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Will Richard Branson's Virgin America Fly?

 
By Brad Stone
     Dec. 29 (Bloomberg BusinessWeek) -- On a sunny, wind-swept
December morning, Virgin America kicked off a day of festivities
along the otherwise unfestive runways of Dallas Fort Worth
Airport. Four longhorn cattle lolled in a pen while dignitaries
such as Dallas Mayor Tom Leppert lunched on pulled pork and ribs,
and lasso artists twirled rope. The main attraction was the host,
60-year-old Sir Richard Branson, billionaire bon vivant and
founder of the Virgin Group. While he was at the center of the
celebration, he was also making an incursion into enemy
territory.
     The enemy, American Airlines (AMR), dominates air traffic at
DFW. The 80-year-old airline and its affiliates send about 765
flights out of Dallas every day, making up more than 85 percent
of traffic at the nation's fourth-busiest airport. Tiny Virgin
America—with its 36 planes and 1,700 employees—was initiating
just four daily flights, two each to Los Angeles and San
Francisco. Branson, in cowboy boots, chaps, and carrying a cowboy
hat that he looked reluctant to don over his golden locks, was
undaunted by the taxiing AA jets that crawled past the party like
Panzers on patrol. "You now have a choice," Branson told a crowd
of around 200 employees, local politicians, and press. "You can
either go on that other carrier and get their kind of service and
get treated a little bit like those animals over there"—he said,
gesturing to the cattle—"or you can come on the Virgin carrier
and you can have a blast."
     Over the last three years, Virgin America's philosophy of
fun in the skies has shown promise, despite byzantine
regulations, powerful competitors, and the ever-present fact that
airlines, as a whole, tend to hemorrhage money during recessions
and spikes in fuel prices. But the airline is at a turning point,
and its future is far from certain.
     Virgin America offers an alternative to the often cramped,
tedious experience of flying on a so-called legacy airline. Its
Airbus A319 and A320 jets are relatively new, there's in-flight
entertainment in every seat-back, and Wi-Fi Internet access on
every plane. As a result, Virgin has collected a passel of
best-domestic-airline awards over the last three years from
publications such as Condé Nast Traveler and Zagat, and has built
a devoted following among circles such as the West Coast tech
industry. "It's clean, it's new, the music makes you happy, and
the mood lighting makes you calm. It's just better," says Jason
Hirschhorn, the former co-president of MySpace (NWS), who selects
Virgin America flights whenever they are available.
     Geek love and awards, though, can only get a young airline
so far. The skies are a brutally competitive marketplace in which
the legacy behemoths corner routes, dominate major airports, and
lock in customers with frequent-flier programs. Since
deregulation of the airline industry in 1978, more than 100 small
airline startups have come and gone. JetBlue (JBLU) is among the
very few to have survived.
     In November, Virgin America announced its first quarterly
profit, of $7.5 million, on $202 million in revenues, but it lost
$22.5 million over the first half of the year and has lost $400
million or more since its founding in 2004. David Cush, Virgin
America's CEO and a former American Airlines executive, promises
the airline will turn an overall profit in 2011.
     Virgin America's small profit seems less hopeful in light of
the extremely positive environment for airlines. With oil prices
well off their 2008 highs and American travelers enthusiastically
flying again despite the groping hands of TSA agents, the entire
domestic airline industry is in one of those hearty periods when
it makes good money. The Bloomberg U.S. Airlines Index, of 12
U.S. carriers, climbed 22 percent in 2010. "They've created a
niche, but I don't think it's sustainable," says Mo Garfinkle,
chief executive officer of GCW, an aviation consulting firm. "If
something happens—and something always seems to happen in this
industry, whether it's fuel prices or war or SARS—they're in
trouble."
     Virgin America does have at least part of one big asset:
Branson. He is a legendary salesman with a special love of
aviation—not only for the business, but for adventures like his
attempted around-the-world balloon flights. To hear him talk,
profits are almost secondary to his mission with Virgin America.
"American carriers are all very much the same, and the people who
run them do not think of the customers at all," says Branson,
sitting in the first row of one of the airline's parked,
white-and-red painted A320s. "It's become a bus service." As
guests mingle on the tarmac under the bright Texas sky, the
interior lights bathe the cabin in a deep magenta, meant to evoke
dawn. "If everything is a joy, if you come onto a plane and the
lighting is right, the seating is right, and the cabin crew is
happy, you feel welcome," Branson says. "It's like you have come
into somebody's home."
