Purchase (Special Situation): Virgin America Takeover

I need to diversify my risk arbitrage positions and took a new position. Unfortunately the returns are low and nowhere near by 10% or so target, but the deal is supposed to close within a few months so I think it's ok.

Alaska Airlines, a Seattle-based discount airline, has offered to purchase another discount airline that was just IPOed a couple of years ago: Virgin America (VA). My opinion is that the probability of success is very high so it seems worth doing it. However, one analyst mentioned the takeover price might be lowered if major divestitures are required in order to satisfy the government so that is something you should be seriously consider if you take a position. If that analyst is correct, it is possible to lose money on this (at current prices) even if the deal closes successfully.

This Bloomberg article is quite good in summarizing the current state of affairs. As usual, if you are interested, you should read the relevant documents filed by both parties (they have a website set up just for the deal). Unlike professional risk arbitrageurs, amateur investors like me often hang on to failed merger companies so if you fall in that category, you should check out that merger website to get up to speed on these airlines.

Takeover price: $57

Deal closing: January 1, 2017

Purchase price: $54.08

Prob (success) = 99%
Return  (success) = 5%
Prob (failure) = 1%
Return  (failure) = -48% ( assume it drops to $28 pre-takeover price, minimum over the last few years)

Expected Return = 4.9%

Buffett's Four Key Questions

(1) How likely is it that the promised event will indeed occur?

Alaska Airlines is one of the few airlines with investment-grade debt and should have no problem with financing, which is supposed to include cash on hand, assumption of debt, and new debt.

The real risk is regulatory. Discussions are underway with DOJ and some analysts have said that some landing slots might need to be given up (government wants to maintain competition and ensure low-cost airlines have landing slots, which are valued due to congestions at some major airports). One analyst says buyout price might be lowered to $50 if major concessions required.  I'm just a total newbie with these things and this is the first time I heard of something like that (I have seen deals being renegotiated due to economic conditions or company business deteriorates but not when the risk is known going into the deal). If a lower price scenario is true, this is one of the risks here and it may be possible to lose money even if the deal closes (it seemed unusual and unlikely so I went ahead with this position).

Finally, a consumer lawsuit challenging merger is being heard by judge in December or January 2017. I think if the DOJ clears the merger, the consumer lawsuit will probably be dismissed quickly (after all, if the DOJ  investigation will look at most of the issues related to antitrust issues and competition concerns so that should address the issues raised.)

This deal makes a lot of strategic sense for Alaska Airlines so I can't seem them trying to back out of it. Alaska dominates the west coast and Virgin is mostly on the east coast. The cross-America flight is lucrative, not to mention popular between major cities, so this merger is strategically very attractive.

(2) How long will your money be tied up?

Merger parties expect deal to be completed by January 1, 2017. The lawsuit by a few consumers being heard by judge could be as late as January 2017. Required divestitures may delay things. Worst case is probably end of Q1 2017.

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

This is one of those situations where a better deal may come. It may not happen right away but Virgin Airlines is a fairly well-run discount airline with good brand and strong consumer ratings.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

One downside to this deal is that the downside is fairly large if the deal fails. Pre-takeover price and the minimum price over the last few years is around $28, which is about 48% below current price. There will be a massive loss if the deal fails. The downside is large because the takeover offer price was very favourable. What this means is that shareholders are more likely to be receptive to the deal--in this case they already voted and approved--and hence the probability of success is much higher. In other deals where the takeover premium is low, which often makes it look like bidder is buying the company cheaply, often can be derailed by shareholders voting against it, or major shareholders challenging the price, and so forth; that's not the case here.

I will likely hold the shares if the deal fails since this appears to be a good airline. It has high consumer ratings, is growing revenue, has a modern fleet, and has access to some valuable slots in major US eastern airports. Airlines were terrible businesses but it appears the industry has been profitable over the last decade (the Alaska Airlines presentation on the merger suggests that the super-long-term terrible performance of the industry may have ended: their slide 9 shows the industry having lost $52 billion between 1977 and 2009, while earning $45 billion between 2010 and 2015). Who knows for sure, but one thing is that government-owned national airlines have mostly disappeared and this has likely improved the industry (government-run airlines in the past were not profit-oriented and were run at losses and uneconomic decisions were the norm). Furthermore, the decline in travel costs, largely due to low-cost carriers, fuel efficiency improvements, and information technology adoption, has also resulted in more people travelling, hence improving utilization rates and industry profitability. Some recent changes by airlines, such as charging for checked-in luggage, has generated additional revenue for them too (but not sure if this is going to blowback in the future). This is still a capital-intensive industry and not an ideal investment but appears much better than the past.


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