Spirit, and now Frontier: ULCC business model gains traction in the US Jan/Feb 2015

The Ryanair-style ultra-low cost airline business model is at last gaining traction in the US, where up-market LCCs such as JetBlue and Virgin America, in addition to low-cost pioneer Southwest, have dominated the scene.

Spirit Airlines — hitherto the only true ULCC in the US — is growing at a heady rate. Having expanded its capacity by 15-22% annually and doubled its revenues since 2010, Spirit is now accelerating ASM growth to 30.4% in 2015.

Fort Lauderdale-based Spirit, which completed a modest $190m IPO in May 2011, is already the eighth largest US airline, with $1.9bn revenues in 2014. It has grown from its original Caribbean/Latin America and domestic north-south leisure niche to become a nationwide operator. It sees potential to expand into more than 500 new markets.

And now there is another ULCC in the works. Since buying Frontier Airlines from Republic Airways Holdings in October 2013, Indigo Partners, the US private equity firm, has been in the process of transforming the Denver-based LCC into a “leading nationwide ULCC”.

It is early days yet. Frontier is still working to attain a ULCC-type cost structure, restructuring its network and trying to educate its customers about the merits of ULCC-style pricing — not an easy task in a domestic marketplace where LCCs increasingly compete with one another and where travellers generally expect them to provide superior service at no additional cost.

But Frontier has two advantages. It is benefiting from the experience of Bill Franke, its current chairman and the managing partner of Indigo Partners, who has a strong record of building successful ULCCs. It can also benefit specifically from the lessons learned at Spirit, which was a struggling LCC when Franke initiated its transformation into a ULCC in 2006.

Franke sold his stake in Spirit and resigned as its chairman in the summer of 2013 after Indigo began exclusive talks about acquiring Frontier. Indigo also previously held a stake in Singapore’s Tigerair and it remains a lead investor in Hungary’s Wizz Air and Mexico’s Volaris.

Las Vegas-based Allegiant Air — the tenth largest US carrier and publicly listed since 2006 — is also a ULCC, but it is a true niche carrier. Allegiant has an unusual business model: it operates from small cities to key leisure destinations such as Las Vegas, Orlando and Hawaii, utilising an old fleet that still included 53 MD-80s at year-end (along with used 757s, A320s and A319s). The old fleet gives it a uniquely flexible business model that allows it to fly when demand dictates. High fuel prices and other factors kept the airline’s ASM growth below 10% in each of the past two years, but a combination of low fuel prices and Allegiant’s lack of fuel hedging — factors that are likely to make its profits soar this year — may help revive Allegiant’s growth model.

The ULCC business model is gaining traction in the US in part because it is proving to be a superior profit generator. Spirit and Allegiant were the two most profitable US airlines in 2014 in terms of operating margins — 19.2% and 17.6%, respectively.

The ULCC model has also proved to be highly recession-resistant. Both Spirit and Allegiant maintained relatively stable unit revenues and profitability through the tough industry years of 2008 and 2009.

Of course, the fundamental reason why the ULCC business model is gaining traction in the US is that it is being increasingly accepted by the US travelling public. The lawsuits, legislative threats and negative press coverage that were previously associated with it have dissipated.

In 2012 Spirit was still fending off federal lawsuits that alleged it misled passengers and dealing with vitriolic national press coverage. One Forbes article (ominously titled “Spirit Airlines: the day of reckoning is yet to come”) slammed the airline for a lack of transparency in fares, for its plans to introduce a $100 checked/carry-on bag fee at the gate, and for an unfortunate incident in which it refused to refund a ticket to a “dying Vietnam veteran”.

But, like Ryanair, which has mended its ways since being rated the worst brand in the UK for customer satisfaction in a 2013 survey (Aviation Strategy, January/February 2014), Spirit has cleaned up its act.

Spirit has made a big effort to educate consumers about ULCC-style pricing and has made its fares and fees transparent. Its “Bare Fares” and “Frill Control” are very clear concepts. It now allows customers to see all available options and their prices before buying a ticket. Interestingly, a recent survey by Spirit found that much of the customer anger it was dealing with was directed at airlines generally.

While Frontier can learn from Spirit’s past mistakes, it will still have to educate its own flyers about the ULCC transition and find the pricing strategies best suited for its markets.