     Over the last two decades, Branson has applied a focus on
customer service and industrial design to an array of businesses,
some more successful than others. His Virgin Group has started
companies, or licensed its brand to startups, in such varied
fields as mobile phones, trains, hotels, soda, vodka, magazines,
condoms, and, most recently, space tourism.
     Branson first tried to start a domestic U.S. airline in the
1990s and discussed teaming up with former Southwest Airlines
(LUV) executive David Neeleman. Branson was concerned, however,
about a U.S. law restricting foreign ownership of domestic
airlines, which would require him to turn over control of the
Virgin brand to Neeleman. The Federal Aviation Act of 1938, meant
to allow airlines to be commandeered by the military during
wartime, limits foreigners to owning 49 percent of a domestic
airline.
     Neeleman went on to start JetBlue, which won its flying
certification from the Transportation Dept. in just three months,
and went public in 2002. Sitting in the airplane at DFW eight
years later, Branson says, "The team at Virgin was probably
slightly too greedy. We were slightly nervous about not
controlling the Virgin brand and wanted to get the foreign
ownership law changed so we could own the airline." Branson says
he lost faith in the possibility the law would be changed and by
2004 had decided to take a different approach.
     To finance the new effort, Branson hired the investment bank
Lazard (LAZ) to canvas U.S. private equity firms, which he says
expressed little more than morbid curiosity about the idea of
starting an airline in the difficult travel environment after
Sept. 11. Two firms with no prior history in the aviation
industry finally pledged backing: Cyrus Capital Partners, based
in New York, and Black Canyon Capital in Los Angeles. Both
minimized their risk by structuring their investments with put
options, which guaranteed them the right to sell their shares
back to the airline with an 8 percent gain if the startup did not
meet certain benchmarks. Branson believed the structure was
enough to satisfy the foreign ownership restrictions. He also
poached charismatic Delta Air Lines (DAL) President Fred Reid,
who started his career as a reservations agent for Pan Am and was
later an executive at Germany's Lufthansa (DLAKY). Reid set up
the first office of the fledgling airline in New York City, in a
three-room office with no running water and sporadic heat.
     With startup capital in hand, Virgin America ordered 16
Airbus jets and set about making them Virgin planes. There would
be plush leather seats, translucent barriers between flight
classes to make the cabin seem less claustrophobic, and a
touchscreen entertainment system that offered dozens of on-demand
movies—many more than competitors—and the ability to have snacks
and meals ordered from your seat at any time.
     In the spring of 2006, with Virgin America applying for
certification from the Transportation Dept., Continental (CAL)
and American Airlines led a battle to block Branson from U.S.
skies. In petitions to the DOT, the legacy airlines questioned
Virgin America's compliance with the foreign ownership law,
arguing that investments with put options did not amount to true
equity ownership and that the billionaire Brit was secretly
pulling the strings.
     The ensuing regulatory fight, waged with lobbyists in
Washington, Sacramento, and Virgin's new home base in San
Francisco, lasted 18 months and included a provisional rejection
of Virgin America's flying certificate in December 2006. Through
it all, most of Virgin America's 16 planes sat unused and empty,
though a few were subleased to other airlines. Branson calls the
delay a "horrendous waste of money" and says competitors "went to
extraordinary lengths to smother us at birth." He declines to
specify how much capital was wasted, but one person with
knowledge of the company's finances during those years, who spoke
anonymously because the number was never formally disclosed, says
Virgin America burned through more than $100 million of cash
waiting to take off.
     To win its flying certificate, the Virgin Group had to make
accommodations, including forfeiting the right to veto decisions
about plane purchases. Fred Reid was also forced to resign as
CEO; the legacy carriers accused Branson's handpicked chief
executive of being too close to foreign interests.
     With David Cush newly installed as CEO, Virgin America's
inaugural flight, from JFK to San Francisco, finally took off in
August 2007. Adding to all the standard difficulties was an
historic spike in oil prices, which peaked at $145 a barrel in
July 2008. While rivals had purchased futures to minimize the
impact of higher fuel prices, "the delay and uncertainty in our
startup limited our ability to hedge oil," says Donald J. Carty,
Virgin America's chairman and a former CEO of AMR, parent of
American Airlines. For the first nine months of 2008, Virgin
America announced a $175.4 million loss on $259 million in
revenue.
