Since the dawn of time, or, uh, the dawn of Virgin America, the airline has planned to go public. There has always just been one little problem. Virgin America was losing tons and tons of money. But after 7 years of flying (one of them profitable), the airline has decided the time has come. Virgin America filed its S-1 with the Securities and Exchange Commission (SEC) indicating that an initial public offering (IPO) is on its way. Will anyone want to actually buy the stock?
The great thing about an S-1 is that it provides all kinds of fun details, explaining why a stock will be a great investment. In this case, it tries to lay out the case for Virgin America. Ultimately, however, investors want to know if they are going to make money on a stock. And that means believing the story the company is telling.
Looking backwards, Virgin America has had a couple good quarters, posting its first full year profit last year. But that does not make for a solid track record. And the airline knows that. Take a look at this statement under the doom-and-gloom “Risk Factors” section, which is an entertaining read in any company’s filing.
We have a limited operating history and have only recorded one year of profit, and we may not sustain or increase profitability in the future.
We have a history of losses and only a limited operating history upon which you can evaluate our business and prospects. While we first recorded an annual profit in 2013, we cannot assure you that we will be able to sustain or increase profitability on a quarterly or an annual basis. In turn, this may cause the trading price of our common stock to decline and may materially adversely affect our business.
Yeah. That. But, Virgin America says, it has a sustainable business model that enables the airline “to compete effectively with other low-cost carriers, or LCCs, by generating higher revenue per available seat mile, or RASM, but at a cost per available seat mile, or CASM, comparable to that of other LCCs.”
Unless I’ve lost the ability to do basic math, if your costs are the same and your revenue is higher, then you shouldn’t be lagging in profitability compared to your competitors. Virgin America posted a 5.7 percent operating margin last year. For Virgin America, that’s stellar, but it lags every other LCC in the US.
You’ll notice I’m using operating margin and not net margin. There’s a reason for that, and it’s directly tied to how Virgin America wants to use this IPO money. See, Virgin America will use a big chunk of the proceeds (though we don’t know how much is being raised in total) to pay off the debt that has kept the airline flying over the years. That means the Virgin Group will get its $400 million back (in exchange for some other favors) and Cyrus Capital will get $250 million. The interest payments on that money comes outside of operating income, so while retiring the debt would help profitability, it wouldn’t help the underlying fundamentals of the airline’s business.
For what it’s worth, I don’t blame Cyrus Capital for wanting to get its money back. Virgin America has restructured its debt several times over the years (the biggest reason, along with lower fuel prices, why the airline actually posted a profit last year), but Cyrus has remained in the mix. Now the time has come, if Virgin America can convince potential investors to buy stock. But those investors know that there’s not much to see looking backwards. Let’s look forward to see if things are indeed looking rosy enough.
Virgin America has styled itself as a low cost, high revenue kind of airline, but as we’ve already seen, its costs aren’t low enough and its revenue isn’t high enough.
On the cost side, it says it has a low cost structure due to a young fleet, single fleet type, and high utilization. But looking forward, young fleets get older and more expensive to maintain. And unless there’s a big change in planned operations, that “high utilization” thing is a myth. Virgin America’s aircraft utilization has steadily dropped from 12.7 hours a day in 2010 to 10.8 hours a day in 2013. That’s not high utilization.
The airline will rely on growth to keep its costs down and to get more scale so that unit revenues increase as the airline becomes more capable of serving business travelers on a wider variety of routes. Virgin America has 53 airplanes today, but starting next July, the airline will take 10 new airplanes within 12 months. (That may very well be why Virgin America needs this IPO now, to pay for those suckers.)
The problem is, however, that Virgin America doesn’t have a ton of places to put these airplanes. Sure, there will be a little going to Dallas to grow the airline’s new Love Field operation. But Virgin America is capped at 2 gates and much of the flying is just being transferred from Dallas/Ft Worth. Most of the rest is being funded by cutting existing flights elsewhere, like Philadelphia. So that’s not really a growth thing.
Instead, Virgin America makes it clear in the S-1 that it expects future growth to happen in its hubs in both LA and San Francisco, but how? There are gate constraints in both places, and I’m not convinced there are a bunch more markets out there that need A320s in them anyway. In general, LA is about to become a bloodbath with American now seeming dead-set on building its Asian gateway there. San Francisco may be better, but how many routes can you think of that make sense? Most are probably other airline hubs, and that doesn’t usually work out so well.
Growth is one thing, but then you also have to look at prospects for the existing operation. Other airlines are ramping up on routes where Virgin America has done well. Most importantly, the JFK-LA and SF markets do really well for Virgin America, but it’s been an arms race to create the best product there. Virgin America now has the worst seat in the premium cabin on that route. Meanwhile, JetBlue is really ratcheting up pressure with its Mint business class offering. Regardless of whether it’s good for JetBlue, it can’t be good for Virgin America as fares are low. And there’s a chance that product will expand to other markets.
The only real saving grace here for Virgin America is if the economy continues to hum as it does today. The domestic market is really, really strong so fares are high. If you think this is going to continue like this for years, then that would bode well for Virgin America’s success. But look at the history of this industry and the good times don’t tend to last all that long. Maybe it’ll be different this time with all the consolidation that’s happened. And maybe the big airlines will get too greedy and create enough of a fare canopy to allow Virgin America to thrive. If enough people believe that, then this might be an interesting IPO.