Last week, JetBlue Airways (JBLU -3.21%) shocked analysts and investors by offering to buy Spirit Airlines (SAVE -3.80%) for $33 per share. This proposal easily topped the implied value of Frontier Group's existing agreement to buy Spirit, even though Frontier Airlines is a far more natural merger partner for Spirit than JetBlue.
Yesterday, I highlighted two key reasons why JetBlue wants to buy Spirit despite the carriers' dramatically different business models. However, while bulking up could unlock substantial revenue and earnings growth potential for JetBlue, the acquisition plan could backfire in two key ways. Let's take a look.
Big antitrust hurdles
The biggest potential pitfall for JetBlue Airways is that antitrust regulators will likely frown on its takeover proposal. First, JetBlue and Spirit Airlines are the two largest airlines in Fort Lauderdale. Combined, they carry over 50% of the airport's passengers, which could give JetBlue considerable market power if it acquired Spirit.
Second -- and more significantly -- JetBlue's average fare (including ancillary fees) is more than 50% higher than that of Spirit. Its costs are significantly higher, too. Consequently, regulators are likely to conclude that removing Spirit Airlines from the competitive landscape in favor of a larger JetBlue would lead to higher fares.
Image source: JetBlue Airways.
JetBlue executives vehemently disagree with this analysis. They argue that the four big airlines that dominate the U.S. industry often ignore ultra-low cost carriers like Spirit when setting their prices, whereas they respond vigorously with price cuts and added capacity when JetBlue enters a new market. As a result, JetBlue says that its proposed acquisition would be good for competition and lead to lower fares on average due to rivals' price-matching behavior.
JetBlue claims it has lots of data to support these claims, but I doubt that it will convince regulators at the U.S. Department of Justice (DOJ). After all, the DOJ is challenging JetBlue's alliance with American Airlines, which seems much less likely to be anticompetitive than buying Spirit Airlines. Perhaps JetBlue could convince a judge and defeat a lawsuit by the DOJ to block the takeover, but going to court would be very costly, and the company couldn't be sure it would win the case.
Making matters worse, JetBlue has agreed to include a "reverse break-up fee" in its acquisition proposal. Thus, if antitrust regulators were to succeed in blocking the takeover, JetBlue would have to pay Spirit Airlines a sum that could total hundreds of millions of dollars.
Can JetBlue succeed in rivals' biggest hubs?
Even if JetBlue were permitted to buy Spirit Airlines, the company's leadership may be overestimating its ability to operate profitably in many of Spirit's current markets.
Image source: Spirit Airlines.
Specifically, Spirit Airlines has significant operations in five of the biggest U.S. connecting hubs: Atlanta, Chicago, Dallas-Fort Worth, Detroit, and Houston. Legacy carriers tend to protect big hubs like these by aggressively matching rivals' fares to deter major competitive intrusions. However, Spirit has found success because its rock-bottom cost structure allows it to stimulate new demand with extremely low fares.
With higher costs and smaller ancillary revenue streams, JetBlue would need to charge significantly higher fares to make money in these markets. That might give the legacy incumbents an opportunity to push JetBlue out of their hubs by cutting fares to levels that JetBlue can't match.
Investors are overreacting
JetBlue stock quickly sank from around $14 to $12 in the days after its takeover proposal went public, knocking more than $600 million off its market cap. That seems like an overreaction.
The $33 per share that JetBlue is offering for Spirit looks like a reasonable price, considering how the acquisition would enable it to grow in key markets like Fort Lauderdale and Orlando, Florida; Las Vegas; and Los Angeles. While I'm skeptical that JetBlue can compete effectively in other airlines' biggest hubs, it could always scale back in those cities over time and redeploy aircraft to more attractive growth opportunities.
In short, I think acquiring Spirit Airlines at the proposed price would be good for JetBlue on balance. The biggest downside risk is that the DOJ might successfully sue to block the deal. But in that scenario, the costs JetBlue would incur will almost certainly be less than $600 million. As a result, the recent plunge in JetBlue stock looks like a buying opportunity for long-term investors.
