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Will Richard Branson's Virgin America Fly?


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."

Stone_190
Stone is a senior writer for Bloomberg Businessweek in San Francisco. He is the author of The Everything Store: Jeff Bezos and the Age of Amazon (Little, Brown; October 2013). Follow him on Twitter @BradStone.

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