     After such a tortured launch, both U.S. investors exercised
the option to sell their stakes back to the airline. The company
faced a simultaneous cash and regulatory crisis, since Branson's
stake now exceeded 50 percent. In the ensuing refinancing, the
Virgin Group lent Virgin America another $60 million (which did
not increase its stake), and Cyrus Capital agreed to step back in
with a $20 million loan and assume the majority ownership
position. Virgin America board members like Cush, Carty, and
Samuel K. Skinner, a former Secretary of Transportation under
George H. W. Bush, also took a collective 21 percent share of the
company to keep it in regulatory compliance. But the damage had
been done: By the time the company got the DOT to confirm the
legality of its new ownership structure, Virgin America was far
behind on its own plans for expansion. It initially predicted it
would fly to 10 cities in its first year of service and 30 cities
within five years. The airline didn't hit city No. 10—Fort
Lauderdale—until two years after it started flying. Dallas is
just its 13th destination.
     Mo Garfinkle and other analysts worry that the young airline
has not grown fast enough to sustain a profit and has only $25
million in the bank. David Cush says the airline also has a $75
million line of credit, though he concedes that "any airline exec
will tell you more cash is a good thing." Don Carty, the
chairman, says an initial public offering "is at least 18 months
away."
     It will likely need the cash. New airlines need to grow
quickly to entice travelers with an array of destinations and a
choice of departure times, and to help with rescheduling
nightmares like the one caused by last week's blizzard on the
East Coast—some passengers on canceled Virgin flights were being
asked to wait a week for a new flight.
     Virgin America has aggressive plans for expansion, with
orders for 56 new jets over the next six years. It wants to
introduce service next year to airports like George Bush
Intercontinental in Houston, where Continental is based,
Hartsfield Jackson Atlanta, home of Delta, and Chicago's O'Hare,
which United counts as a major hub. Virgin hopes its distinctive
service is enough to lure travelers away from those airlines.
     The strategy is an unconventional one. "In this business you
have to own something," says JetBlue founder Neeleman, who now
runs a Brazilian startup airline, Azul, and is skeptical of
Virgin America's chances. "Skimming off popular routes leaves you
too vulnerable. People can come in and match your fares with
better frequency."
     American's reaction to Virgin's incursion into Dallas
provides a glimpse of what the airline can expect as it enters
the territory of deeper-pocketed rivals. Since Virgin started
selling tickets to Dallas over the summer, American added two
flights a day to Los Angeles and San Francisco and cut its fares
on those routes by about 25 percent.
     Furthermore, any airline can add the sorts of services and
amenities Virgin features. Carriers including Delta and United
are currently adding Wi-Fi throughout their fleets. Continental
is in the process of bringing satellite television to its planes,
though passengers have to pay for it, and Boeing (BA) has
integrated color LED mood-lighting into the designs of its new
737. Virgin America's in-flight system is already showing signs
of age. Passengers hardly need an in-flight chat room, or a store
that offers Callaway (ELY) golf bags for $400, when they are
surfing the Web and e-mailing friends on their laptops.
     "We don't worry about the last product we put out," says
Cush. "We are thinking about the next one." That next one would
be what the company calls Cabin 2.0, a new design that will
include more responsive touchscreens, more channels of live
television, and multiplayer video games. Nor does Virgin plan to
lose the mood lighting war: It is examining LED lighting systems
that can display thousands of colors instead of the current
twelve shades of pink, purple, and blue. "We are not going to sit
back and let the other guys overtake us," says Cush.
     What Virgin America may really need is more Branson. In a
perfect world, he could freely inject capital, or even merge the
airline with Virgin Atlantic, shaving off costs and allowing it
to offer service more quickly to more cities. The foreign
ownership laws, however, make it hard for him to work his usual
magic in all but the most superficial ways. A few hours after the
party on the tarmac at Dallas Forth Worth airport, Virgin America
hosted more than 1,000 guests at Dallas' Winspear Opera House for
a concert by Willie Nelson, days after his latest arrest for
marijuana possession. Introducing the country crooner, Branson
joked that Nelson and Virgin America have much in common: "We
both like to fly high," he cracked. The crowd laughed, then
celebrated throughout the night. After the event, even close
backers acknowledged the flight ahead could be rough. "It's sad.
There's a confluence of things working against these guys," said
Fred Reid, Virgin America's first CEO, adding, "I'm hopeful
because this is the right thing for air travelers."

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