OREANDA-NEWS. 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.