Virgin America Earnings Miss: Why Alaska Air Investors Shouldn't Worry

By Markets Fool.com

Virgin America (NASDAQ: VA) quietly reported subpar earnings for its second quarter on Friday afternoon. With the West Coast airline already set to sell itself to Alaska Air (NYSE: ALK) for $57 per share in cash, Virgin America investors don't really have a stake in the company's financial results anymore.

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On the other hand, Alaska Air investors may be nervous, given the hefty sum that Alaska is paying for Virgin America. However, Virgin America's Q2 performance wasn't quite as bad as it seemed -- and the merger will unlock significant revenue synergies that will boost the profitability of Virgin America's present-day route network.

Virgin America posted worse-than-expected Q2 earnings. Image source: Virgin America.

Profit plunges -- with a few caveats

For Q2, Virgin America reported a 41% year-over-year profit decline as net income fell from $65 million to $38 million, due in part to a sharp drop in unit revenue.

The two figures aren't really comparable, though. In 2015, Virgin America wasn't accruing any taxes, thanks to its long history of operating losses that only ended in 2013. Virgin America is still years away from actually handing any money over to Uncle Sam, but it is now reporting taxes on its income statement.

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Thus, pre-tax results are a better indication of the year-over-year earnings trend at Virgin America. On that basis, and excluding $4.4 million of one-time merger-related costs, Virgin America's profit actually increased modestly year over year. Lower fuel costs essentially offset the decline in unit revenue.

Virgin America's management also noted that the company benefited from a one-time revenue adjustment in Q2 2015 that boosted its unit revenue (and profit margin) by about 1 percentage point a year ago. Finally, Virgin America had five major aircraft maintenance events last quarter, compared to none in Q2 2015.

Still making plenty of money

Virgin America's unit revenue decline, while severe, wasn't much worse than what many of its competitors -- including Alaska Airlines -- experienced last quarter. To some extent, the wounds were self-inflicted, as both Virgin America and Alaska Airlines grew capacity at double-digit rates last quarter.

Additionally, Virgin America's adjusted pre-tax margin during the second quarter was a very respectable 15.9%. That fell far short of Alaska's industry-leading 28.4% adjusted pre-tax margin, but it still indicates that Alaska Air is acquiring a highly profitable business. Furthermore, the merger itself should make Virgin America more profitable.

Don't underestimate the merger synergies

In the short term, Virgin America will continue to operate separately from Alaska Airlines after the merger is completed. In that sense, Alaska Air will simply be acquiring the earnings of Virgin America. This alone could boost its earnings per share by about $1.

But in the long run, the biggest benefit will come from unlocking revenue synergies. Alaska's management has estimated the long-term revenue synergies at $175 million annually.

The Alaska-Virgin America merger will drive substantial revenue synergies. Image source: Alaska Airlines.

Some of those revenue synergies will come simply from combining the Alaska Airlines and Virgin America route networks to offer even more travel options to and from the West Coast. However, introducing regional jets into Virgin America's primary markets of San Francisco and Los Angeles represents an even bigger opportunity.

Virgin America's all-mainline fleet helps keep costs down, but it makes it hard to serve smaller markets -- or to match competitors in terms of flight frequencies on busy routes. By contrast, Alaska Air operates turboprops and regional jets through its Horizon Air subsidiary. It also contracts with SkyWest for additional regional jet flights.

Alaska Air could quickly grow the combined airlines' route network in San Francisco and Los Angeles with new regional jet service from those airports. For many business travelers, the increase in flight options would make Alaska Air much more useful than Virgin America is today. This would help the combined company win more lucrative corporate travel contracts.

Still a good merger

Back in April, when the merger was announced, many Alaska Air shareholders balked at the $2.6 billion price tag. Undoubtedly, Virgin America's recent performance hasn't helped reassure them that the transaction will work out.

However, despite facing significant unit revenue pressure, Virgin America remains highly profitable. As a result, it will provide an immediate earnings boost for Alaska Air after the merger closes. Moreover, revenue synergies will make Virgin America's San Francisco and Los Angeles focus cities even more profitable going forward, driving strong future profit growth at Alaska Air.

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Adam Levine-Weinberg owns shares of Alaska Air Group. The Motley Fool recommends Virgin America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.