Spirit: Rare US growth story

Spirit began life as Clipper Trucking Company in Detroit in 1964, before transforming into a tour operator in 1983, a charter airline in 1990 and a scheduled carrier in 1992. In the 1990s it was a typical mainstream LCC, operating north-south low-fare services with DC-9s and MD-80s.

In 1999 Spirit moved its headquarters to Fort Lauderdale — a market it already knew well and where it had spotted an opportunity to build Latin America service. It became “South Florida’s hometown airline”.

Subsequently, Spirit made significant investments in its systems, technology, product and brand and essentially transformed itself into an up-market LCC, with a separate business class. It launched international operations to Mexico in 2003.

In 2004-2005 Spirit received a total of $225m in equity funding from Oaktree Capital and Goldman Sachs Credit Partners, which enabled it to order up to 95 A320-family aircraft and complete a transition to an all-Airbus fleet in 2006.

In 2004 Spirit formally positioned itself as an LCC with a focus on the Caribbean and began launching those routes after the A320 deliveries started in late 2004. Spirit also terminated many thinner domestic routes and began to add major markets. The current CEO, Ben Baldanza, arrived from US Airways in 2005.

So, while Spirit was incurring losses, many of the key components for future success were already in place when Indigo acquired a majority stake and control from Oaktree in July 2006. Oaktree wanted to bring in Indigo’s significant airline expertise to accelerate Spirit’s growth.

The new fleet, the network realignment and the switch to the ULCC business model had an immediate dramatic impact on Spirit’s financial performance. After three years of operating and net losses totalling $172m and $236m, respectively, the airline turned modestly profitable in 2007.

Since then Spirit’s profits have soared (see chart). In recent years, the annual operating margin has been in the mid-to-high teens. Pretax ROIC has exceeded 28% each year since 2011; in 2014 it was 30.1%.

The post-2006 financial recovery reflected success in reducing ex-fuel unit costs while maintaining relatively stable total unit revenues. Between 2006 and 2009, ex-fuel CASM fell by a stunning 21%, from 6.89 to 5.45 cents, while RASM was unchanged (9.37 and 9.35 cents). Importantly, since then Spirit has retained the low ex-fuel CASM (up slightly in the past five years, to 5.88 cents in 2014), while increasing its RASM by 26% over the period.

Spirit has one of the lowest cost structures in the Americas. According its recent presentation, on a stage length adjusted basis, Southwest, JetBlue and American had 9%, 28% and 50% higher CASM, respectively, than Spirit in the 12 months ended September 2014.

Like ULCCs typically, Spirit achieves its low cost structure through high aircraft utilisation, a single-type fleet, high-density seating, simple operations, no hub-and-spoke inefficiencies, high labour productivity, use of outsourced services and use of low-cost distribution methods.

Spirit has the highest average daily aircraft utilisation among US airlines — 12.7 hours (up from 9.1 hours in 2006). Its A320s have 178 seats, compared to Virgin America’s 146.

While Spirit aims to hold ex-fuel CASM “flat to down slightly” in the long term, it is projecting a significant 6-8% reduction to 5.41-5.53 cents in 2015. The airline believes it can achieve that thanks to accelerated ASM growth (up 30.5% this year, compared to 17.9% in 2014), larger-aircraft efficiencies (all of this year’s 15 deliveries will be A320s and A321s) and a shift from operating leases to debt funding. There will also be benefits from cost measures implemented in late 2014, including many renegotiated agreements and leases, a new aircraft heavy maintenance agreement with Lufthansa Technik in Puerto Rico, and a transfer to third-party catering.

So Spirit is set to further increase its cost advantage over other US carriers this year. The trend could continue beyond 2015, because Spirit is targeting 15-20% annual ASM growth in the longer term.

The low costs enable Spirit to offer very low base fares, which are combined with a range of optional services for additional fees. The low fares stimulate demand, and the resulting higher passenger volumes and load factors lead to increased sales of ancillary products and services. This, in turn, enables Spirit to reduce the base fares even further, stimulating additional demand.

Citing the DoT, Spirit says that its base fares are on average 40% lower than other airlines’, and that even after paying extra for bags, seat assignments and snacks, its total price is still 35% lower.

