Ben and David deviate entirely from the stated purpose of the show, tackling this non-technology acquisition that is so recent, we have no idea if it went well yet. But, the April 2016 acquisition of Virgin America by Alaska Airlines was so fascinating, we had to do it!
Items mentioned in the show:
"The Carve Out":
Full Transcript below: (disclaimer: may contain unintentionally confusing, inaccurate and/or just-plain-hilarious transcription errors)
Ben: I should see what episode this is going to be.
Ben: Ten. Easy.
Welcome to Episode 10 of Acquired, the podcast where we talk about technology acquisitions that actually went well. I am Ben Gilbert.
David: I’m David Rosenthal.
Ben: And we are your hosts. Today, we come to you with an acquisition that is actually not a technology acquisition, but something that David and I were inclined to talk about anyway because we both sort of have a little romantic fascination with anything involving airplanes, and this is particularly interesting.
Today we’re going to be talking about Alaska Airlines acquiring Virgin America right here in our own backyard in Seattle. Before we get into the acquisition history and facts, I wanted to remind you that you can sign up now at Acquired.fm to get our episodes delivered via email. We also would really, really, really appreciate it if you could rate us on iTunes. It will help us grow the show and expand what we can do with it from productions to new topics and guests.
Now, with that out of the way, David, you want to dive into acquisition history and facts?
David: Indeed, yeah. This will be a fun one. Listeners, let us know what you think. Don’t worry, we’re not changing the topic of the show, but we thought we’d have some fun and analyze a very different industry than technology.
Ben: Yeah, and not to mention the fact that it’s not a tech acquisition. There is technology involved, but the way we’re kind of breaking the mold into this one too is this just happened last month.
Ben: Or this month actually.
David: A couple of weeks ago.
Ben: Yeah. So this is something where it’s going to be highly speculative, but I think it’s going to be a fun ride.
David: All right, with that. So, Virgin America was actually founded in 2004 by Richard Branson and then had to go through a whole series of machinations to end up finally launching their airline service in the US not until 2007. Over those three years, a whole bunch of things happened. So one, it turns out that due to some crazy laws, US domestic airlines cannot have foreign ownership greater than 25 percent of the company.
David: Crazy. So, Branson and Virgin had to basically sell off 75 percent of the company before they could even have a hope of operating.
Ben: It’s wild. I think at that point, when they were first starting, it was Virgin USA even and they rebranded.
David: It was later that they rebranded to Virgin America. So, Branson sells 75 percent of the company to a couple of hedge funds.
Ben: And licenses the Virgin Brand to Virgin America, so that Virgin America doesn’t even own Virgin that’s painted on their own airplanes.
David: Yup. There was talk at various points in time about ditching Virgin, the name, would that help get regulatory approval earlier, faster. Craziness. Anyway, they finally clear all the regulatory hurdles, they buy some aircraft, and they start operations in San Francisco with SFO as their hub. They launched in 2007. Things go fairly well. They don’t die at least like a lot of startup airlines, and they actually have some major technology-related innovations. So, in 2009, Virgin actually becomes the first airline to offer Gogo in-flight wireless, in-flight Wi-Fi, which is that’s hard to imagine now.
Ben: As Louis C.K. says, “It’s magic and it’s the newest thing I know that exists.”
David: I still hate it now – the random, you know, rare times when you end up on a plane without Wi-Fi.
David: They also are the first airline, I believe, to install in-flight seat back interactive touch screens for everybody all throughout the whole plane.
Ben: Not to mention purple afterglow light.
David: Not to mention nightclub-inspired lighting. For our listeners who haven’t flown Virgin America, they probably have no idea what we’re talking about.
Ben: Yeah, I guess it’s pretty West Coast, and anybody listening in the Bay Area has definitely flown it since they’re hubbed out at SFO.
David: So, Virgin actually ends up going public having an IPO in November 2014 and then not that long later where about 18 months since then, a bidding war erupts for the company between Alaska which ended up buying them and had rumored to be interested in the company, in Virgin, for a long time and JetBlue. Then Monday morning, April 4, Alaska announces that they have agreed to acquire Virgin for $2.6 billion, which was a 47 percent premium to the Virgin stocks closing price, the previous price at about an 80 percent premium to where the stock was before rumors came out that a bidding war was happening.
Ben: Yeah, this is the first red flag for me. I mean, I think that…
David: Basically, a massive premium.
Ben: Yeah, yeah. Anytime you see a spike like that, you start to dig in to why, and I think we’ll talk a little bit more about kind of the way that industry has shifted. But with all the consolidation, the only way that an airline can really compete with the big guys is to be big themselves, and the big guys being United, Delta, American, and Southwest.
David: Which itself started as a little guy.
Ben: Very true. I think that’s like the typical low end disruption case study. That’s a great business and a really interesting story on its own. But, I mean, clearly, Alaska in trying to compete, there’s a limited number of airlines that it could buy. JetBlue clearly identified the same opportunity and the result is this very, very inflated purchase.
David: Yeah. So when the dust clears and all is said and done, basically the total enterprise value of the deal ends up being about $4 billion, if you include the debt and the aircraft leases that Virgin had.
