JetBlue: investors love the low-cost plus frills concept April 2002

JetBlue, which started service in February 2000, has adapted the classic low–cost formula to include some frills and an operation based at a major international airport — New York JFK. In February it issued an IPO prospectus, aiming to raise some $125- 135m to fund the expansion of its A320 fleet, and in April the IPO was successfully launched and in fact raised $148m for the equivalent of about 15% of the equity.

JetBlue achieved an operating income of $26.8m (before $18.7m of government aid under the Stabilization Act). Its operating margin, 8.4%, was only bettered by one US airline — Southwest. Its expansion has been rapid. Last year it carried 3.1m passengers on a network that comprises the New York- Florida, upstate New York and transcontinental. It has established a second operating base at Long Beach in California.

September 11 had an immediate and severe impact on JetBlue, but it managed to stay profitable, although its operating margin dropped to 4.2% in the final quarter of the year compared to 12.2% in the first half. Traffic has now recovered to the level expected before the terrorist attacks, although yields are still suffering. It did not, however, reduce capacity or lay staff off. Like Southwest, it has been able to capture market share from its traditional rivals which were forced to instigate much more drastic cutbacks. For instance, US Airways closed down its MetroJet operation, which was its product to compete with low–cost airlines, and Delta significantly reduced capacity of its Delta Express service, its subsidiary leisure carrier on Northeast and Midwest to Florida routes.

Also like Southwest, JetBlue enjoys investor confidence. There is little doubt that the IPO will succeed in raising the required funds by the end of the month. None of the original venture capitalists — including George Soros, BancBoston Ventures, JP Morgan and all of JetBlue’s senior management, who have put some $175m into the airline — are going to cash in at this point.

Their redeemable preferred stock will be converted into common shares following the IPO, and they make take up some of the new shares, either directly or indirectly.

At the IPO share price of $27, JetBlue will have a total stock–market valuation of about $1.1bn, and on paper the original investors will have more than quintupled their stakes. For comparison, the stock–market valuation is almost the same as that of UAL Corporation, but is dwarfed by Southwest’s $16.2bn and is less than half of easyJet’s capitalisation. This stock–market price also implies that analysts will be expecting at least a doubling of profits in 2002 (assuming JetBlue commands roughly the same p/e ratio as Southwest).

The reputation of JetBlue’s CEO, David Neeleman, is extremely important in this regard. He was the president and one of the founders of Morris Air, bought by Southwest in 1993, developed the Open Skies reservation system, and set up WestJet, Canada’s successful low–cost carrier. He has built up a management team that includes high–level expertise from Southwest and his previous ventures.

The financial community generally is now focusing almost all its attention on the low cost or regional carriers while temporarily despairing of the mainstream network carriers. This means that not only are investors lining up to support JetBlue but also the airline currently has no problems finding funding for its ambitious expansion plans.

Including long–term debt and lease commitments for its A320s and its contract with Live TV, JetBlue’s liabilities add up to $3.3bn.

This might be considered as a daunting amount for a start–up airline with just 24 months of operating experience. But in today’s market it is likely that JetBlue will be able not only to finance its new A320s but also raise a cash surplus on each transaction, justified by the difference between the unit price it has paid Airbus and the appraised value of the aircraft.

The JetBlue model consists of the following elements.

New A320 fleet

The all–new A320 fleet, configured to 162 leather seats in mono–class, is central to JetBlue’s strategy. Indeed, the newness factor is an even bigger selling point in the post- September 11 environment. JetBlue emphasises the security aspect by highlighting its kevlar doors and titanium bolts on the cockpit door, and now it is introducing cameras that will allow the pilots to monitor the cabins.

The homogenous fleet clearly delivers the standard benefits in terms of maintenance costs, aircrew training costs, scheduling flexibility and high average utilisation (12.6 hours per day in 2001, compared to 11.1 for Southwest). Utilisation is boosted by its transcontinental operations and in particular by its red–eye flights which keep A320s in the air throughout the night. Also, new aircraft are operationally more reliable. JetBlue currently has 61 A320s on order with a further 30 options (and purchase rights for a further 19). The fleet is planned to grow to at least 113 units by 2009 (about a third the size of Southwest today). JetBlue has the possibility of converting A320s into A319s or A321s, which would allow it to tailor aircraft types to different markets but retain all the benefits of fleet communality.

JetBlue also appears to be able to exploit its position as the only Airbus low–cost operator (Southwest, AirTran, WestJet, Ryanair and easyJet are all Boeing customers).

Airbus has deferred pre–delivery payments of about $78m over the past three years, which has greatly assisted JetBlue’s cashflow. The depreciation policy is interesting — the A320s are depreciated over 25 years to a 20% residual value. This is rather more aggressive than usual for a low–cost airline: the annual depreciation cost for a $35m aircraft would be $1–1.5m lower than at easyJet in the early years of its operation.

Market stimulation

JetBlue’s original concept was based on the theory that many of New York routes had been neglected following the demise of People Express in the late 80s. According to DOT statistics, from 1985 to 1999, the number of origin and destination passengers rose 77% nationally, but rose only 6% in the New York market.

JetBlue has demonstrated that its entry in underutilised markets stimulates traffic strongly. It targets fare–conscious leisure and business travellers who might otherwise have used alternative forms of transportation or would not have travelled at all.