Between 2006 and 2014, Spirit’s non-ticket revenues grew from $23.8m to $786.6m, to account for 40.7% of its total revenues. This may be the highest ancillary revenue percentage in the world; according to Spirit’s data for the 12 months ended June 2014, its 40.4% compared with Allegiant’s 34.2% and Ryanair’s 24.3%.

On a per-passenger-flight-segment basis, between 2006 and 2014, Spirit’s non-ticket revenues increased from $4.80 to $55.03, which amply offset the decline in average ticket revenue from $104.56 to $80.11.

Spirit generates non-ticket revenues by charging for checked and carry-on baggage, passing through all distribution-related expenses, charging for premium seats and advance seat selection, enforcing ticketing and service change policies and selling subscriptions to its “$9 Fare Club”. Spirit also derives revenues from proprietary services such as its co-branded credit card, sells third-party travel products (hotel, car rental, attractions) packaged with air travel, sells third-party travel insurance through its website and sells in-flight products and onboard advertising.

The management conceded recently that the non-ticket revenue line was maturing and that growth would be a little flatter from now on, though there are many enhancements and new products in the works. Future growth will come from three areas: “applying proven revenue management techniques to ancillary items” (such as peak pricing for bags); “capturing a larger portion of the total travel budget” (more hotels, new items such as show tickets and dive packages); and “more products” (credit cards in Colombia and Central America, advertising onboard aircraft, plane wraps).

Of course, there will also be a near-term drag on ticket unit revenues resulting from this year’s heady ASM growth and increased price competition in off-peak periods (evidently because of the fuel price decline). Spirit estimates that its RASM will fall by 9-11% in the current quarter.

Spirit already has a diversified network covering 57 destinations. It is a major player in the Florida to the Caribbean/Latin America markets — one of its key strengths. After several years of expansion, it also has a nationwide domestic network covering 84% of the top 25 US metro areas.

The airline is interested in markets that are underserved and/or overpriced and operates mainly point-to-point services. Route selection is based on optimising operating margin and utilisation. The services are often low-frequency or seasonal. Spirit has “no emotional attachment to any particular route” and places “no value in market share”.

Spirit continues to target both international and domestic growth, but the focus has now shifted to “connecting the dots”. This year’s plan is to add 35 new routes, but Cleveland (added in January) may or may not be the only new city. So far, Spirit has announced plans to boost service in Atlanta, Los Angeles, Las Vegas, Boston, Denver, Cleveland and Houston IAH. The Houston move is significant in that it will add many new Latin America routes, making IAH Spirit’s second-largest base for international flights (after Fort Lauderdale), just as Southwest is preparing for its Latin America push out of Houston Hobby.

In recent presentations, Spirit executives noted that the airline accounts for only 1.6% of the total average weekly seats for sale in the US. By comparison, Ryanair accounts for 10.6% of the seats in Europe (a similar-sized market). Therefore, Spirit argues, there is significant untapped market potential for a ULCC in the US. Spirit has identified more than 500 markets in which it could grow while maintaining current levels of profitability.

The current fleet plan is to grow from 65 aircraft (at year-end 2014) to 144 at the end of 2021. In that period Spirit is currently scheduled to add 20 A320ceos, 45 A320neos, 28 A321ceos and ten A321neos, while reducing its A319 fleet from 29 to five.

Spirit is at last leveraging its strong balance sheet by taking on debt to finance aircraft (the first such transaction was in 4Q14). Cash at year-end was $633m or 33% of annual revenues. The company has announced a $100m share buyback authorisation, but dividends will have to wait because Spirit is very much a growth company.

Spirit’s share price has rocketed since it was listed in May 2011, vastly outperforming XAL. The industry-leading growth prospects have kept it as a “top pick” for many analysts.

Can Frontier make the transition?

All eyes are now on Frontier to see if it can emulate Spirit’s ULCC success. Frontier, which began operations in 1994, has struggled financially through much of its existence. It filed for Chapter 11 in April 2008, from which it was rescued by Republic in 2009.

Frontier’s historical struggles could largely be attributed to the decision to be a hub-and-spoke carrier at Denver International (DIA) — a relatively high-cost location and one of the most competitive markets in the US. DIA is a hub for United. Since Southwest’s 2006 entry and subsequent extremely aggressive expansion there, Frontier has fallen from #2 to #3 position at its home base. The fierce competition between Frontier, United and Southwest has made DIA’s average fares among the lowest for the top 100 US airports.