Ben: Which is fascinating because normally when we talk about these acquisitions, we would say a $2.6 billion purchase in cash and stock or maybe an all stock deal, this was an all-cash $2.6 billion purchase plus taking on that $1.4 billion of leases on your planes and debt. What a ridiculous capital-intensive, high fixed cost industry air travel is.
David: That’s four Instagrams, Ben.
David: Then perhaps the craziest part about this deal is, again, relative to the technology sector, so it was announced a couple of weeks ago on April 4, 2016, not expected to close until early 2017 at the latest. Huge amount of regulatory review that still has to happen here.
Ben: We’ve actually precedent I think in the American Airlines – US Air merger where there was regulatory troubles and it almost didn’t go through.
David: Yeah. The government extracted huge concessions from those two airlines when they merged.
Ben: So, we may be doing a follow-up at some point in the future if by 2017 we don’t see a joint airline here.
David: And our listeners don’t revolt against us, we’re talking about airlines.
Ben: It’s true.
Ben: Well, the other really interesting thing here is in just talking about the deal price, Alaska Airlines does not have $2.6 billion in cash to make this purchase. If I have my numbers right, as of November 2015 according to their earnings, they had $88 million in cash and $1.1 billion in marketable securities. So, I believe what happened here is in the bidding war with JetBlue, Alaska has incredibly clean books. They’re one of the few airlines that actually is investment grade debt.
David: Very low debt load. Actually, investment grade debt, which for listeners who aren’t in the… come from the investment banking world basically means that the amount of debt that Alaska has is small enough relative to its earnings power that people think it’s very, very unlikely they’ll go bankrupt especially for an airline. No other airline is rated as highly, basically which means that people who don’t think there’s a good chance they’ll go bankrupt.
Ben: Yeah. So, is there a chance then, that the way I sort of understand it is JetBlue sort of had to cry uncle because they didn’t have the amount of debt available to them.
David: Didn’t have the borrowing power to be able to…
Ben: Make the purchase.
David: Yeah, reach this price. But now, this is going to totally transform Alaska, like they’re going to take out another $1.5 billion, perhaps plus with debt.
Ben: To make the, well, yeah, I mean to make the purchase and then to take on the debt and leases that…
David: Virgin was also a fairly low debt load airline as far as airlines go. But still, it’s changing the capital structure of the combined company, pretty significant.
David: Great. So, we move on to acquisition category.
Ben: Yeah, it sounds good to me. Why don’t I start with that?
Moving on to the acquisition category, this, to me, doesn’t fit our mold necessarily of people, technology, product, business line or other, and I guess if everything fits in other. In some ways, it’s a business line. They picked up a brand that people have tremendous affinity for and access different customers with…
David: That’s assuming they keep the brand.
Ben: Well, yeah, and that’s something we should talk about. Ultimately, though, what I think they’re acquiring here is capacity. They identified the opportunity that they wanted to be the West Coast airline and right now, they don’t have a meaningful presence in California. They’re hubbed out of Seattle, they have very little in San Francisco, and even less LAX presence. This gives them major, major capacity to be the West Coast airline.
David: Yeah, basically, if you look at it, if you think about airline route maps that you see on the back of the cards and the back of your seats.
Ben: It makes your head spin, but it’s super cool.
David: It makes your head spin but it’s usually, you know, it’s like the spider web that emanates from a few major cities. The Alaska hub at Seattle and there’s a huge spider web coming out of Seattle to every city in America and in several international destinations and then very few route pairs from other cities. Virgin is the same thing but just from SFO.
Ben: So, in your opinion then, well, before we get into that, how would you categorize?
David: So, yeah, actually we hadn’t discussed this beforehand, but I was going down the same path you are and say in our framework, this would fit closest to a business line, like buying the local San Francisco airline and the local Seattle airline.
But I actually think the best categorization is this is industry consolidation, which is in a super mature old school industry like the airline industry, very different from technology, you get these periods of consolidation where players merge with each other because they feel like they need greater scale to compete. And I think that’s what we’re seeing happen here.
Ben: Yeah, and this is an interesting time to go into how Alaska makes the case to their investors for this. There’s this great investor deck that they have on their website where they talk about why their investors should feel comfortable with this purchase. And they say that “we’re bullish on the industry.” From 1977 to 2009, the industry lost $52 billion.
David: The airline industry is notorious for…
Ben: Oh, yeah.
David: I mean, we should talk about there’s a great, great… I almost included this as my carve-out for the week, but I’m going to do something else because I knew we’d talk about it on the episode.
There’s a great paper that was written by Michael Mauboussin and his team who’s a great investor. He was head of Legg Mason which is a large mutual fund and at Credit Suisse for a long time. I believe he’s now back at Credit Suisse. He’s written a number of great books. He’s also a professor at Columbia Business School, I believe. He wrote this great paper called Measuring the Moat. It’s all about the concept of the moat, you know, as an investor is sort of the most important thing. Warren Buffet emphasized it in Berkshire Hathaway and Charlie Munger emphasized the moat as sort of the most important thing they look for. And it uses the airline industry as an example of a terrible industry that has destroyed so much economic value and has no moat.
Ben: Yeah, and this is… I’m not sure if this… I think this is still true. It was at least true a couple of years ago. If you look at the airline industry since its inception and you look at basically a profit loss statement for an aggregate of every single airline, it’s lost value, like it’s actually not been profitable if you look at every single.
