On Wednesday morning, Bloomberg reported that Virgin America (NASDAQ:VA) may be looking to sell itself, sending the stock up 13%. The carrier was contacted by a potential buyer, according to Bloomberg, and it is now working with a financial advisor to reach out to other potential suitors.
It's possible that this takeover speculation won't lead to anything concrete. But let's take a look at who might be interested in bidding for Virgin America.
The legacy carriers are out
Virgin America would be an attractive target for any of the three big legacy carriers. It operates in desirable markets, with major bases in San Francisco and Los Angeles -- two crowded airports. Virgin America also chases the same valuable high-fare business travelers that the legacy carriers constantly fight over.
However, the U.S. airline industry has become highly concentrated in the past decade due to a round of mergers among the largest airlines in the country. Federal regulators are already very worried about insufficient competition in the industry. As a result, they are unlikely to let the legacy carriers grow any further through mergers.
What about Southwest?
Frank Holmes, the CEO of the world's only airline ETF, opined on Wednesday that Southwest Airlines (NYSE:LUV) could buy Virgin America.
Southwest Airlines is about half the size of the three big legacy carriers, but in the domestic market, the size difference is much smaller. This means that it, too, could run into antitrust issues if it tries to buy Virgin America. However, Southwest would at least have a chance of appeasing regulators through modest divestitures.
A bigger issue is the poor strategic fit between the two companies. Both Southwest and Virgin America utilize single fleet types to reduce costs. However, Southwest uses the Boeing 737 family, whereas Virgin America uses the Airbus A320 family. If it purchased Virgin America, Southwest Airlines would have to replace its entire fleet with 737s, which could be fairly expensive.
Southwest and Virgin America also have different target customers. Virgin America has eight plush first class seats on every airplane, whereas Southwest doesn't even have an extra-legroom section. Virgin America offers all kinds of high-tech bells and whistles, while Southwest's planes still have a somewhat spartan feel.
As a result, if Southwest were to buy Virgin America it would have to replace the latter's planes and it might also have to develop a different customer base. That's hardly a recipe for a successful merger.
JetBlue would be a better merger partner
JetBlue Airways (NASDAQ:JBLU) would be a much more suitable merger partner for Virgin America than Southwest. It is about a third of Southwest's size, so antitrust regulators would be much less likely to object to a JetBlue-Virgin America tie-up. (It also helps that JetBlue is mainly an East Coast airline, while Virgin America is based on the West Coast.)
Furthermore, JetBlue primarily operates A320 family planes, so it would be able to relatively easily integrate Virgin America's fleet into its own. Finally, JetBlue focuses on "high-value geography" where it can attract customers who are willing to pay a modest premium for better service. That's very similar to Virgin America's target market.
This isn't to say that Virgin America would be a perfect fit at JetBlue. While JetBlue does have extra-legroom seats on every flight, it only has a first class-like section on a handful of routes. Virgin America fans who pay up for the carrier's first class seats might look elsewhere if JetBlue moved to a single-class configuration on other routes.
Nevertheless, the strategic fit between JetBlue and Virgin America is pretty good. A merger would give JetBlue a much stronger West Coast presence while providing Virgin America customers access to a much broader route network, creating significant revenue synergies. The companies would also gain cost synergies from greater scale.
Private equity firms could be interested, too
Virgin America could also be an interesting target for private equity firms. First, the stock is quite cheap -- even after its 13% surge on Wednesday, it trades for a little less than 10 times forward earnings.
Second, Virgin America ended 2015 with $496 million of cash on its balance sheet, or roughly $11 per share. A private equity firm bidding for the company would be able to use some of that cash to cover the purchase price.
Third, Virgin America is likely to generate plenty of free cash flow in the next few years. While the company is buying five new A320 planes this year, it doesn't have any further aircraft purchases scheduled until 2020. (It has agreed to lease 10 planes that will arrive in 2017 and 2018, though.)
As a result, Virgin America could potentially produce $200 million to $300 million in annual free cash flow over the next few years. This would allow a private equity firm to borrow a lot of money to cover the purchase price but then quickly pay down that debt.
Virgin America doesn't need to sell itself. It has a solid stand-alone business plan based on maintaining its premium positioning while gradually growing into new markets. But if it manages to spark a bidding war among potential suitors, Virgin America just might get an offer it can't refuse.