US new entrants mired in deep financial trouble February 1998

In sharp contrast to the boom times enjoyed by the majors, the US low–cost new entrant sector is in deep financial trouble. The quarterly results available indicate that the sector as a whole may produce net losses accounting for as much as 24% of revenues for 1997.

Most of the new entrants began operations during 1993–1995, when the barriers to entry were at their lowest ever, and some were verging on profitability by early 1996. But ValuJet’s May 1996 crash, its subsequent three–month grounding, the extended debate about maintenance practices and the questions raised about the FAA’s competence in overseeing safety had a devastating impact on the new entrants. As they also faced a sharp hike in fuel prices, reinstatement of the ticket tax, fare wars led by Southwest and aggressive expansion or price cuts by other majors in targeted markets, it was hardly surprising that all the start–up carriers incurred substantial financial losses in 1996.

What is surprising is that their losses accelerated in 1997 despite buoyant economic conditions, an easing in fuel prices and a flawless safety record; why?

First, the events of 1996 evidently dealt a severe blow to the former image of the low–cost operator. The US consumer still demands low fares, but established or conventional–type carriers are preferred when the choice exists.

Second, the majors have taken full advantage of the situation and are now financially stronger and keener than ever to defend their hubs. Delta and United are behaving much more aggressively at Atlanta and Denver respectively. Delta launched its own low–cost venture, Delta Express, in October 1996, while Southwest also began to expand on the East coast.

Third, some of the struggling carriers had little hope of long term survival in the first place, while others have messed up their chances by choosing wrong markets or inappropriate business strategies.

ValuJet, which resumed scaled–down operations at the end of September 1996, was not able to make a comeback. It had to discount heavily to win back passengers and yields plummeted. Costs, in turn, surged due to reduced fleet size, increased maintenance needs and the various structural changes required by the FAA. The airline was not allowed to build up its fleet fast enough — last summer it was still five aircraft short of the 30 considered necessary to restore profitability. A $14.6m net loss in the critical third quarter, following $48m accumulated losses in the previous three quarters, was enough to concede defeat. The company decided to tap into its still–substantial cash reserves to buy AirTran Airways and give up the ValuJet name.

AirTran itself had been hit hard by the 1996 events, and over the past year it has had Delta Express to deal with on its home turf. Since reporting a $1.2m net profit for 1995, the carrier has lost $12.6m and was close to running out of cash last summer.

Western Pacific, the most promising of the new–generation start–ups, ended up filing for Chapter 11 on October 6. The company had raised $48m in an IPO in December 1995 and developed a unique low–fare niche at Colorado Springs. However, because of its extremely rapid initial expansion, WestPac had little cash left when it plunged into heavy losses in the fourth quarter of 1996. New capital kept coming in, but escalating losses ($33.3m in the first half of 1997) meant a continuous cash crisis last year. Unsuccessful merger talks between WestPac and Frontier also had a negative financial impact. Frontier lost $7.4m in January–September 1997.

Air South is unlikely to fly again. The South Carolina–based carrier went into Chapter 11 in late August 1997 after defaulting on lease payments for most of its fleet, and operations were suspended. A year earlier it had been temporarily rescued by San Francisco–based investment bank Hambrecht & Quist. But given the absence of local traffic and the failed attempts in other markets, Air South had little chance of ever making a profit and its majority investor refused to inject more funds.

A similar fate may now await another Hambrecht & Quist–controlled carrier, Vanguard, which has never made a quarterly profit despite continuously shifting markets and raising new capital. The Kansas City–based carrier lost $24m in 1996 and $22m in the first nine months of 1997.

Pan Am has lost $80m (including $14.7m pre–operating expenses) since beginning operations in September 1996. This is in part due to the ValuJet factor but also because of mistakes made in the choice of fleet and markets. The company has kept going by raising new capital and is now restructuring and consolidating its operations with Carnival.

Carnival's financial decline over the past two years has been staggering. The old–established, low–profile operator used to be consistently profitable, but since the ValuJet crash it has reported ever–worsening quarterly losses. In the second quarter of 1997 it lost $40m, bringing the 1996/97 financial year net loss to $75.3m. After losing another $28m in the third quarter, the company had virtually depleted its cash reserves.

Kiwi, which was partially grounded over paperwork violations in June 1996, filed for Chapter 11 in September of that year and subsequently suspended scheduled service. The carrier resumed operations in January 1997 with the promise of $16.5m backing from a private investor and has since then been venturing back to its old East coast markets. After a surprise $1.2m net profit in the first quarter of 1997, Kiwi lost $8.9m in the April–September period.

Reno appears to be the only low–cost new entrant carrier of any size to be staging a recovery. After losses totalling $11.3m in the 1996/97 winter period, the carrier became marginally profitable in the June quarter and reported a $4.8m net profit for the third quarter. This is attributable to a young fleet, well–established business class product, full participation in AAdvantage FFP and all CRS systems and code–sharing with American.

Are mergers the answer?

Low–cost carriers have increasingly viewed mergers as the answer to their problems in the post–ValuJet era. The idea is to increase scale in order to reduce costs and to make it harder for Two companies also saw mergers as a discreet means to change their names.

ValuJet’s $62m acquisition of AirTran Airways, completed in late 1997, seemed like a long overdue move. Since the ValuJet name evidently carries lasting stigma, the decision to operate as AirTran Airlines (with ValuJet Inc as the parent) should benefit the Orlando–headquartered company — one recent survey suggested that most passengers do not know that the airline used to be called ValuJet.