David: The entire industry, yeah, yeah. And not just lost value but lost a huge amount – a huge amount of capital has been destroyed in this industry.
Ben: So, they said that 1977 to 2009, they’ve lost $52 billion as an industry. It is interesting that people continue to invest in it, yet from 2010 to 2015 over the last six years, it generated…
David: It’s been good times in the airline.
Ben: Yes, $45 billion of value.
David: We’ll get into that.
Ben: So some of the things they cite are… or Alaska cites to their investors are “a fundamentally changed industry structure.” That, I think, is largely… I mean, when you look at the consolidation that’s going on they’re basically saying, “Okay, the fragmentation is gone and right now the industry structure is that there’s four relatively perfect substitutes and these big ones that are all, you know, you’re going to get treated sort of like cattle when you’re in coach.”
David: And you’ve seen in the past few years, I believe the first was United and Continental merged. You’ve seen all the major legacy domestic airlines consolidate and merge, and then US Air and American merged. So you’ve got this consolidating power structure of the industry that actually represents, between the top four airlines, 80 percent of all US domestic airline traffic.
Ben: Yes, so it’s interesting. I went and grabbed all their market caps today. Highest right now is Southwest, is a $30 billion company. Delta is higher at $36 billion, Southwest at 30, American at 25, United at 21. Then if you look at… Alaska is $10 billion without Virgin. Virgin is 2.5 and JetBlue at 7. So if you just look at those players, $132 billion effectively market cap for the industry, and when you think about Apple as a $590 billion market cap company, you start to understand like, “Wow!” The whole industry here is, you know, if we’re looking at this any given airline and comparing it against one of these mega technology companies that we usually talk about on the show, the airline companies just don’t create that much value.
Ben: Or maybe more accurately, they don’t capture that much value.
David: Yeah, and it’s super interesting. I’m sure we’ll get into throughout the show the supply chain of the airline industry is fascinating. You’ve got basically a duopoly that are direct suppliers to the airlines in Boeing and Airbus that make the big passenger jets. They have a huge amount of power over the airlines because while there is two of them, you could go from one to the other, it’s not like you can say it’s not like the airlines can be like a Google and be like, “Oh, we’re going to become a full stack company and we’re just going to obsolete you and we’re going to make our own cloud,” or whatever, like, the airlines can’t make their own airplanes.
Ben: Yeah. Getting good at servers is different than getting good at airplanes.
Ben: Yeah. So getting back to the Alaska, reasons they’re bullish on the industry, the industry structure is consolidated. This is sort of a BS bullet point, I think, but returns focused leadership teams, that’s like tuning your own horn and claiming competency.
Constrained airport real estate – this one’s sort of interesting. I guess they’re saying like we reached a saturation point right now where we’re not building more airports, the airports aren’t getting bigger, and over the last since 1960, that’s been the case. Now, it’s all about vying for space at the existing airports that we have, and then the capacity acquisitions starts to make a lot of sense.
David: Yeah. There are only so many gates.
Ben: Right, right. Growth in leisure travel, which is interesting to pick apart and think about why that might be, and then new revenue sources. I think we can all grape about how we are well aware of all the revenue sources that airlines can…
David: Charging for bags.
Ben: Food and entertainment.
David: I mean, some of these are new services they’ve added. Virgin and Alaska have both been kind of the leading edge here. The in-flight Wi-Fi and entertainment and movies and snacks that are actually edible.
Ben: And co-branded with Tom Douglas. It’s always so funny to get on those planes and see how far – for those of you not from Seattle, he’s like the big restaurateur in town – to see how far he’s leveraged that brand. Now that I open the little snack pamphlet in American Airlines, there’s Tom smiling at me on the front of it.
David: I love it.
Ben: So artisanal. So, yeah, from a category perspective, I think absolutely I would chalk it up to capacity.
David: Yup. The other point I want to explore here a little bit is there’s a really interesting context for this deal that people in Seattle might be aware of, but I doubt anyone not here is, and that’s that Delta actually has been putting a huge amount of pressure on Alaska here in Seattle in their hub. Delta has been growing over the last few years their presence in Seattle a lot. For a long time I think Alaska was probably either concerned or expecting that Delta was going to make an offer to buy them, and they haven’t. Instead, they have just organically grown and taken more and more gates here in Seattle. It’s really interesting.
I was talking to somebody who was far more of an airline industry expert than we are and he was making the point that the frame of reference is really different for these two companies, Delta and Alaska. Alaska is a domestic carrier and it’s a West Coast focused carrier. Delta is an international carrier. Delta coming in to Seattle was part about competing with Alaska domestically because Alaska has built a really nice business here. But also, an even bigger part probably for Delta is using Seattle as a gateway for international flights to Asia because gate real estate, as you were saying Ben, is so scarce and the other big cities on the West Coast at SFO and in LAX is so competitive and impossible to get more real estate there. I think Delta really viewed Seattle as their gateway so that they could send people from all over the US on flights to Seattle and then hop over to Japan, to Korea, to China, to what-have-you.
Ben: Makes sense.
David: Whereas for Alaska, that’s not even an accessible market to them right now.