The table below shows the market stimulation effect once JetBlue enters a market, especially the north New York state to JFK sectors where new passengers flying on the airline exceeded the total market growth.

Frills and branding

Frills include the leather seats and free LiveTV (a 24–channel satellite television service) at every seat, pre–assigned seating and a FFP, which is in the process of being introduced.

All this goes to branding JetBlue as an efficient low–cost with a bit of gloss and business- orientated service. The latest Zagat Airline Survey, ranked JetBlue as second out of 22 US airlines in the “overall,” “comfort” and “service” categories for coach travel (Midwest Express was number one). It has also received plaudits from Conde Nast and Business Traveller magazine.

Distribution, pricing and YMS

JetBlue’s distribution channels in 2001 were: travel agents, 7%; direct tele–sales, 49%; and internet sales, 44%. This is the highest percentage of web sales in the US, and has now risen to over 50%, but is far from the near 100% online sales achieved by the leading European low–cost carriers.

JetBlue’s simplified fares structure is based on 14–day, 7–day and 3–day advance purchase fares and a “walk–up” fare in each market. The highest “walk–up” fare is set at approximately twice that of the lowest 14–day advance purchase fare. All fares are one–way and do not carry restrictions such as Saturday night stays, but they must be purchased at the time of reservation and are non–refundable. Bookings can be changed or cancelled prior to departure for a $25 change fee. Advance purchase fares are often 30%-40% below those existing in markets prior to JetBlue’s entry; while its “walk–up” fares are generally 60%-70% below US majors’ unrestricted “full coach”.

The yield management system is reputed to be one of the most effective models designed for low–cost operations, based on the principle that fares inevitably increase as the departure date approaches. The system does not allow overbooking, reflecting the standard low–cost no refund policy. JetBlue’s load factor in 2001 was 78.0%, higher than that of any major US airline.

Labour productivity and company culture

In 2001 JetBlue’s operating cost per ASM was 6.98 cents, the lowest of the US Majors. This is partly due to the productivity of the fleet (and transcontinental stage) and partly due to the workforce.

JetBlue claims to have one of the most productive workforces in the industry, partly due to the use of part–time employees and new technology. For example, most of the reservation sales agents are part–time employees who work from their homes. A significant number of employees participate in a stock option plan, and all employees, including part–time employees, will be able to participate in an employee stock purchase plan after the IPO.

JetBlue puts great store on its culture, which, it states “ is built around our five key values: safety, caring, integrity, fun and passion”.

This may sound a bit naff, but it does work and it is clear that this intangible asset is present at all the successful “low–costs”.

As a new airline, JetBlue has the opportunity of making full use of advanced technology. For instance, all pilots use laptop computers in the cockpit to calculate the weight and balance of the aircraft prior to departure. They also access manuals in an electronic format during the flight. The reservation system allows JetBlue managers to monitor their loads, yields and sales on a daily basis, allowing rapid responses to market changes.

JFK base and network expansion

New York’s JFK airport provides access to a market of approximately 21m potential customers in the New York metropolitan area and approximately 6m potential customers within 15 miles of the airport.

While LaGuardia and Newark are congested throughout the day (in normal times), JFK generally is only congested the late afternoon to the early evening when international traffic and the domestic traffic that feeds it are heaviest. This period, from 3:00 p.m. to 7:59 p.m., is regulated by the FAA’s High Density Rule.

JetBlue has 75 daily slot exemptions at JFK that allow it to fly during this congested period, but schedules almost two–thirds of its flights at other times.

The Port Authority of New York and New Jersey is in the process of a $10bn JFK redevelopment project, which includes new terminals, improved roadways and construction of the AirTrain, a direct, light–rail link between JFK and the New York subway system. AirTrain, which will allow passengers to travel from JFK to Manhattan in 45 minutes, is expected to be fully operational in 2003.

With a geographically diversified flight schedule from JFK, JetBlue can adjust its schedule to accommodate seasonal fluctuations in demand in certain markets. For example, it offers increased service on New York–Florida routes in the winter when demand is higher. JetBlue is now one of the top two carriers (in terms of daily flights) in the New York City to Ft. Lauderdale route, which, perhaps surprisingly, is the busiest route in the US.

JetBlue’s west coast operation, based at Long Beach Municipal Airport, is located in the Los Angeles metropolitan area, the second largest in the US with 16m inhabitants, of which over 6m live within 20 miles of Long Beach. Average airfares from the Los Angeles area are generally high, other than fares to markets served by Southwest. Also, Long Beach has historically been underutilised for scheduled flights. JetBlue has 27 out of a total of 41 daily non–commuter departure slots, leaving only 14 slots for other airlines, and, of these, only nine are held by passenger airlines.

Risks

JetBlue’s prospects certainly look very promising, but there are challenges ahead. It might just begin to regret the cost of the extra frills and the cost of its JFK base if it ever gets into close competition with Southwest. More immediately, it has generated a competitive reaction from two of the Majors.

American is entering a fare war with JetBlue on New York routes and is also attempting to obtain Long Beach slots to launch services to New York and Chicago from there. United will compete directly with JetBlue’s Long Beach–Washington Dulles service when it launches a new A320 twice–daily service between Oakland and Dulles in May. United also plans to offer tickets at prices comparable to JetBlue’s.