One thing that will drive increases in finance costs is new aircraft deliveries. During 2022, Virgin Atlantic took delivery of two A330-900s and one A350-1000. This was one of the reasons their un-discounted lease commitments went up by £547m, despite making £139m of lease repayments. Whilst those deliveries were already reflected in Virgin’s year end debt, there will be a full year effect in the profit and loss account through higher interest costs this year. In 2023, they have already taken delivery of two more A330-900s which will need to be paid for, plus any other subsequent deliveries.
Even though most of Virgin’s financing is at fixed rates, with dollar interest rates having risen by about 5% since the start of 2022, new aircraft financing will also be more expensive.
Shareholder loans
Earlier in this article I said I would come back to the topic of shareholder loans and how these are accounted for. We saw in the last section that part of the increase in Virgin’s gross debt was due to increases in shareholder loans. Most of the money that Virgin Atlantic raised from its shareholders during the pandemic came in the form of loans, with £275m in 2020 and another £422m in 2021. Of the total £697m raised, £206.9m came from Delta and the rest from Virgin Group.
I’m pretty sure these loans were interest free, but since that was understandably not seen by the accountants as representing an “arms length” interest rate, the accountants did as they often do these days and made up some numbers accounted for the loans using “fair value” accounting. What that means in practice is that initially only £351.7m of these loans were recorded as debt. This is a calculated figure, based on the present value of a £697m repayment in November 2026 with no payments in the interim, discounted using a “fair value” interest rate. I calculate they must have used something like 14% per annum. The rest was treated as an equity contribution. Since Virgin Atlantic isn’t making any interest payments, each year the notional interest gets added to the shareholder debt, increasing the interest charge each year as interest is charged on unpaid interest. At the end of December 2022, the amount of shareholder debt shown in Virgin Atlantic’s balance sheet was £426m. That is still £271m less than the amount that will need to be repaid in November 2026. That £271m will flow through the P&L statement as notional interest payments over the next four years, adding to the debt even if no further loans are extended by shareholders.
As we saw earlier, management adjusts out all the notional interest payments on shareholder loans when considering underlying profits. In 2022, that was a £62.6m adjustment and it will get bigger next year for the reasons discussed above.
Cash and liquidity
Virgin’s unrestricted cash balance at the end of 2022 was £328.7m, equivalent to 11.5% of revenue. That’s not dissimilar to the £352.6m (12% of revenue) figure they had at the end of 2019. But it is still very tight for an airline. BA by contrast had cash equal to 23% of revenue at the end of 2022 and there is cash equivalent to 14% of group revenues sitting at the IAG group level and in the Loyalty arm.
Virgin Atlantic’s 49% shareholder Delta also has oodles of cash, with liquidity of $9.5 billion at the end of March 2023. However, ownership and control restrictions would prevent it putting in more money in the form of equity, unless it could be matched by the Virgin Group. Back in 2021, Richard Branson sold $300m of Virgin Galactic shares, presumably to fund loans to Virgin Atlantic. However, he can’t repeat that trick again, since the subsequent fall in the share price of Virgin Galactic means his remaining stake is only worth $140m. On the other hand, Forbes estimates Richard Branson’s personal net worth at $3 billion, so I guess he could find more cash from somewhere if he wanted to.
What the company really needs is more equity, but with debts £1.5 billion higher than its assets, it will be hard for anyone to justify putting in more money until the company shows that it can generate proper levels of profit and cashflow. The company likes to present adjusted net liability figures by adding in the value of its slot portfolio. But even on that basis, the company had net liabilities of £913m. That’s more than the balance sheet value of its shareholder loans.
So all roads lead back to the need for Virgin Atlantic to start generating profits. What are the prospects of that in the near term?
Prospects for pre-tax profits in 2023
In 2022, net finance costs were £206m, excluding notional interest on shareholder loans. For the reasons we’ve just explored, I think that this is likely to go up a bit in 2023.
We saw earlier that there are good reasons to believe that Virgin Atlantic will start to generate operating profits in 2023, assuming yields hold up and fuel prices stay where they are. Playing with a few assumptions, I could see them achieving operating profits of £300m or better. That would be approaching the double digit operating margins that well-performing airlines target and would be enough to generate a small pre-tax profit on an underlying basis in 2023. Making a profit on a statutory basis will be a tougher task, with another £70m or so of interest on shareholder loans to cover.
Digging itself out of its financial hole
Virgin Atlantic’s management say that 2023 will be “a year of delivery towards achieving our vision of becoming the most loved travel company and sustainably profitable”.
That’s a nice vision, but what does “sustainably profitable” really mean?
Even if Virgin Atlantic manages to start making pre-tax profits of £100m a year, it would still take the company fifteen years to eliminate its negative equity. I can’t see how the company will generate anywhere near enough cash to be able to repay £697m of shareholder loans in November 2026, so the status of those shareholder loans will have to be addressed before then.
If the shareholders agree to write off their loans, the company’s negative net worth would immediately shrink to £1.1 billion. Notional interest on those loans would cease to go through the P&L, improving headline results by circa £70m a year. If Virgin Atlantic could somehow match the 15% operating margin that BA managed pre-crisis, pre-tax profits would rise to something like £300m a year. Add a bit of growth and the company could claw its way back out of its negative equity position within three years. That kind of performance level would also support a real injection of equity capital to get to a decent balance sheet that would be resilient to future shocks.
A more plausible scenario based on the past would be a “muddling through” approach. The shareholders would dribble in small amounts of additional cash in the form of loans as needed to avoid default on the debts, and to maintain a barely adequate level of liquidity. The term of existing shareholder loans will be extended, to the extent required to avoid admitting they can’t be repaid. “Being loved” will trump “being sustainably profitable”, and getting to breakeven will be regarded as “mission accomplished”.
A critical year ahead
I am unclear whether the company has actually given up on getting back to profitability in 2023. Perhaps they are just being cautious in public, with internal targets which are much more ambitious. I also don’t know what the shareholders are going to do, if anything, about sorting out the company’s balance sheet.
What I do know is that Virgin Atlantic is still a great brand and, like everyone in aviation, its people have been through a lot over the last three years. I’m certainly hoping that when I write next year’s article, I won’t be lamenting a seventh successive year of losses.
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