Ben: Right, right. In looking at this acquisition category in kind of the way we’ve both defined it, in a $2.6 billion sale that it seems inflated for two reasons. One, kind of the bidding war because it was scarcity of good airlines to buy that would compliment JetBlue or Alaska well. But two, a lot of the value, the intrinsic value that was given to Virgin even before rumors of a sale was brand value. They have tremendous customer affinity, they do things a little bit differently.
David: People who love Virgin love Virgin.
Ben: I always have a better experience.
David: And people who love Alaska love Alaska, too.
Ben: It’s true. Actually, those are two of my favorite airlines to fly. But Virgin is notoriously different and better and feels premium, and that had to be factored in to their market cap. When you think about what they are going to be used for, I mean, Alaska announced that by 2018 they hope to be fully rebranded as Alaska. Hopefully, they can learn some things from Virgin, and they’ve been watching them very carefully. But if they obliterate that brand, what was the point of paying a markup on a markup for capacity?
David: Yup. It’s a great point. The Alaska brand, again, it was very good especially in the airline industry on its own. I think really was kind of like very professional. They had either the best in the industry or the best on the West Coast on time percentage, lots of great… very, very business commuter-friendly. Virgin was, like we joked earlier, like a nightclub on a plane. It was the favorite airline of all of my classmates when we were in business school. We can leave it at that.
Ben: So then one other thing that I want to bring up in that realm is payback period. So Alaska cites that they’ll have $225 million of total net synergies at full integration. So what we can pull from that is that there will be $225 million of cost savings after they’re fully integrated, so let’s call that 2018-ish, and that means that there’s probably other value that they can create on top of that like ability to create more revenue because they have these economies of scale, new things just on top of that. But that means that they have on this, if we look at the $4 billion as the figure, that’s a 17-year payback period on this acquisition just on the synergies.
David: Now, Virgin had earnings as well that would contribute to that, but two points I want to make, but go ahead.
Ben: No, no, go for it. I’ve pretty much made the point there. It seems like it’s going to take a while to…
David: Yeah. Any way you slice it, it’s going to take a while and I think there are two really head-scratching things about this merger that are really important, that certainly industry experts are questioning, but Alaska hasn’t talked a lot about, one, the primary reason for the sort f economic renaissance of airlines in the last couple of years has been falling fuel prices.
Ben: Yeah, which are not only passed on to consumers and everyone’s getting a little…
David: Right, right. So airlines as a whole, across the whole industry, have gone from call it spending X on fuel which was a huge amount of their operating budget and kept their budgets low to negative to spending X divided by two on fuel. Thus, they are enjoying as an industry much greater profits than they used to.
Now the question is, like, is that the new normal or is our oil prices going to go back up at some point. We could do another show on the oil and gas industry. This is a major existential question for that whole industry, but, if you were to take the viewpoint that this is a temporary thing and prices will go back up, which historically they have fluctuated throughout history. Gosh, it seems like you’re buying at the top of the market here where profits are artificially inflated. So, that’s one.
Two, synergies as you rightly mentioned, Ben, are often about the combined revenue potential and being able to extract more money from consumers and routes and whatnot, but they’re also really about cost savings.
Ben: Yeah. And consolidating the back office.
David: Consolidating and economies of scale and all that front. But there’s kind of a problem here with this acquisition and that’s that Alaska flies Boeing planes and Virgin flies Airbus planes.
Ben: Exclusively Airbus, their entire fleet.
David: Yeah. Alaska only flies Boeing and Virgin only flies Airbus. You might say as a naïve consumer, as I did before I started looking into this, like no big deal. I mean, they look like… it’s a plane. A plane is a plane, right? I get on it and it looks the same. Well, it turns out that actually they have completely different control systems and pilots who fly Boeing planes can’t fly Airbus planes, and pilots who fly Airbus planes can’t fly Boeing planes.
Ben: So it’s not like they’re going to be able to share pilots at all between these fleets.
David: Not going to be able to share pilots and, of course, all the maintenance and all the parts are completely different.
Now, the other major airlines do use a mixed fleet of both.
Ben: Except for Southwest.
David: Except for Southwest, yes.
Ben: So Southwest is entirely Boeing 737’s because they realized that a part of their business model was going to be staying as lean as possible and keeping everything totally interchangeable and swappable.
David: That’s actually been a big part of their story to Wall Street and investors about why they’re a great company. That’s been kind of a pillar of it. Alaska had the same playbook. Now all of a sudden, they’re like a 50-50 shop of Airbus and Boeing.
Ben: Yeah. From a heartstrings perspective too, how dare a Seattle company buy a company that’s entirely Airbus planes? That’s just not patriotic.
David: That’s much sorted in history on Seattle and Boeing and perhaps for another show.
Ben: Yeah, yeah.
David: So yeah, and I think that actually segues into what usually is a short segment for us and I think we’ll probably be short here of what would have happened otherwise. Here, clearly, the otherwise… I mean, Virgin was going to be acquired and the otherwise was JetBlue had acquired them. Now, JetBlue is also an Airbus company, so it would have been a lot easier for them to realize cost synergies.
Ben: Yeah. There’s two points I want to make here. One, Virgin is sort of only recently profitable, I think. So they launched in 2007, took them three years to have their first profitable quarter. They’re struggling as pitching themselves as both a low-cost airline and an airline that has a really premium service.
