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The Justice Department on Tuesday approved Alaska Air Group Inc.'s acquisition of Virgin America Inc., but imposed conditions requiring Alaska Air to scale back its route partnership with American Airlines Group Inc.

The $2.6 billion merger deal, struck in April, would create the fifth-largest U.S. airline by traffic, surpassing JetBlue Airways Corp., which lost a bidding war with Alaska Air for Virgin America.

Even after the merger, the combined carrier would control just 6% of the domestic market, compared with the four U.S. giants that control more than 80% as a result of a series of megamergers since 2008.

The Justice Department said the modifications to the partnership with American would ensure Alaska Air has the incentive to compete as vigorously with American as Virgin America does today, going head-to-head on 20 nonstop routes. Under Alaska's route-sharing pact with American, called a code-sharing deal, each carrier sells certain flights belonging to its partner as if they were its own.

Alaska Air currently markets American flights on more than 250 routes, while American sells seats on 80 Alaska Air routes, a Justice Department official said, resulting in the two airlines often behaving more as partners than competitors.

Alaska Air also has a code-sharing agreement with Delta Air Lines Inc., which wasn't mentioned in the Justice Department's proposed settlement.

Brandon Pedersen, Alaska Air's chief financial officer, on Tuesday said his company currently derives $190 million in annual revenue from the American code-share pact and $65 million from that with Delta.

Mr. Pedersen said there are only about 45 markets where Alaska Air would lose existing code-share revenue because of the curtailments to its American partnership, with the net financial impact being $15 million to $20 million a year. He estimated Alaska Air could recapture $40 million to $45 million of lost code-share revenue by replacing it with more of its own planes and passengers.

Antitrust enforcers said they would prohibit Alaska Air and American, the nation's top airline by traffic, from code-sharing on routes where Virgin America and American compete today, as well as on routes where Alaska would otherwise be likely to launch new service in combination with American following the merger. But they would be able to continue code-sharing in limited circumstances, the Justice Department said.

The Justice Department also said it would require Alaska Air to seek approval before selling or leasing any of the gates or slots Virgin America won in a settlement that allowed regulators to green-light the huge American-US Airways merger in late 2013.

Virgin America, based in San Francisco, began flying in 2007. After finally becoming profitable in 2013, it went public the following year. It is much smaller than 84-year-old Alaska Air and operates a different type of aircraft. But its stylish service and cult following was part of the lure that drove the bidding for it up to $57 a share, a 47% premium.

The parties face another potential hurdle, however. In September, a consumer lawsuit seeking to prevent the merger on antitrust grounds was filed in federal court in San Francisco. The judge has scheduled a trial for next Monday, to be preceded by a mandatory settlement conference and pretrial hearing slated for Wednesday.

Now that antitrust regulators have blessed the transaction, it remains to be seen if the trial would move ahead. The judge also ordered Alaska Air to give at least seven calendar day's notice to the plaintiffs before closing the transaction, which the company has said it would abide by.

Mr. Pedersen said Alaska Air wants to close the Virgin deal "as soon as possible" and that timing will depend on the disposition of the lawsuit. "We'll know much more tomorrow with our meetings with the judge," he said. A Justice Department official said the San Francisco judge would have to decide how to proceed.

Joseph Alioto, a San Francisco antitrust lawyer who is leading the consumer lawsuit, on Tuesday called the Justice Department's proposed remedies "abominable" and said one option would be to ask the judge to stay the closing of the deal until the bench trial has concluded. He reiterated his intention "is to provide this merger should be prohibited."

Seattle-based Alaska Air has raised $1.5 billion in financing for the deal and already has booked $36 million in one-time merger expenses. The combination would give it and Virgin America the largest seat-share on the West Coast, lift them to second-largest carrier in San Francisco and make them more relevant, with an 11% seat share, in the fragmented Los Angeles International Airport market.

Write to Susan Carey at susan.carey@wsj.com and Brent Kendall at brent.kendall@wsj.com

(END) Dow Jones Newswires

December 06, 2016 17:15 ET (22:15 GMT)

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