Although the two carriers will continue to operate separately for a few months at least, the increased scale of operation (initially about 50 aircraft) puts the combine into a stronger position to take on both Delta and Delta Express. Growth will not be constrained by aircraft availability, because there are still DC–9s in storage and the MD–95 (or rather Boeing 717) deliveries are due to commence in 1999. Financing the $1bn order (50 firm plus 50 options) should not be a problem because of ValuJet’s still robust balance sheet. But the one–time expenses associated with the merger and efforts to improve image will mean further substantial losses over the winter, and the earliest return to profitability will be in the June quarter.

WestPac’s proposed acquisition of Frontier through a $41m stock swap last year seemed like an even better idea, because the two small carriers need critical mass to compete effectively against United at Denver. WestPac had already started shifting flights from its Colorado Springs base to DIA and it began code–sharing with Frontier on August 1. However, both the code–share arrangement and the merger talks were terminated at the end of September due to financial issues and philosophical differences over scheduling, yield management and suchlike.

Both WestPac and Frontier now intend to make it on their own. Having secured a rescue deal and the bankruptcy court’s approval for a reorganisation plan, WestPac looks likely to continue implementing the business strategy introduced in early 1997. Frontier, which has adequate cash reserves, is making schedule changes and gearing up for expansion.

The general view about the late September merger between Pan Am and Carnival, in which Pan Am forwarded Carnival’s shareholders 10m Pan Am shares (worth $65m at the time) and Carnival’s owner Mickey Arison contributed $30m in cash, is that putting together two cash–strapped and heavily loss–making airlines is unlikely to produce one stronger carrier.

Pan Am has stopped transcontinental service and the merged company will focus on north–south flying (including the Caribbean). The combined A300 fleet will be phased out by the end of 1998 — the aircraft are too large for year–round operation in most markets — and the company will become an all–narrowbody operator. However, its survival through 1998 depends on its ability to raise substantial new funds. A planned $115m private placement has been on hold for months,while SEC filings indicate that existing credit facilities will not sustain operations beyond the immediate future.

Going up-market

The past year has seen a concerted effort by low–cost carriers to focus on the higher–yield passenger segment. The new AirTran has launched a “no–frills” business class which offers larger seats, more legroom and assigned seating but no meals or FFP. It has also joined all major CRS systems and begun paying commissions to travel agents. This is broadly in line with the strategy that WestPac introduced in early 1997 and what Reno and Frontier have been doing for years, except that the Midwest–based carriers offer also limited meal service and FFPs. Vanguard and others have also joined CRS systems. The strategies are based on the premise that the environment has changed and it is no longer possible to compete as a pure low–cost, low–fare, no–frills, ValuJet–type shoestring operation.

While the experience of many carriers suggests that joining CRS systems is probably a worthwhile move, the business class strategy is very questionable. The key to successful low–cost operation has always been to keep things simple, and the business class fare mark–ups (typically $25, as in AirTran’s case) seem too low to compensate for the extra costs involved. In addition to running the risk of ending up as a low–fare, high–cost operation, the new entrants are also more likely to provoke the majors if they go after the business passenger segment too explicitly.

Can the DoT help?

The DoT remains determined to help low cost carriers surmount some the obstacles erected by the majors. The most concrete new measure implemented so far is the opening up of two key slot–controlled airports, New York’s La Guardia and Chicago’s O’Hare, to five new entrant carriers (AirTran Airlines, AirTran Airways, Frontier, Reno and St. Louis–based Trans States Airlines).

Since those airports cater primarily for business traffic, the new routes are likely to substantially boost low–cost carriers’ revenues. Frontier and AirTran Airlines began serving La Guardia from DIA and Atlanta respectively in December. The DoT and the DoJ are also reviewing a rising number of complaints filed by carriers such as Frontier and AirTran about predatory pricing by the majors. The DoT is considering strengthening the current antitrust regulations.

Who will provide the finance?

Most of the US new entrant airlines have been able to limp through the past two years’ crisis essentially because of their continued ability to attract finance. However, there are signs that the market has now tightened up. Raising the capital needed to start a new low–cost airline has become a hopeless undertaking, although in any case a tougher regulatory environment and a tighter supply of second–hand aircraft have meant that new applications have virtually dried up.

Air South’s experience showed that even investors with the deepest commitment and pockets will not tolerate persistent losses when an airline has obviously failed to find a promising market niche. Vanguard may find itself talking to a brick wall as it continues to seek its majority investor’s approval for a $15m rights offering.

Pan Am may find it impossible to raise the funds that it needs to continue operations until the fourth quarter of 1998, when it tentatively anticipates making its first profit, as the financial markets and individual investors reflect on the scale of Pan Am and Carnival’s past losses.

However, as several recent financings suggest, capital continues to be available for carriers that have found promising market niches and have reasonable growth prospects. In October 1997 Reno raised $33m through a private stock offering, which it will use to buy more aircraft and to convert leases to ownership. In November Frontier finalised a $15m loan for expansion purposes from a Connecticut–based investment company, which indicated that it could provide more funds in the future.

Contrary to earlier speculation that WestPac would not be able to secure sufficient rescue funding, the carrier received a $10m loan and a commitment for a further $40m investment in the first quarter of 1998 from New York–based investment company Smith Management (which controls Hawaiian Airlines and also helped TWA with its second reorganisation). This should enable WestPac to emerge from Chapter 11, though the of a possible 1998 IPO seems premature.