Alaska Air (NYSE:ALK) finalized its acquisition of trendy competitor Virgin America last week. This acquisition should provide a big boost to Alaska Air's earnings next year. Virgin America has earned a pre-tax profit of nearly $200 million over the past 12 months, whereas the annual cost of financing for the deal is less than $50 million.
However, in the long run, the main way that Alaska will benefit from this acquisition is through revenue synergies and new organic growth opportunities. In particular, Alaska Air's experience with using regional aircraft like Embraer's (NYSE:ERJ) E175 opens up lots of growth opportunities in San Francisco, Virgin America's main base. That could be worrisome for market leader United Continental (NASDAQ:UAL).
Virgin America has a limited route map
Virgin America is a fairly small airline by U.S. standards, with only 63 aircraft. Fifty-three of those planes are A320s with 146 to 149 seats. There is also a small subfleet of 10 119-seat A319s.
As a result, Virgin America only serves 21 airports (representing 19 cities) from San Francisco. Furthermore, nearly all of its destinations are very large markets -- it lacks the smaller regional aircraft that it would need to be successful on many other routes.
Even with this relatively limited footprint, Virgin America has been quite successful in competing against United Airlines in San Francisco. However, United is a behemoth. It operates about 275 daily flights to roughly 100 destinations from San Francisco. Virgin America's comparatively small scale complicates its efforts to gain share among business travelers.
Alaska Air has a potential solution
Unlike Virgin America, Alaska Air uses regional aircraft to supplement its mainline fleet. This allows it to serve a wider range of destinations from its hubs.
In the past few years, Alaska Air's regional subsidiary Horizon Air has operated a fleet of more than 50 turboprops on short-haul regional routes. Alaska has also been relying increasingly on regional airline partner SkyWest to operate roomier Embraer E175 regional jets on so-called "long and thin" routes. By next spring, SkyWest will operate 20 E175s for Alaska Air, flying routes like Seattle-Milwaukee and Portland-St. Louis.
The Embraer E175 appears to be working very well for Alaska. As a result, earlier this year, it ordered 30 E175s for Horizon Air to operate in-house, with another 33 options. Fifteen of these new planes will be used to replace turboprops; the rest will be used for growth.
By deploying some of these E175s in San Francisco over the next few years, Alaska Air and Virgin America can build up their route network there in a way that wouldn't be possible with mainline aircraft. This will enable them to challenge United Continental on more routes than ever.
Alaska Air begins to expand in San Francisco
Alaska Air hasn't wasted any time in bringing new regional jet service to San Francisco. On the day that the merger closed, it announced three new nonstop routes from San Francisco. Two of those will use Embraer E175s.
Starting next summer, Alaska Air will offer two daily roundtrips between San Francisco and Minneapolis using E175s. It will also offer four daily roundtrips between San Francisco and John Wayne Airport in Orange County, California. With these flight additions, Virgin America and Alaska will together serve 20 of the top 25 destinations from San Francisco.
Both of these new routes have plenty of passenger traffic. However, as a new entrant, Alaska Air is likely to be more successful by starting with small planes, in order to offer multiple daily flights without flooding the market with capacity. As these routes mature in the coming years, they could potentially be upgauged to mainline aircraft.
There are plenty of other routes from San Francisco for which the Embraer E175 would be an ideal aircraft, either for opening new markets or as a long-term solution. The more business routes that Alaska and Virgin America serve from San Francisco, the greater their chances of luring corporate accounts away from United Airlines with the promise of lower fares.
In the next few years, the biggest constraint on adding new E175 flights is likely to be gate space. Fortunately, San Francisco International Airport recently started work on a terminal expansion project that will start to address overcrowding at the airport, enabling incremental growth by 2019 or 2020.
Good news for Embraer?
If Alaska Air's E175 regional jet operations in San Francisco perform well, the company could exercise many of its E175 purchase options in order to expand further. That would be very good for Embraer, which is in the midst of a tricky model transition.
Embraer is already essentially sold out of production slots for 2017. It is scheduled to deliver the first next-generation E2 planes in early 2018, but the current-generation E175 will remain in production for at least three or four years beyond that. Unfortunately, Embraer doesn't have many E175 firm orders for 2018 and beyond as of now.
Alaska Air could be a key source of incremental E175 orders for Embraer during the 2018-2021 transition period. Indeed, the E175 is uniquely suited to accelerating Alaska Air's growth in San Francisco, enabling it to expand into markets where Virgin America has historically been unable to compete.