Virgin America: profits/growth dilemma as IPO nears March 2014

Virgin America, the award-winning San Francisco-based LCC, faces an interesting challenge: how to consolidate profitability and go public successfully in late 2014 or early 2015, while taking advantage of some unexpected, rare growth opportunities.

Virgin America has at last become profitable. After net losses totalling $651m since the beginning of 2008, when it began reporting its results (operations launched in August 2007), the carrier has now had three consecutive profitable quarters (including Q4 2013, which as of March 19 had not yet been reported). 2013 is likely to have been Virgin America’s first profitable year.

The turnaround was a direct result of Virgin America’s late-2012 decision to halt ASM growth, which had been running at a dizzying 30%-plus annually. In 2013 Virgin America’s capacity declined by 2.2%.

The idea was to maintain strict capacity discipline at least a while longer, so that there would be a nice string of profitable quarters to present to potential IPO investors.

The IPO cannot be delayed much longer, because Virgin America’s original investors have bailed out the company on several occasions and because new aircraft deliveries from Airbus are scheduled to begin in the second half of 2015.

Indeed, in recent months Virgin America has stepped up preparations for a potential IPO. In February it named the investment banks that will lead the offering (Barclays and Deutsche Bank). There have been moves to strengthen the board and management team (notably the appointment of Intel’s CFO Stacy Smith to the board). Both CEO David Cush and minority investor Richard Branson have talked of Q3 or Q4 2014 being the target periods for an IPO (subject to favourable market conditions, of course).

But now there is a potential spanner in the works — something that could make it harder for Virgin America to consolidate profitability this year: major new route expansion. This is because, surprisingly, Virgin America is poised to become a major beneficiary of the AMR-US Airways slot and gate divestitures.

First, Virgin America won permission to buy six daily slot pairs at LaGuardia (LGA) and four slot pairs at Washington Reagan National (DCA). Since these slots are subject to the rules prohibiting flights beyond a 1,250-mile perimeter, Virgin America will not be able to use them for transcontinental service; instead, it will have to add riskier new service in markets that do not involve its SFO and LAX hubs.

Second, Virgin America is now bidding for the two gates that American is required to relinquish at Dallas Love Field (DAL). If successful — and the chances seem high — Virgin America would expand significantly in the Dallas market from October, aggressively taking on Southwest and American on their home turf.

These are the sort of rare growth opportunities that an airline in Virgin America’s position cannot turn down. In the past Virgin America has had terrible difficulties in obtaining gates and slots at desirable airports.

Of course, there is much Virgin America could do to minimise the adverse short-term financial impact of new expansion. Among other things, it could shed less profitable existing routes. Virgin America has already announced that it will pull out of the LAX-San Jose market in May, after just one year there, in favour of focusing on more lucrative longer-haul expansion.

But the upcoming growth spurt, which may require the airline to lease additional A320s, is certainly something that needs to be kept in mind, as Virgin America announces strong 2013 results in the coming weeks and as the IPO process gathers pace.

An IPO has been on the cards for Virgin America for at least a couple of years. After all, the airline became a “major carrier” in 2011, with annual revenues exceeding $1bn. It will be celebrating its seventh anniversary this August. Last year its revenues were around $1.4bn.

Virgin America has been a huge hit in the marketplace. It has differentiated itself with its blend of friendly, hip upscale service and competitive fares. It has continued to sweep the “best domestic airline” type awards. Like JetBlue, it enjoys significant customer loyalty. After the LAX-San Jose termination announcement, several passengers were quoted saying that they would go a “roundabout” way into SFO International so that they could continue to fly Virgin America, even though the LAX-San Jose route will continue to be served by five other carriers (Alaska, American, Delta, Southwest and United).

Virgin America has developed an attractive niche as San Francisco’s hometown or business airline. The product has been keenly embraced by the typical younger Silicon Valley business travellers, as well as small and medium-sized businesses in the Bay Area generally.

But the lack of profits kept the IPO a pipe dream and necessitated repeated bailouts from Virgin America’s deep-pocketed and patient investors. Cyrus Capital, the airline’s main US investor, played a pivotal role in recapitalising it in late 2009 and helping it raise $150m through a debt offering in December 2011.

In November 2012, after seeing its cash reserves dwindle alarmingly during that year, and with investors evidently unwilling to inject more funds as long as the losses continued, Virgin America finally did the sensible thing: reduced and deferred its substantial A320 order commitments, to drastically scale back growth and preserve its balance sheet.

Under the revised agreement with Airbus, Virgin America’s firm A320 orders were reduced from 30 to 10 and deliveries rescheduled from 2013-2016 to 2015-2016. The 30 A320neo positions were deferred by four years, from 2016-2018 to 2020-2022.

So, after adding 24 aircraft or almost doubling its fleet between Q2 2010 and Q2 2012, Virgin America is taking a 2.5-year pause in fleet growth. Its fleet has remained unchanged since its 53rd A320 arrived in March 2013, and it is not due to take more aircraft until the Airbus deliveries begin in the second half of 2015 (five in 2015 and five in 2016).

The no-growth strategy paid %immediate

dividends. In Q4 2012 Virgin America saw its first-ever fourth-quarter operating profit. In Q1 2013, when its ASMs fell by 4% as a result of much culling of seasonally weak flights, the airline’s unit revenues surged by 18% and its operating loss narrowed significantly.

In Q2 2013 Virgin America recorded its first-ever Q2 net profit of $8.8m. And the Q3 2013 results were a cause for celebration: an operating margin of 11.5% and a net profit of $44.4m.