Ben: I think that they were better at adhering to the premium service than they were to the low cost, but that’s a tough story to sell to consumers. I think they were struggling with how to be both because you can’t both be a Volvo and a Cadillac, and have that story be sustainable and enduring. So I think that Virgin didn’t necessarily need to sell. They were definitely in the right place, right time where they had exactly what…
David: They got an 80 percent premium to the pre-acquisition share price. That’s pretty good.
Ben: Yeah, yeah. Good on them for their M&A positioning, but that seems like a little bit of a precarious position. At prior scrap labs, a lot were thinking about starting these companies, I think I would get a lot of crazy looks if I was like, “Well, we’re going to be a low cost premium company.”
David: It reminds me of, I’ve been reading… another could have potentially been my carve-out, but won’t be, I’ve been listening on audiobook to a great book called Business Adventures. It’s a classic. I believe it was written in either the ‘70s perhaps. It was recommended to me by a good friend and I’ve been listening to it, and it’s just 10 vignettes of more and more aptly titled Business Misadventures. The first one is about a stock market crash in the ‘60s. But the second one that I’m listening to now is about the Edsel, the car that Ford launched that’s widely considered the worst product launch in history.
One of the key lessons from it is that Ford wanted the Edsel to be everything to everyone. They say like “daringly adventurous with a dash of conservative.” It’s like, “What? Are you kidding me?” “It’s an elegant luxury for the aspiring young executive and affordable for the middle market,” and it’s like, “What?” And it failed spectacularly.
Ben: Yeah, yeah. I’m not over here preaching that that was going to be Virgin’s path, but that was always sort of a head scratcher maybe about that company.
Now, the question that I want to pose to you is: What would have happened to Alaska with all the consolidation in the market going on and kind of moving four major players?
David: And the pressure from Delta.
Ben: The pressure from Delta on the home front. What if they don’t expand?
David: Yup. I think to give some credit to Alaska, I feel like we’ve been taking potshots of this deal, we’re in a tough position I think. Doing well in the moment but facing this pressure from Delta, this consolidation across the whole industry and they had developed a really, really nice niche here in Seattle as by far the best routes and customer service for people who live in Seattle and flying in and out of Sea-Tac with great business routes. But they had nowhere to go. They were getting pressure from Delta here. It was super hard for them. What are they going to do, expand internationally? Are they going to go to other cities?
And that’s what they did with this. They said, “We need to grow. It’s going to be super hard to do organically. We have a great balance sheet and for an airline, a lot of cash. We know we’re relative to the industry pretty well run. Here’s an opportunity to buy Virgin and basically double our size and run the same playbook again.” Or they could have just stayed in a steady state where they are.
Ben: Well, it’s funny. You would hope that they double their market size because the acquisition is so expensive, but when you look at the numbers of what Alaska is doing and what Virgin is doing, Alaska has 32 million total passengers a year, Virgin has 7. Alaska has a thousand departures a day, Virgin has 200. There’s 112 destinations served by Alaska, Virgin has 24. Pre-tax profit from Alaska is at $1.3 billion, Virgin $200 million. So, that is an expensive purchase for a much, much smaller operation.
David: Yeah. And a much smaller operation with no room to grow in San Francisco.
David: Not just SFO but the other airports in the Bay Area, too – Oakland and San Jose, which they’re really commuter airports, although pro tip for Seattle to Bay area commuters: never fly to SFO. You always got to do Oakland or San Jose because if you do SFO, there’s so much fog and fog delays, and they always delay the Seattle flights because they want the cross-country flights to land on time. Got to do Oakland or San Jose.
Ben: Pro tip.
David: Pro tip. Anyway, but there’s no room to expand with any of these airports.
Ben: Yeah. All right, let’s move on to our next section. What tech themes does this illustrate for you?
David: Yeah, this is a really interesting one. I debated a lot of ideas here and it’s ironic because this is not a technology acquisition. But actually, I’m going to go with niche marketing and again, even though we’ve been taking potshots against this deal, both Virgin and Alaska before the merger really succeeded at this. In a crowded marketplace with lots of big platform players and the big national carriers, they found a niche – Alaska here in Seattle and with business travelers, and Virgin in San Francisco with quality of service and style-minded customers. They served it really, really well. The group, very big businesses out of that. I mean, combined obviously the price for Virgin at $2.6 billion and… I can’t remember, what was Alaska’s market cap before?
Ben: Oh, their stock actually went down on announcing acquisition, it’s about $10 billion now.
David: About $10 billion. These are great businesses and I think that same principle totally applies in technology and people, especially startups, often overlook it. They try and go after the Delta or the United or the Southwest on day one. They try and go after Google on day one. You’re not going to be Google on day one. The way you’re going to be Google down the road is you start with a small audience, a small niche of people who love you passionately and then you grow from there. Then you knock down, in crossing the chasm speak, the next bowling pin and the next bowling pin and the next bowling pin. That’s much easier to do in technology than it is in airlines.
But the great thing about it is that you probably not going to become the next Facebook or Google. But if you knock down a couple of bowling pins along the way, you’re still going to become a really great value company and then maybe you got a chance to knock them all down and you will be Snapchat and become the next Facebook, calling it here.
