Virgin Australia is spending $700 million to buy back the 35% share of the Velocity frequent flyer program that it sold in 2014 for $336 million. It is funding the purchase through the issuance of A$325 million of ASX listed notes paying 8% interest and US$425 million of high yield bonds.

At a basic review the Virgin business is not unlike Tesla; some prospects of making a decent profit but the debt is being sold mainly on the equity story rather than credit fundamentals. A couple of basic financial points:

  • The business has net assets of $619 million of which $581 million is intangibles. For a $6.5 billion balance sheet that’s effectively zero tangible equity.
  • Current liabilities are roughly 1.5 times greater than current assets.
  • Over the last 3 years the smallest loss was $186 million.
  • Much of the fleet is security for other debts. There’s little in the way of hard assets for unsecured lenders.
  • The market capitalisation of $1.3 billion is very small relative to the $6.5 billion balance sheet. For Qantas it is $10.5 billion versus $19.4 billion. This means even Virgin’s shareholders have doubts this business can generate a decent profit.

For me, a business like this is clearly in the CCC band. If there’s no profit, the debt to earnings and earnings to interest ratios are negative, but Moody’s has it at B2 and Standard and Poor’s at B+. These ratings would typically align with a business that can cover its interest from EBIT (earnings before interest and tax) 1.3-2.0 times. Yet Virgin has had negative EBIT for each of the last 7 years with no ability to cover its interest from earnings. The ratings are well ahead of the business, banking much of the hoped for turnaround benefits that the new CEO is promising. Given this business has a long history of under-delivering on turnaround strategies that’s a significant stretch.

The debt is also unsecured, which means it ranks behind the secured debt most notably aircraft financing. This is where the smart lenders play in the airline sector, making sure they have something valuable to grab when an airline can’t pay its debts. There are guarantees from and debt restrictions on some group entities, but importantly not from the Velocity business which generates a profit. This leaves open the possibility of Virgin adding more debt to this business if it can’t obtain anymore unsecured debt or debt secured against its aircraft, further subordinating the position of unsecured debt holders. 

The major positive for unsecured debt holders is that shareholders have a history of tipping in more money, hoping that Virgin’s place in a duopoly will eventually yield profits. Whether that continues to hold true, particularly if there is a global downturn that makes the primary businesses of the major shareholders unprofitable for a time, is doubtful. At some point all rational investors stop throwing good money after bad, just as one of Virgin’s major shareholders did with Air Berlin in 2017 and Air New Zealand did with Ansett in 2001. Both of these situations resulted in the underperforming airlines going bankrupt and being dismantled.

Notwithstanding all of the above, the debt raising was a smashing success more than doubling the A$150 million target with the bookbuild closing early. If you are looking for a case study of how low interest rates lead to yield chasing this is a pretty good one. 

Damien Klassen

Are you saying that you don't have a line in your valuation model for the charisma of Richard Branson / Elon Musk?

Jonathan Rochford

Thanks Damien and Harry - yes I'm a maths over magic investor. Re Qantas, it has $5.8 billion of no cost funding from customers buying their tickets in advance. Not many industries get a deal like that. The flipside is that if bondholders lose confidence it can be a while before the cash crunch hits, if customers lose confidence and stop buying or trade creditors stop supplying insolvency will happen much faster.

Stephen McDougall

Good analysis as it turns out.