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Virgin Australia Luring Buyers to Weaken Qantas: Real M&A

Virgin Australia
A Virgin Australia aircraft touches down in Sydney. Photographer: Ian Waldie/Bloomberg

What makes Virgin Australia Holdings Ltd., the second-largest competitor in a market with only 23 million passengers, such an attractive takeover target? The chance to weaken Qantas Airways Ltd. on international routes.

Singapore Airlines Ltd., Air New Zealand Ltd. and Etihad Airways PJSC have been lifting their stakes in Brisbane, Australia-based Virgin to cement partnerships and help it take on a domestic monopoly that Qantas enjoyed for almost a decade. With the three airlines and Richard Branson’s Virgin Group nearing an 80 percent holding, the $1.25 billion company may be taken private, said UBS AG and Macquarie Group Ltd.

“The shareholding structure, with the three major guys there, suggests that M&A remains a distinct possibility,” John O’Shea, an analyst at Bell Potter Securities Ltd. in Melbourne, said in a phone interview. “If one or two move, the others may have to block it or make an alternative bid.”

Propping up Virgin helps weaken Qantas’s ability to compete internationally, said Morgan Stanley, and a takeover would let the owner also reap profits from Australia’s domestic market. A buyer would gain control of an airline that’s projected to boost its cash flow this year at the fastest rate globally, according to data compiled by Bloomberg.

The most likely outcome is that Air New Zealand and Singapore Air turn Virgin Australia into a joint venture, possibly with Etihad owning 20 percent, Macquarie analysts Russell Shaw and Warren Doak wrote in an Oct. 14 note to clients. Shaw has since left to join Virgin Australia.

Branson’s Role

Virgin Group, which helped set up the Australian carrier in 2000 and holds a 10 percent stake, “will clearly have a role to play in either facilitating or blocking” any deal, the analysts wrote.

“How many businesses do you know with four major shareholders on the register who all sit there passively?” Ian Myles, a Sydney-based analyst at Macquarie, said in a phone interview. A full takeover is a “logical move.”

Virgin today fell 1.3 percent to 38.5 Australian cents. The stock has fallen 6.8 percent in 2013.

The three airlines have bought A$730 million ($664 million) of Virgin shares since Air New Zealand started building up its stake in 2011. The investments have strengthened the code-share partnerships under which the carriers can offer passengers seats on each others’ planes to fill up flights and provide a broader range of destinations.

Ultimately controlled by the governments of New Zealand, Singapore and Abu Dhabi, the airlines will spend another A$316 million if they take up their full entitlements under a A$350 million equity raising announced by Virgin last month. That would leave Air New Zealand with 26 percent of the company, Etihad and Singapore Air each holding about 22 percent, Virgin Group owning 10 percent, and other shareholders with 20 percent.

Competitive ‘Nuisance’

The airlines “want to keep Qantas bogged down because it’s moving into their backyard” with flights to Asia, the Middle East, Europe and Oceania, Peter Esho, chief market analyst at Invast Financial Services Pty. in Sydney, said in a phone interview. “What they want is to be a nuisance to Qantas.”

Representatives for Virgin Australia, Singapore Air and Etihad declined to comment about the prospects of a takeover. Representatives for Air New Zealand and Virgin Group didn’t respond to e-mails seeking comment.

Buying out other shareholders would deliver control of an airline that commands almost 35 percent of Australia’s domestic aviation market, which Deutsche Bank AG analysts Cameron McDonald and Entcho Raykovski estimate has the potential to yield annual profits of about A$1 billion.

Profitable Market

“Australia’s one of the few airline markets in the world that makes a lot of money,” Tony Webber, a former Qantas chief economist and now managing director of Webber Quantitative Consulting, said in a phone interview. “It’s a big place, with people distributed all around it and few competitors.”

Qantas’s domestic operations posted operating profit of more than A$450 million ($410 million) in its most recent fiscal year, compared with global profits of about $655 million for Singapore Air, Air New Zealand and Etihad put together.

Analysts estimate Virgin will also have the fastest rate of cash flow growth this year among global airlines for which such data is available, according to data compiled by Bloomberg. Cash flow may grow fourfold to 8.8 Australian cents per share in the year ending June 2014, the data show.

Originally established as a low-cost carrier, Virgin has added full-price tickets, business class seats and rural flights to compete directly with Qantas since John Borghetti took over as chief executive officer in May 2010.

Qantas Opposition

The investments in Virgin have attracted opposition from Sydney-based Qantas, Australia’s dominant carrier.

“The agenda of these foreign airlines is to terminally weaken Qantas,” CEO Alan Joyce wrote in a Nov. 22 e-mail to staff. “They will be perfectly placed to take a domestic monopoly position.”

Virgin is in effect “overwhelmingly majority-owned by foreign state-owned enterprises,” and Qantas may need government funding or a loosening of laws restricting foreign investment, Treasurer Joe Hockey told 3AW radio on Nov. 28.

“A small equity take-up by a government entity” is an option for Qantas, shadow transport minister Anthony Albanese said in an interview with Australian Broadcasting Corp. television the same day.

Buying back as much as 10 percent of Qantas is the most likely political solution, the Australian Financial Review newspaper reported Nov. 29 without saying where it got the information, a move that may boost support for the company’s investment-grade credit rating.

Stock Support

Last week, Hockey rejected U.S.-based Archer-Daniels Midland Co.’s A$2.2 billion acquisition of GrainCorp Ltd., saying it’s not in the national interest.

The prospect of Virgin’s major shareholders buying even more of the stock is already supporting the company’s share price, according to Morgan Stanley and UBS. Virgin closed at 39 Australian cents yesterday, after trading in a range of 37 cents to 47 cents for the past year.

Virgin’s fundamental value is about 0.5 times to 0.6 times its net assets, or about 22 cents per share, Julia Weng, a Sydney-based analyst at Morgan Stanley, wrote in a Nov. 15 note to clients. The ongoing shareholder support and the potential for the company to be taken private are underpinning the price, Simon Mitchell, a Sydney-based analyst at UBS, wrote in a Nov. 14 note.

Virgin’s Valuation

Virgin’s enterprise value is about 46 times last year’s earnings before interest, taxes, depreciation and amortization, according to data compiled by Bloomberg. That’s the third-highest among airlines globally and compares with a median of 7 times, the data show.

That may not deter Singapore Air, Air New Zealand and Etihad, which may end up in competition for control of Virgin, said Evan Lucas, a market strategist at IG Group Holdings Plc in Melbourne.

“If two gang up on the other,” it could end in a bidding war similar to the ongoing one that’s doubled the share price of Australia’s Warrnambool Cheese & Butter Factory Co. since Sept. 12, Lucas said by phone. “It’s a back-door takeover.”

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