Pre-Indigo, Republic had already implemented successful restructuring at Frontier, which enabled Frontier to close the unit cost gap with the mainstream LCCs. But much work remained to be done to turn the carrier into a ULCC.

One of Franke’s early moves was to put together what could be described as a ULCC “dream team”. CEO David Siegel is supported by a new president (Barry Biffle), who was previously CEO of VivaColombia and EVP at Spirit, and a new CFO (Jimmy Dempsey) who was previously Ryanair’s treasurer.

Frontier is working to reduce its ex-fuel CASM from 7.5 cents at the time of the Indigo acquisition to the 6-cent level, which is typical for ULCCs. CEO Biffle reportedly predicted in January that the target would be reached by year-end 2015. Among other cost saving moves, Frontier is outsourcing 1,300 airport operations and reservations workers — about a third of its workforce.

Under the initial unbundling strategy adopted in April 2014 (which is evolving), Frontier lowered its fares by an average of 12% and introduced fees for baggage and seat selection. The carrier has said that even before the 12% reduction, its fares in Denver were 6% lower than Southwest’s and 45% lower than United’s. Frontier has introduced a “Discount Den” club and has continued its long-time FFP.

But there are some important differences between Spirit’s and Frontier’s brands. Bill Franke, who spoke at a Wings Club lunch in New York in late January, called Spirit a “tremendously successful investment for us” but mentioned three lessons that he had learned. First, Spirit did not communicate the ULCC transition well with customers — a mistake that Frontier wants to avoid. Frontier puts more emphasis on customer service (picture a nicer, more genteel carrier). Second, Franke felt it was important to also offer a convenient, fully bundled fare. Frontier offers such as fare, called Classic Plus. Its mantra is “low fares done right”. Third, Franke felt there should be more focus on operational performance, such as punctuality, at LCCs in general.

Franke described Frontier’s progress so far as “encouraging”. In the first nine months of 2014, Frontier had revenues of $1.17bn, up 15.7%, and a net income of $103m, up from less than $10m in the same period in 2013.

Fleet plans are in place to support growth well into the future. The 80 A320neo orders placed by Republic in 2011 begin delivering in 2016. In November 2014 Frontier ordered its first larger A321ceos (nine aircraft). So the fleet strategy takes a page from the Spirit playbook: moving to larger aircraft over time, which will help maintain the low cost structure. Frontier’s current 55-strong fleet consists of 35 A319s and 20 A320s.

Frontier’s two key challenges are, first, the point Franke made about successfully communicating the ULCC transition to its longtime flyers. In both 2014 and December, Frontier came worst in the DoT’s customer complaint rankings (though it must be noted that Spirit has chosen not to voluntarily report that data).

Second, Frontier has to find the good markets. It does not have any obvious highly promising growth niches, such as Spirit’s Caribbean out of FLL. While Frontier is committed to the Denver market, it is not a growth market. Even before Indigo’s involvement, Frontier was reducing its dependence on Denver, which used to account for 90% of its operations. It began growing from relatively small underserved airports such as Trenton (NJ) and Wilmington (Del). But under Indigo the focus has shifted to bigger cities, and last year the withdrawal from small Denver markets intensified.

Only about 50% of Frontier’s routes now touch Denver. It is uncertain how much lower that percentage will go. Perhaps it will also depend on rent and fee negotiations with the airport authority; Frontier’s lease on its gates and terminal space at DIA is up in 2016.

So far Frontier has made two notable big-city moves: Chicago O’Hare and Atlanta. It is aggressively developing ORD as its second-largest base. Its planned April expansion from Atlanta will make Delta’s main hub its third-largest base. The Atlanta expansion is possible because of Southwest’s contraction there since its merger with AirTran, which freed gates. Apparently, fares are higher than average at Atlanta. Frontier is also growing at Cincinnati and Cleveland — cities that have seen sharp contractions by Delta and United, respectively — and in Miami and Philadelphia.

One potential problem is that the best growth opportunities will draw interest from multiple LCCs. Spirit and JetBlue, too, are growing at Cleveland, while Spirit continues to also target Chicago, Atlanta and Denver. No-one has hinted that this might happen, but it is really hard not to picture Spirit and Frontier merging at some point in the future.

By Heini Nuutinen

hnuutinen@nyct.net