Assuming a similar rate of improvement in the fourth quarter (for which a small profit was expected), Virgin America is likely to report a reasonably healthy operating margin (perhaps in the 5-7% range) and possibly a small net profit for 2013.

The past year’s turnaround has been driven by a spectacular RASM performance. Having curtailed growth, Virgin America quickly went from an industry-laggard to an industry leader in unit revenue growth. In 2012, when its ASMs surged by 27.3%, it trailed the industry with a mere 1% RASM increase. In January-September 2013, its when ASMs declined by 2.5%, its RASM shot up by 11.1%. The RASM improvement also reflects increased focus on business-oriented routes and strong demand for Virgin America’s product and service.

%The strong RASM growth much more than offset the inevitable unit cost increases resulting from the halting of ASM growth and reduced aircraft utilisation.

Thanks to the positive results from the no-growth strategy, Virgin America’s investors agreed to another major financial restructuring in the spring of 2013. The shareholders agreed to eliminate $290m of the carrier’s debt in return for future stock purchasing rights and to provide an additional $75m of debt.

The investors will obviously be looking to sell at least part of their stakes in the IPO. Virgin America’s shareholders include the UK’s Virgin Group (25% of voting stock) and US-based VAI Partners (75%). The latter has four partners, with Cyrus Aviation Investors being the largest.

The result was a significant improvement in Virgin America’s unrestricted cash position, to $148.2m in mid-2013 (though that was still only 11% of 2012 revenues, very low by US major carrier standards). Also, the airline expected a substantial reduction in interest expenses, to around $20m in the second half of 2013, roughly a third of the prior year amount. Virgin America described the changes as a “first step toward preparing the company for access to the public markets at a future date”.

After years of struggles to access certain key airports, Virgin America began to have better luck three years ago, largely thanks to airline mergers. Its 2010-2012 growth spurt included some of the country’s largest business markets: Dallas Fort Worth (December 2010), Chicago O’Hare (May 2011), Philadelphia (April 2012) and Washington DCA (August 2012).

Those are the type of markets that Virgin America needs for long-term success, given its upscale service. But the higher costs at such airports and the need to aggressively court business traffic amid intense competition may have added to the delays in attaining profitability.

Fortunately, that does not appear to have been the case with Newark, one of the nation’s top business markets, which Virgin America was able to add as its 20th destination in April 2013, with three daily flights from both SFO and LAX. By late summer the Newark operations were already profitable, with Virgin America’s revenue share exceeding its capacity share in both markets. The carrier may have been helped by the strong following it had already built on the transcon sectors out of JFK. Before its entry, SFO-EWR had only one carrier (United) and LAX-EWR had no LCC. After Virgin America began selling its Newark services, fares on the routes dropped by as much as 40%.

Otherwise 2013 was a good time to pause growth, because Virgin America’s management had begun to feel that the airline had reached critical mass. CEO David Cush reportedly said last year that although cities such as Houston and Atlanta were definitely on Virgin America’s list, he was already quite happy with the way the network looked. He has frequently noted that Virgin America now serves nine of the top 10 business markets from SFO and eight of the top 10 from LAX.

But the opportunities arising from the AMR-US Airways divestitures, and the coincident full expiration of the 1979 Wright Amendment restrictions on long-haul flights from Dallas Love Field in October, are simply too good to miss. As CEO Cush observed, “the opening of access to these slot-constrained and gate-constrained airports is an infrequent occurrence at best”.

In its bid for the two gates at Dallas Love Field, Virgin America is proposing to operate a total of 16 daily flights to LGA, DCA, Chicago O’Hare, SFO and LAX. It would be starting new services from Dallas to three major business destinations (New York, Washington and Chicago) and increasing flights to its two current destinations (SFO and LAX). The current operations to LAX and SFO would be moved from DFW — not a sacrifice at all since Love Field is closer to the downtown area. Most of the new flights would start in October, but the Chicago flights would start in early 2015.

Virgin America would use the newly acquired LGA and DCA slots for service from Dallas. It is unclear at this point if it will also bid for the gates that AMR has to give up at ORD.

Southwest, which dominates Love Field (its home base) and currently operates 16 of the airport’s 20 gates, is also bidding for the two AMR gates. It has put forward an impressive proposal to add nonstop service to 12 new destinations from the airport. However, if the DoJ sticks to its stated aim of using the AMR-US Airways divestitures to give LCCs better access to slot or gate constrained airports, Virgin America will win hands down.

IPO prospects

Importantly, the no-growth strategy has been effective in making Virgin America profitable. The airline has proved that there is nothing wrong with its network or business strategy and that the earlier problems could entirely be blamed on too-rapid growth and too-low a percentage of mature markets in the network. Another one or two profitable quarters, and the airline could be reasonably well positioned for an IPO.

However, a major new growth spurt at Dallas, and to a lesser extent New York and Washington, from October might be just a little too early from the IPO viewpoint. It could mean a tight balancing act for the airline.

Virgin America would have to find a way to convince a sceptical investment community that it would be able to manage the growth better than in the past, while remaining consistently profitable. Assurances of future ASM growth amounting to a “manageable” 8-10% may not be enough.

Then again, having some growth lined up at primary airports could be a positive thing for the IPO. Virgin America is looking to expand its fleet to nearly 100 aircraft over the next decade, and it can only do that if it can access the public markets (equity or debt) for funds.