Ben: There you go. That’s a good point.
David: Does that analogy also apply to the brand loyalty aspect of airlines? Which they have huge innovation…
Ben: Yeah, invented loyalty.
David: In the inventing the loyalty and the airline miles and status.
Ben: So you’re postulating that in order to capitalize…
David: Are there other technology companies that have – probably not enough, there should be more – but that have taken that loyalty aspect where the more I use a platform, the deeper I get locked in because the more airline miles I have on it, for lack of a better word.
Ben: Yes, totally. I think that everybody that has done well at loyalty in the last 50 years has taken it from airlines. The question is do you need to…
David: OpenTable definitely did.
David: Quite successfully.
Ben: I guess I’m wondering do you need to…
David: That will be a great acquisition to cover at some point.
Ben: Yeah. I’ll add it to the list. Yeah, I’m trying to think about is it necessary? Has something changed in the world where it’s necessary to consolidate to keep loyalty? Does something exist now that didn’t exist before where people only ever want to use one airline?
David: That’s definitely the case in technology. I think about the power of network effects like HipChat, right? Two years ago, a bunch of our portfolio companies used HipChat and some of them used Slack and some of them used HipChat. I talked to people using HipChat and I’ll be like, “You should really check out Slack.” They’d be like, “We use HipChat, it’s good enough.” But then as their friends and other companies got on Slack and then Slack channel started popping up for industry groups and whatnot, then it was like, “Well, we should really think about moving to Slack.” Then this parallel takes over and being on…even if I think Slack has done a lot of great product innovations, but even if it hadn’t, you would be pushed to move towards it even if you’re on HipChat because the rest of the world is on it.
Ben: Yeah. It was Slack I think that the network effect was because people were starting inter-company Slacks so you would end up with like, “Oh, I’m in this Slack,” that’s like a social thing or an industry thing. Then it was like, “I’m not going to keep using two separate applications.” So, does that apply here where, “Oh, I’m not going to maintain points in two separate loyalty programs,” because that was always super annoying. There were a few startups that I was trying out that we’re trying to aggregate my loyalty programs for me or at least help me keep track. That was total pain.
To segue off of aggregator onto another technology trend, let me think through this and see if this logic follows. So, sites like Kayak and Hipmunk and all these Travelocity and Priceline, travel aggregators pop up.
Ben: That’s 15-20 years ago. That effectively commoditizes airlines and compresses their margins because people’s loyalty to those airlines is shaken because they have an easy way to find cheaper prices. So therefore, margins are driven down because airlines get more commoditized and when they’remore commoditized and there’s less profits that you’ve had even though they weren’t making a lot of profit before, they need to consolidate to create a cheaper back office, taking economies of scale. Now, if you’re a smaller airline, the inefficiencies from you having a smaller operation could kill you.
So if you follow it all the way back to the online travel aggregators, does that create the environment in which you need to have a bidding war for this acquisition so that you could be a more major player in a consolidate market?
David: Yeah. That’s interesting. It’s different because it hasn’t fully become a digitized industry, but it’s reminiscent of Ben Thompson’s aggregation theory where aggregating a consumer endpoint and experience, he argues, in the digital 21st Century post-internet world, is where all the value is. Then you can aggregate all the difficult content creation behind that… content creation but in this case, airlines like point to point travel, and own that relationship with the customer at the front end. Then you commoditize everything on the backend. That’s completely happened.
Interesting, Southwest has refused to participate in the aggregators to let themselves be aggregated and probably has some of the most loyal customers. I mean, their ticker symbol is LUV and they always talk about how much everybody loves each other at Southwest. Yeah, they’ve fought that actively and it probably and they’ve probably had the most success on the branding front.
Ben: Yeah, yeah. Why don’t we move on to rendering our conclusions?
David: I think it’s that time.
Ben: Yeah. I think we’ve expressed our opinions laced in a bunch of comments throughout this. For me, I think the value has inflated both by the bidding war and by the fact that they bought something that had brand built into the market cap when they’re not necessarily a leverage and in fact have announced they’re not going to leverage that brand.
But, I think they needed to. I don’t think they had a lot of options and I think they both picked the time right when this was an available purchase. They put themselves in a really good position to make that purchase – I’m probably the wrong person to talk about this – but by putting their books in a great position over the last 5 years and being really intentional about being an investment grade or having investment grade credit. I think that JetBlue didn’t prioritize that as much and neither did any of the smaller airlines and in a world where they need to consolidate, they had put themselves in the position where they’re able to do so.
So, I’ll give it a B minus.
David: Yup. It’s hard to separate out just, at least for me, coming from the tech industry this sort of shock looking at the terrible economics of the airline industry as a whole in dynamics versus the actual quality of decision-making in this acquisition. So I think a lot of what you said, I agree with. But I’m going to go lower. I’m going to go C minus because what you said is right, but they paid so much money. They paid so much money! I don’t think it’s public and I don’t know that anybody except the executives involved know what Alaska’s initial bid for Virgin was, but it got bid up so many times and that’s a large price for something that your pilots can’t fly.
Ben: Can an airline make a good purchase?
David: Yeah. Good point, good point.
David: All right. Should we move on to the carve-out?
