Alaska Air Premium Purchase of Hawaiian, is the merger worth it?

First some history…

Merger and acquisitions have been a fixture of the American aviation industry since the sector was let off its leash in 1978. The Airline Deregulation Act phased out the Civil Aeronautics Board (CAB) which up until that point had controlled all domestic interstate air transport routes as a public utility, regulating fares, routes as well as market entry of new airlines. Its neutering, intended to open up the market and serve customers better, had long term unforeseen consequences.

The resulting fare competition beat airline industry participants soundly between 1977 and 2009, forcing a series of mergers between 2005 and 2015. After the bloodbath, airline traffic in the U.S. was controlled by four players American Airlines, Delta Air Lines, Southwest Airlines and United Airlines, which captured over 60% of the business, 80% if you consider international travel. None of the remaining players even come close to controlling 10%.

In the wake of this grand consolidation, consumers’ worst fears were realized as airfares increased, but after low-cost carriers started expanding services in 2016 straining the market, the standing oligopoly pushed toward monopolistic competition and the mergers between smaller players continued at whatever cost necessary.

Now some context…

This was most notably illustrated by Alaska Airlines (ALK) $2.6 billion merger bid for relatively young upstart Virgin America in 2016. The deal didn’t necessarily make sense on the surface. The money Alaska was offering was at a 47% premium to Virgin’s value when Virgin’s mostly leased Airbus aircraft were incompatible with Alaska’s all-Boeing fleet. Not to mention Virgin owned little to none of its infrastructure and had a lackluster frequent flier program.

In fact, Virgin had only managed to post a profit of $206 million in 2015, so at that rate, it would take Alaska 13 years to recoup its investment in the smaller carrier. This without considering the massive effort and capital it would take to integrate Virgin’s fleet, business and staff into Alaska. Why would they commit so much for seemingly so little?

Behind the scenes, the incentive for Alaska’s proposed deal was much clearer. Besides removing the annoyance of Virgin’s competing cut-rate fares, Alaska, the seventh largest airline in the U.S. at the time, needed to bulk up to fend off Delta Airlines, who was continuing to take bites out of Alaska’s business in Seattle. Alaska also needed to nip JetBlue’s competing bid for Virgin in the bud as losing the deal to JetBlue would have unpleasant long term repercussions.

After further sweetening the deal to ensure the support of Virgin’s employees, Alaska successfully closed the transaction and began what some analysts would describe as a disastrous integration process that took approximately three years to complete, making Alaska the fifth largest airline carrier in the U.S. Market pundits remarked that the process had been so cumbersome that Alaska may have had its fill of acquisitions and we wouldn’t see them entering the arena again.

The matter at hand:

However, in a post pandemic world, all bets are off and Alaska has once again bellied up to the merger table with a $1.9 billion offer to purchase Hawaiian Airlines. The proposed transaction offers $18 per share for a stock that closed on Friday at $4.86. The announcement triggered an investment rush, pumping Hawaiian’s value 193% to $14.22 by the end of trading on Monday. That still puts Alaska’s bid at a 26% premium. Alaska’s SP slid up to 19% on the day of the announcement. Shares have recovered somewhat since, but are well below trading on the Friday before Alaska made its intentions known. Should Wall Street be so sour?

Cons:

In its latest quarterly report, Hawaiian experienced a net loss of $48.7 million. The Maui wildfires back in August, which caused damage in excess of $6.0 billion, halted traffic to Maui. Even though recovery efforts have opened up portions of West Maui to tourism in October, demand for travel, although increasing, is well below historic levels. In fact, analysts suggest that 2019 tourism levels won’t return until at least 2025. Growth is anticipated to be in the mid-single digits during 2024.

The airline is also currently plagued by engine issues when Pratt & Whitney announced recall inspections of its PW1100G-JM engine fleet which currently powers Hawaiian’s A321 neo aircraft. The inspections are ongoing, causing unanticipated fleet downtime.

Construction of a new runway project at Daniel K. Inouye International Airport (HNL) is presenting the potential of delays of 20 to 40 minutes on average, the construction is expected to continue through to 2024. This airport improvement project has also raised costs for Hawaiian and other airlines operating out of HNL.

Southwest has crept into the intra-island market where Hawaiian had a considerable lead in, but now has fallen from ~80% to ~60% with Southwest going from ~10% to ~30% of the market.

Hawaiian also has a fair amount of debt, and the majority of it, including $1.2 billion loyalty notes and its 2013-1 EETCs, matures in January 2026 which the airline will have to renegotiate. If economic headwinds and market challenges continue for the company, those negotiations will be less than favorable.

Pros:

Hawaiian and Alaska are the second and third largest players respectively flying US mainland to Hawaii. By merging, the resulting combination would become the undeniable leader with more than 40% of $8.0 billion pacific island airline market. The merger would also bolster Hawaiian’s intra-island efforts, successfully staving off Southwest’s growing intrusion.

The Hawaiian merger would also expand Alaska’s international footprint beyond the six countries currently serviced by the airline as well as opening opportunities in the Asia-Pacific Region where Alaska has never operated before, including Auckland, New Zealand; Fukuoka, Osaka, Tokyo Haneda and Tokyo Narita, Japan; Pago Pago, American Samoa; Raratonga Island, Cook Islands; Seoul Incheon, South Korea; Sydney, Australia; and Tahiti, French Polynesia.

Hawaiian has dedicated 10 A330-300Fs to a deal with Amazon for package delivery and began delivery in October, this new revenue stream is based on an eight-year contract and if all goes well an additional two and three year period.

There is considerable liquidity in Hawaiian, which the company reporting $1.3 billion in cash, short term investments and full revolver ability. This will help offset costs and capex requirements as the company modernizes its fleet with the delivery of 787-9s starting 2024.

Unlike the Virgin merger which ended in a costly trademark dispute long after integration, Hawaiian keeps its colors, its operations and its culture. This will free up both airlines to focus on the business of making money instead of shoe-horning their operations together.

So what does this all mean?

Considering the current economic environment and the general state of the airline industry, Alaska’s outsized offer makes more sense and Wall Street may be taking things a little cautiously. If the combined entity can continue to execute and reach its milestones, it will remain in play and may even retain its market position even if the JetBlue-Spirit deal gets regulatory approval. Speaking of which, the Alaska-Hawaiian transaction, although approved by both boards, still needs to make it past regulators. Good luck to all.

–Gaalen Engen