction, ALK's plans for cash deployment
for share repurchases, liquidity policies after the acquisition, the
pace of debt reduction, and the expected merger synergies. If Fitch were
to take a negative rating action, it is unlikely that ALK would be
downgraded by more than one notch. A negative rating action could also
come in the form of a Negative Outlook at the current rating level.
Fitch expects the incremental $2 billion in debt to increase ALK's total
adjusted debt/EBITDAR to around 2.9x-3.2x on a pro forma basis. ALK's
standalone leverage was 1.6x at year end 2015. Assuming a sustained
healthy U.S. aviation market, Fitch expects the combined companies to
generate a meaningful amount of free cash flow (FCF) over the
intermediate term, which should allow the company to de-lever. Fitch's
initial base case forecast anticipates an adjusted debt/EBITDAR falling
towards or below 2.5x by 2019. Fitch anticipates that FCF as a
percentage of revenues will remain in the high single digits or low
double digits and funds from operations (FFO) fixed charge coverage will
remain above 3x-3.5x.
VA's leased aircraft will also add a material amount of off balance
sheet debt to ALK's books, over and above the new debt being raised to
finance the transaction. VA's rent expense in 2015 totalled $219.8
million, equating to $1.76 billion in off-balance sheet debt as
calculated by Fitch.
Fitch expects the combined carriers to produce annual revenues
approaching $8 billion by 2017. ALK was by far the larger stand-alone
airline, producing 2015 revenues of $5.6 billion on a fleet of 212
aircraft (mainline and regional). In contrast, Virgin America produced
total revenues of $1.5 billion on a fleet of 57 aircraft.
Strategic Considerations:
Strategically, Fitch considers the merger to have merit. On a
stand-alone basis, ALK's route system is concentrated on the West Coast
and in the Pacific Northwest specifically. Its heavy reliance on its
Seattle hub has been a standing ratings concern. According to company
filings, some 61% of its total passengers in 2015 flew either to or from
Seattle. The combination with Virgin America will help to bolster ALK's
presence in San Francisco and Los Angeles, eliminate a competitor, and
further build-out its route network, more firmly establishing its market
position on the West Coast. The merger also has some defensive benefits,
as it blocks the possibility of a JBLU/VA merger, which would have given
JetBlue a stronger toehold as a competitor on the West Coast, where it
currently has a limited presence.
Virgin America also places a particular emphasis on its transcon
business. Fitch estimates that well over a third of revenues are driven
by flying between LA, San Francisco and several East Coast markets
including New York JFK, Newark, Boston, Washington Dulles and Fort
Lauderdale. The growth of ALK's transcon business was one key element of
the company's network transformation that has taken place over the last
decade. Merging with VA will give ALK additional presence in these
markets. Outside of the transcon markets, ALK and Virgin America have
limited overlapping routes.
Fitch also notes some similarities between the strategic positioning of
the two companies. Although neither are traditional 'low cost carriers',
both operate with relatively low cost structures compared to their
mainline competitors. Both airlines strive to offer more amenities than
the mainline carriers offer, but with an emphasis on maintaining low
ticket prices. However, the branding of the two companies is quite
different. VA emphasizes its upscale services, signature in-flight
entertainment, leather seats, mood lighting, etc., whereas ALK's product
is more traditional. Should ALK phase out the Virgin America branding
over time, it could potentially alienate some customers that appreciate
VA's offerings. That said, ALK has a strong reputation among its
customer base, and has won recognition in the industry for its on-time
performance and low number of customer complaints.
Operating Margin Headwinds:
ALK will likely face some margin headwinds as it works to fold a less
profitable carrier into its network. VA generated a positive net income
for the first time in 2013 after generating years of losses since its
first flights in 2008. Margins have improved sharply since then,
partially due to a pause in the company's aggressive growth rates and
partially due to low fuel prices and a highly favourable U.S. aviation
market. Nevertheless, VA generated an EBIT margin of 12% in 2015
compared to 23.8% at ALK and an industry average of around 17.5%. ALK
has been one of the most profitable airlines in North America in recent
memory, consistently generating margins well above most network
operators, and only lower than carriers like Spirit and Allegiant. Fitch
believes that ALK's high level of profitability and sustained efforts
towards reducing unit costs reflect well on ALK's management team and
Fitch believes that ALK may be able to drive better results into VA's
operations over time. Nevertheless, some near-term headwinds are likely.
