Lose the battle, win the war

Twice in one day? The news fairy strikes!

Nearly two years ago, when JetBlue first announced its attempt to steal Spirit Airlines away from Frontier, the conventional wisdom said there is no way a JetBlue/Spirit deal would be approved by regulators.

But JetBlue pressed hard and lobbied extensively. By the time the Department of Justice decided to sue to block the merger the Activision/Microsoft regulatory defeat had happened, and feelings were changing. I’m not saying the conventional wisdom had totally flipped and approval was expected, but I think the court’s decision to block the deal did catch a lot of people off guard.

The judge, for his part, was having no part of this deal. One of the best things in finance is a judge who enjoys their job. To wit…

The airlines could appeal, but don’t let that distract you: It’s over. And the real fun is about to begin. The world is a much different place today for these airlines than it was just 18 months ago.

It is telling that JetBlue shares were up and Spirit lost half of its value after the announcement. Part of that is arb unwinding (never do arbitrage!). But the market was saying that JetBlue is better off not having to buy Spirit, and Spirit is in real trouble. And the market, in this case, is correct.

JetBlue was buying Spirit because it has no other real path for sizeable growth. That is still true today, but growth is much less important in an environment where airlines are cutting back and demand is showing signs of ebbing.

JetBlue is fine. JetBlue still has serious long-term questions to answer, but they are fine. And investors are right in being relieved it is over. Spirit was the only merger option, but it was a poor fit for JetBlue in a lot of ways and would have been a nightmarish integration. JetBlue has been in the hole since it lost out on Virgin America, which sold to Alaska Air. I’m not sure how they dig out from that hole. And I get why they went for Spirit. But Spirit was a poor answer.

Spirit is in a world of trouble. Spirit is the butt of a lot of jokes, but they are an effective carrier when times are good. Frontier (and Ryanair in Europe) shows the model works. But Spirit is also a “spill” carrier, which means its role is basically to mop up the extra demand after bigger airlines have filled their planes. In a shrinking market, there is much less business to mop up.

Not long ago, Spirit mortgaged what it could to raise $400 million or so. That’s something. But airlines need massive amounts of cash just to keep the lights on. The $400 million won’t save them.

There have been market whispers for weeks that Spirit was out looking for options. That’s not to say they knew the deal would be shot down. It just means they realized they would need a plan B quick should the deal be scrapped. Quick is now.

Frontier was always a better merger partner, and a deal would still (theoretically) make sense. But I can’t see Frontier coming in right now. For one, Frontier was going to use its stock to buy Spirit. That stock has lost half of its value since the first offer was made. And although a deal makes more sense and is more likely to win approval, it is still not a slam dunk. Frontier faces the same economic pressures as the rest of the industry and doesn’t need the uncertainty or a regulatory battle right now. And I’m not sure Spirit has the time to wait out another merger review even if Frontier came calling.

Private equity has been kicking the tires, from the whispers I have heard. But that’s a tough spreadsheet to get right. Airlines have a way of attracting dreamers who are willing to look past common sense, and it is possible Spirit might find a sponsor in the weeks to come. But it will take a dreamer.

Spirit could go bankrupt. Perhaps I am fear mongering, but I think the possibility is real. And if it does, that’s when things really get interesting.

In normal times, airlines have been able to use Chapter 11 rather effectively in part because they are usually holding aircraft at a time when the economy is down and no one wants aircraft. So, there is a deal to be reached. That’s not really the case this time. Airlines are under pressure relative to a year ago, and demand is dropping, but there is still plenty of global demand for aircraft, especially newer, fuel-efficient aircraft like the ones Spirit is flying around.

Boeing’s current issues will only exasperate the demand issues.

So, Spirit is in a situation with no good option, and the option that usually works best for airlines with no good options is off the table. Should Spirit have to file, my guess is their creditors would be happy to repossess aircraft instead of renegotiating terms. That’s a problem for Spirit.

Which gets us to a really tasty endgame: Will we see a reenactment of the bidding war from two years ago? There’s a scenario where JetBlue and Frontier are in court battling over Spirit’s corpse, jumping between negotiating in private with creditors for airframes and weighing a bigger package to bring planes and pilots into the fold.

Obviously, I’m getting way ahead of myself. Perhaps Spirit will be able to muddle along thanks to a stronger-than-expected spring break season and get back on its feet to at least fight another day. But there is a real chance here that both Frontier, and JetBlue, will have a chance to turn a massive loss into a win in the quarters to come.

As an investor, what should you do? Nothing. Or better yet, run. Whatever comes next for all of these companies, it will be a mess. Buy popcorn futures and sit back and watch. Or read this whole thing back again and understand why I am so high on AerCap.

Buckle up.

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