US LCCs: reaching critical mass? June 2004

The US low–cost carrier (LCC) sector has, in many respects, come of age in 2004.

Recent months have seen broad recognition that LCCs are no longer just a driving force for change but that the balance of power has shifted from the legacy carriers to LCCs. After growing extremely rapidly since September 11, LCCs have gained critical mass and now control pricing in the domestic market. This has had the consequence — one analyst called it a "cyclical first" — that the legacy carriers are not seeing any revenue recovery despite the resumption of healthy GDP growth.

Yet, LCCs are also reporting lower profit margins or losses in 2004, due to aggressive competitive responses from the legacy carriers, excess industry capacity and high fuel prices.

How will they navigate through these challenges? As another interesting twist, UK entrepreneur Richard Branson is going ahead with plans to launch a "Virgin USA" low–cost unit despite the difficult environment. The venture, formally announced in early June, is expected to begin operations in 2005 initially out of San Francisco, though the headquarters will be in New York City.

The key question is: given the tough industry fundamentals and extreme crowding in the East Coast and transcontinental markets, is there still room for a sizeable new LCC entrant? The Virgin–branded carrier would represent an interesting new ownership model (the overseas franchise) in an industry sector that is already diverse. There are currently four or five LCC types in the US:

• Stand–alone entities — LCCs since their inception. The largest are Southwest, JetBlue, AirTran and Frontier, representing three generations of start–ups: pre–deregulation, early 1990s (AirTran and Frontier) and early 2000 (JetBlue).
• "Reformed legacy" carriers — currently only America West. AWA is a rare survivor from the early 1980s crop of entrants. A Chapter 11 visit in the early 1990s gave it low unit costs. Since being rescued by the ATSB in January 2002, it has also transitioned to an LCC–style simple, low fare structure (Aviation Strategy briefing, November 2003).
• Regionals that have transformed themselves into LCCs — Independence Air (formerly Atlantic Coast), which begins operations this month, is currently the only example (Aviation Strategy, May 2004). However, Mesa has indicated that it will consider following that route and acquiring 737s if its largest partner, US Airways, is liquidated.
• Major carriers' competitive responses — the only examples currently are Song and Ted (by Delta and United, respectively); past examples included Continental Lite, Shuttle (United), MetroJet (US Airways) and Delta Express. While Song is Delta’s response to JetBlue, Ted is little more than a new image used to market leisure–oriented flights.
• Charter–into–scheduled leisure carriers — ATA is probably the only example. It is old–established (1973), has extremely low unit costs and focuses heavily on leisure markets.

Most estimates of LCCs' domestic market share include only the stand–alone carriers plus America West. The sector’s share of total domestic passengers is currently about 25% and is expected to grow to 40% or more within five years.

Currently about 70% of domestic markets have LCC service available.

The sector is dominated by Southwest, which accounts for nearly half of the LCCs' total passengers. Even then, JetBlue has already reached "major carrier" status, with $1bn–plus annual revenues in 2003, and both AirTran and Frontier are approaching that mark.

The shift in market share to LCCs has been a continuous trend since deregulation. The 14–15 years up to the early 1990s saw steady growth by Southwest and numerous start–ups and failures. No fewer than 32 of the 34 carriers that began primarily scheduled passenger service between 1978 and 1992 had disappeared.

In the early 1990s, there was a strong surge in start–up airline activity in the US, thanks to a rare combination of favourable economic, political and industry conditions. There was a good supply of cheap second–hand aircraft and a large pool of experienced airline workers. Getting up and running was easier as a whole new industry had emerged to provide support services.

Technological developments had made it possible to dispense with travel agents and their commissions. Getting federal approval had become easier, thanks to the very pro–competitive stance adopted by the Clinton Administration.

The government was dealing decisively with predatory behaviour. Economic circumstances were ideal and finance was readily available. The numerous new low–cost entrants from the 1993–95 period included AirTran’s predecessor ValuJet, whose June 1994 IPO and subsequent spectacular financial success made it a favourite on Wall Street. The airline earned net profit margins as high as 16–18% in the mid–90s (similar to JetBlue’s in recent years) in competition with Delta in Atlanta. It set a favourable trend for new entrants generally, paving the way for several successful IPOs and stock and bond offerings. The LCC sector’s domestic passenger share surged from just 7% in 1990 to 18% in 1995.

However, the sector’s good fortunes were brought to an abrupt end by ValuJet’s May 1996 DC–9 crash and subsequent grounding on safety grounds. The airline had evidently overextended itself and some of its profits were earned at the expense of safety. The negative publicity and tightened FAA scrutiny turned the tide against start–ups, and the sector saw no market share growth in the second half of the 90s.

ValuJet itself was able to weather the crisis because of its exceptionally strong cash reserves and because it underwent a thorough transformation over several years. Among other things, changes implemented in maintenance and organisational structure made it a more conventional type of operation, which helped restore public confidence. The name was changed to AirTran and profitability was restored in 1998.

By 2000 it was clear that two LCCs from the early 90s crop of new entrants — the other was Denver–based Frontier, which had also been through tough times — were again doing well and ready to start growing. They had survived when numerous others had failed — Kiwi, WestPac, Air South, Reno and Nations Air, to name just a few.

As UBS analyst Sam Buttrick aptly observed: "A large number of inconsequential failures and a small number of highly consequential successes".

US LCCs have used the post–September 11 industry turmoil to sharply accelerate growth and grab market share. Between 2000 and 2003, their capacity surged by 44% and passenger share increased from 20.6% to 25%. The bulk of the growth has come from JetBlue, AirTran and Frontier, because Southwest grew very conservatively in 2001–2003 and is only now returning to its normal 10% annual growth rate.