Ben: Yeah. So this is wild. I was stopping myself from laughing and my jaw dropped and I think it almost ruined David’s train of thought earlier when he started talking about how it wasn’t going to be his carve-out but it was a paper that Michael Mauboussin wrote about this. I picked my carve-out as a Michael Mauboussin talk that he gave at Google.
David: Oh, this is so good. Everybody should watch this talk, it’s really good.
Ben: David, this is so weird. I haven’t watched this in probably two years and it was something that I’ve recommended to friends very often and so I was sitting here before the episode thinking I didn’t see anything particularly interesting this week that I wanted to recommend, but I have an oldie but goodie. It is absolutely wild.
David: This talk is great and it’s based on a book. I’ve read the book too which is worth reading, too, called Untangling Luck and Skill.
Ben: Yup. Untangling Skill and Luck: The Success Equation, and it is so, so fascinating. He gives so many great examples that will make you both follow it logically and nod your head and sort of scared about how much of your own success has been out of your control or how much the world is out of our control. So how much of your own success cannot be attributed to you and how much of your own failure cannot be attributed to you, and trying to figure out what are things that you have perfected.
David: Attributed to your own skill.
Ben: Yes, yes. And what are things that you actually should be focusing on and what are things that you should know that there’s going to be redness in the world.
David: If you only have an hour, listen to the talk. If you really want to go deep on this, get the book. It’s so good. I will restrain myself, I could go in so many directions. But one real quick vignette I want to throw out is one of my favorite themes from this talk and book is the paradox of skill, which is such a cool thing that in a given activity… the whole premise of the talk and the book is that any activity, the results of which are going to be based somewhat on the skill of the participants in the activity and somewhat online. There’s a spectrum and some things go more towards the luck and some towards the skill. The paradox of skill is that even in things that are highly skill-based, as the level of play gets higher, so imagine the example, Mauboussin uses basketball, as basketball which is very skill-based. As the level of play gets higher and higher and the parody of skill amongst the players gets more and more uniformed, then luck plays an increasing role in the outcome, even though it’s a skill-based game.
Ben: Particularly due to globalization because the only people who are even considered for this are the best in the world. So then it’s like, well, among the people that are all the best that look very similar to each other in skill level…
David: Yeah, the variation in skill gets so minute.
Ben: Then luck is magnified.
David: Then luck is magnified, yeah. And the exact same dynamic holds true in investing in startups and lots of things.
Ben: When the world is the pool, you always are the cream of the crop and then it’s all about all the crazy dynamics that play off of there. So, can’t recommend it enough. It’s on YouTube. We’ll link it in the show notes. Definitely check out The Success Equation: Untangling Skill and Luck.
David: I’ve taken enough time. I’m going to save mine for another time. It wasn’t super interesting anyway. I’m going to doubly recommend this. It’s so good.
Ben: All right. Well, there you have it. Thanks for listening today. Again, if you have the time, please, please, please leave us a review on iTunes. Can’t say enough how much it’s important to the success of the show and we love your feedback.
David: And if you want to receive episodes by email going forward, just sign up on Acquired.fm and we’re also now going to start publishing the show by email updates as well, if you prefer that channel.
Ben: It’s true. You can give us feedback on the website or Acquiredfm@gmail.com. See you later, everyone.
We finally did it. After five years and over 100 episodes, we decided to formalize the answer to Acquired’s most frequently asked question: “what are the best acquisitions of all time?” Here it is: The Acquired Top Ten.
Note: we ranked the list by our estimate of absolute dollar return to the acquirer. We could have used ROI multiple or annualized return, but we decided the ultimate yardstick of success should be the absolute dollar amount added to the parent company’s enterprise value. Afterall, you can’t eat IRR! For more on our methodology, please see the notes at the end of this post. And for all our trademark Acquired editorial and discussion tune in to the full episode above!
Purchase Price: $4.2 billion, 2009
Estimated Current Contribution to Market Cap: $20.5 billion
Absolute Dollar Return: $16.3 billion
Back in 2009, Marvel Studios was recently formed, most of its movie rights were leased out, and the prevailing wisdom was that Marvel was just some old comic book IP company that only nerds cared about. Since then, Marvel Cinematic Universe films have grossed $22.5b in total box office receipts (including the single biggest movie of all-time), for an average of $2.2b annually. Disney earns about two dollars in parks and merchandise revenue for every one dollar earned from films (discussed on our Disney, Plus episode). Therefore we estimate Marvel generates about $6.75b in annual revenue for Disney, or nearly 10% of all the company’s revenue. Not bad for a set of nerdy comic book franchises…
Total Purchase Price: $70 million (estimated), 2004
Estimated Current Contribution to Market Cap: $16.9 billion
Absolute Dollar Return: $16.8 billion
Morgan Stanley estimated that Google Maps generated $2.95b in revenue in 2019. Although that’s small compared to Google’s overall revenue of $160b+, it still accounts for over $16b in market cap by our calculations. Ironically the majority of Maps’ usage (and presumably revenue) comes from mobile, which grew out of by far the smallest of the 3 acquisitions, ZipDash. Tiny yet mighty!