VA's low historical margins were partially driven by its position as a
start-up, and its efforts to grow aggressively in highly competitive
markets. The company started out by quickly building its presence in its
of its focus cities of Los Angeles and San Francisco, going from 13
aircraft at the end of 2008 to 53 aircraft by the end of 2008. That high
level of initial growth along with a tough operating environment drove
the company into a precarious financial position by 2013 which prompted
its primary shareholders to agree to sharply reduce its related party
debt, and its lessors to renegotiate many of its operating leases. The
2013 recapitalization, the proceeds from its 2014 IPO, and a pause in
its capacity growth, have allowed VA to greatly improve its balance
sheet, reduce interest costs and lease expenses, and create a much more
sound financial profile in recent years. Nevertheless, on a standalone
basis, VA represents one of the weaker credit profiles among North
American carriers. The combination of the two companies will represent a
material improvement for VA's credit risk profile and a marginal
deterioration in ALK's credit profile.
Integration Risks:
Merger integration issues represent a key risk. United's merger with
Continental provides an example of a combination that presented serious
difficulties, as technology issues and troubles combining the two
workforces have led to years of sub-optimal performance. The full
integration of the two carriers is likely to take several years once the
deal closes, and execution risks will remain a primary area of concern
throughout that time. Although Fitch does not expect it at this time,
serious merger integration issues could put pressure on ALK's ratings.
There is some risk that the merger will face objections from the
Department of Justice. Fitch feels that the relatively small size of the
two carriers, particularly compared to the large airline mergers that
were approved over the past decade, gives the deal a strong chance of
being approved. The fact that the combined carriers will arguably have a
better competitive position against the larger network carriers may also
mitigate concerns over anticompetitive issues. Nevertheless, the
Department of Justice had some serious objections to the American
Airlines/US Airways merger, and there is a risk that any further
consolidation in the industry may be viewed negatively.
The merger will improve ALK's position among the U.S. airlines to a
stronger #5 behind the big four operators (AAL, DAL, UAL, LUV) that
control over 80% of the traffic. Although it will still pale in
comparison to its larger rivals (LUV generates around $18 billion/year
in revenue while the other three all generate around $40 billion), the
combined ALK/VA network will allow the company to compete more broadly.
Fitch also sees some benefits from the geographic diversification
created by the merger. The combined company would have less emphasis on
ALK's position in the Pacific Northwest.
Fleet Considerations:
The acquisition will require ALK to integrate a new fleet type into its
network. Alaska currently operates an all Boeing 737 fleet at its
mainline operation (Alaska Air Group's regional subsidiary, Horizon,
operates Bombardier Q400's), while Virgin America has a fleet of 60
Airbus A319s and A320s. Maintaining a new fleet type will create some
inefficiencies in terms of maintenance, spare parts inventory, crew
flexibility etc. However, at 60 planes, Virgin America's fleet has its
own critical mass, and maintaining separate maintenance operations and
crews for those aircraft is unlikely to cause significant harm to ALK's
cost structure. ALK's management has also shown that they can run a lean
operation, and they will bring that experience with them when combining
the two fleets.
Another key difference is that Virgin America largely leases its fleet,
whereas most of ALK's aircraft are owned. 53 of Virgin America's 60
aircraft are under operating leases, whereas only 27 of Alaska Air's 147
mainline aircraft were under operating leases. ALK will likely have to
have to accept VA's existing leases for the intermediate term. Virgin
America's fleet is relatively young, and its operating leases do not
begin to expire until around 2020. It is unclear at this point whether
ALK will maintain the two fleet types over the long run, or if they may
attempt to move back towards a single type once VA's leases begin to
roll off over the next decade. In either case, ALK will likely have some
additional bargaining power with both aircraft manufacturers when as it
evaluates its next aircraft purchases.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for ALK include:
--Sustained modest macroeconomic growth in the United States;
--Mid-single digit annual capacity growth for the combined carriers;
--A conservative fuel price assumption with crude oil rising to around
$75/barrel by 2019;
--A significant portion of free cash flow being directed towards debt
reduction over the forecast period.
RATING SENSITIVITIES
Factors that could individually or collectively prompt a negative rating
action include:
--Adjusted debt/EBITDAR sustained above 3x;
--FCF falling to the low single digits or below as a percentage of
revenue;
--Failure to actively pay down debt in the 12-24 months following the
completion of the transaction;
--FFO fixed charge coverage sustained below 3x-3.5x.
Fitch does not anticipate a positive rating action in the near term.
FULL LIST OF RATING ACTIONS
Fitch has placed the following rating on Rating Watch Negative.
Alaska Air Group, Inc.
--Issuer Default Rating 'BBB-'.
Additional information is available on www.fitchratings.com.
Applicable Criteria
Corporate Rating Methodology - Including Short-Term Ratings and Parent
and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362
Additional Disclosures
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