Total Purchase Price: $188 million (by ABC), 1984
Estimated Current Contribution to Market Cap: $31.2 billion
Absolute Dollar Return: $31.0 billion
ABC’s 1984 acquisition of ESPN is heavyweight champion and still undisputed G.O.A.T. of media acquisitions.With an estimated $10.3B in 2018 revenue, ESPN’s value has compounded annually within ABC/Disney at >15% for an astounding THIRTY-FIVE YEARS. Single-handedly responsible for one of the greatest business model innovations in history with the advent of cable carriage fees, ESPN proves Albert Einstein’s famous statement that “Compound interest is the eighth wonder of the world.”
Total Purchase Price: $1.5 billion, 2002
Value Realized at Spinoff: $47.1 billion
Absolute Dollar Return: $45.6 billion
Who would have thought facilitating payments for Beanie Baby trades could be so lucrative? The only acquisition on our list whose value we can precisely measure, eBay spun off PayPal into a stand-alone public company in July 2015. Its value at the time? A cool 31x what eBay paid in 2002.
Total Purchase Price: $135 million, 2005
Estimated Current Contribution to Market Cap: $49.9 billion
Absolute Dollar Return: $49.8 billion
Remember the Priceline Negotiator? Boy did he get himself a screaming deal on this one. This purchase might have ranked even higher if Booking Holdings’ stock (Priceline even renamed the whole company after this acquisition!) weren’t down ~20% due to COVID-19 fears when we did the analysis. We also took a conservative approach, using only the (massive) $10.8b in annual revenue from the company’s “Agency Revenues” segment as Booking.com’s contribution — there is likely more revenue in other segments that’s also attributable to Booking.com, though we can’t be sure how much.
Total Purchase Price: $429 million, 1997
Estimated Current Contribution to Market Cap: $63.0 billion
Absolute Dollar Return: $62.6 billion
How do you put a value on Steve Jobs? Turns out we didn’t have to! NeXTSTEP, NeXT’s operating system, underpins all of Apple’s modern operating systems today: MacOS, iOS, WatchOS, and beyond. Literally every dollar of Apple’s $260b in annual revenue comes from NeXT roots, and from Steve wiping the product slate clean upon his return. With the acquisition being necessary but not sufficient to create Apple’s $1.4 trillion market cap today, we conservatively attributed 5% of Apple to this purchase.
Total Purchase Price: $50 million, 2005
Estimated Current Contribution to Market Cap: $72 billion
Absolute Dollar Return: $72 billion
Speaking of operating system acquisitions, NeXT was great, but on a pure value basis Android beats it. We took Google Play Store revenues (where Google’s 30% cut is worth about $7.7b) and added the dollar amount we estimate Google saves in Traffic Acquisition Costs by owning default search on Android ($4.8b), to reach an estimated annual revenue contribution to Google of $12.5b from the diminutive robot OS. Android also takes the award for largest ROI multiple: >1400x. Yep, you can’t eat IRR, but that’s a figure VCs only dream of.
Total Purchase Price: $1.65 billion, 2006
Estimated Current Contribution to Market Cap: $86.2 billion
Absolute Dollar Return: $84.5 billion
We admit it, we screwed up on our first episode covering YouTube: there’s no way this deal was a “C”. With Google recently reporting YouTube revenues for the first time ($15b — almost 10% of Google’s revenue!), it’s clear this acquisition was a juggernaut. It’s past-time for an Acquired revisit.
That said, while YouTube as the world’s second-highest-traffic search engine (second-only to their parent company!) grosses $15b, much of that revenue (over 50%?) gets paid out to creators, and YouTube’s hosting and bandwidth costs are significant. But we’ll leave the debate over the division’s profitability to the podcast.
Total Purchase Price: $3.1 billion, 2007
Estimated Current Contribution to Market Cap: $126.4 billion
Absolute Dollar Return: $123.3 billion
A dark horse rides into second place! The only acquisition on this list not-yet covered on Acquired (to be remedied very soon), this deal was far, far more important than most people realize. Effectively extending Google’s advertising reach from just its own properties to the entire internet, DoubleClick and its associated products generated over $20b in revenue within Google last year. Given what we now know about the nature of competition in internet advertising services, it’s unlikely governments and antitrust authorities would allow another deal like this again, much like #1 on our list...
Purchase Price: $1 billion, 2012
Estimated Current Contribution to Market Cap: $153 billion
Absolute Dollar Return: $152 billion
When it comes to G.O.A.T. status, if ESPN is M&A’s Lebron, Insta is its MJ. No offense to ESPN/Lebron, but we’ll probably never see another acquisition that’s so unquestionably dominant across every dimension of the M&A game as Facebook’s 2012 purchase of Instagram. Reported by Bloomberg to be doing $20B of revenue annually now within Facebook (up from ~$0 just eight years ago), Instagram takes the Acquired crown by a mile. And unlike YouTube, Facebook keeps nearly all of that $20b for itself! At risk of stretching the MJ analogy too far, given the circumstances at the time of the deal — Facebook’s “missing” of mobile and existential questions surrounding its ill-fated IPO — buying Instagram was Facebook’s equivalent of Jordan’s Game 6. Whether this deal was ultimately good or bad for the world at-large is another question, but there’s no doubt Instagram goes down in history as the greatest acquisition of all-time.
Methodology and Notes:
Transcript: (disclaimer: may contain unintentionally confusing, inaccurate and/or amusing transcription errors)
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