Why no new US entrants?

The post–September 11 period has seen a strong surge of new–entrant activity in other parts of the world — Aviation Strategy’s recent survey identified 53 such airlines worldwide (March 2004 issue). Yet there have been no new entrants in the US, other than two or three small niche or charter–type operators (Hoover’s Air, for example).

There are several reasons.

First of all, the extreme severity of the post- September 11 financial crisis in the US made the environment hostile towards newcomers. It was inconceivable that anyone would have wanted to start (or fund) a new airline when the industry was struggling for survival and seeking government assistance.

Second, while experienced workers and cheap aircraft are certainly available, the barriers to entry in terms of regulatory approval, cost of certification and start–up capital needed are certainly higher now in the US than they were a decade ago (before the ValuJet crash).

Third, and most importantly, there just happened to be already well–established LCCs (AirTran and Frontier) and a new entrant of JetBlue’s calibre keen and ready to grow as the major carriers began shrinking.

Those carriers had already proved themselves to the travelling public, and September 11 gave them their big opportunity. Their presence has effectively prevented new LCCs from starting up.

There is a school of thought that as long as the current LCCs continue to build market share and remain profitable and flexible, new entrants may not get a chance to establish a foothold. That seems even more likely if other surviving LCCs from the early 90s crop start growing, as now appears to be the case with Spirit Airlines. A privately owned, hitherto extremely low–profile low–cost operator based in Fort Lauderdale, Spirit recently received a $125m equity investment from Oaktree Capital Management. It had sought additional liquidity since being turned down by the ATSB for a government–guaranteed loan in 2002.

The airline subsequently placed a major Airbus order to replace its MD–80s and double the fleet size within five years. Spirit is an obvious future IPO candidate.

Nevertheless, there will undoubtedly be new entrant hopefuls that have been inspired by the success of the established LCCs. The start–ups will be keen to grab some of the new opportunities that will open when industry restructuring gets under way.

Significant aircraft orders

US LCCs totally dominate order books for new aircraft that will be delivered over the next several years. According to Continental, the US LCC sector has about 400 large jet aircraft (excluding E190s) on order for delivery in the 2004–2007 period, compared to 150 large jets on order by the six legacy carriers.

Recent months have seen several significant new orders from US LCCs. The largest of those was probably Spirit’s March order for 35 A319/A321s plus 50 options, with deliveries starting in November. The airline expects to take 15 of the firm aircraft directly from Airbus and the other 20 from ILFC. Also, in early June JetBlue exercised 30 additional A320 options.

There have been no recent Boeing orders from the US LCCs because both Southwest and AirTran already have significant order books sorted out. Southwest is taking 91 737–700s in 2004- 2006, including a staggering 46 aircraft this year.

As a result, US LCCs are expected to grow their combined capacity by about 15% annually over the next five years. Individual carriers' growth rates will range from 10% annually for the largest, most mature operators (Southwest and AWA) to perhaps 35% for JetBlue.

US LCC characteristics

Even though European LCCs far outnumber US LCCs, there seems to be more diversity in business models in the US, with many airlines moving further and further away from the traditional Southwest model. It could just be that Europe is a step behind the US.

The US LCCs are characterised by the following:

• High utilisation, high productivity Virtually all LCCs have those characteristics.
• Low cost structures, but not rigidly so Unit costs are typically in the 6s or 7s (cents per ASM). However, Frontier is still classed as an LCC with CASM of 8.3 cents — its costs are higher partly because it is based at one of the country’s most expensive airports. The unit cost gap between LCCs and legacy carriers is typically 2–4 cents.
• Lower labour costs LCCs still enjoy a significant labour cost advantage over the legacy carriers, due to less senior work forces, more flexible work rules and substantially lower pension and benefit expenses.
• Lower–cost distribution channels Critical for US LCCs. However, Internet sales (JetBlue 74%, AirTran 64%, Southwest 55%) are less well developed than at some of the European LCCs. Independence Air aims for 100% selling via its own web site.
• Both point-to-point and hub models used LCCs tend to prefer point–to–point markets, where costs are the lowest. AirTran’s and Frontier’s business models are based on hub operations, in Atlanta and Denver respectively. Many LCCs operate a mixture of the two, or "focus cities" instead of hubs. Like Southwest, JetBlue is essentially point–to–point though may become more hub–style with the E190s.
• Both secondary and primary airports Anything goes in this respect, the key factor being the desirability of the market. Even Southwest has now departed from its usual strategy of flying to cheaper and less congested secondary airports — Philadelphia was too good an opportunity to miss.
• Trend away from single fleet type Last year JetBlue opted out of the traditional Southwest formula of operating a single aircraft type in the 150–seat category when it ordered 100–seat E190s. This month AirTran is introducing its second new aircraft type, the 737–700, to supplement its 717 fleet. ATA has announced its interest in the 717 or the E190. While Southwest remains dedicated to a single aircraft type, it is keeping the matter under review. A second aircraft type offers flexibility but will increase unit costs. It really depends on what types of markets an LCC wants to serve.
• Low, simple fare structures The key characteristic for all LCCs.
• Frequent-flyer programmes Most sizeable US LCCs have them. FFPs are important to the airlines for two reasons: to be accepted by mainstream (including business travellers) and building customer loyalty.

High-quality product/on-board service In many cases, US LCCs have succeeded in providing a higher–quality product and better service than the legacy carriers. They have some of the newest fleets, state–of–the–art technology and similar or better amenities than the legacy carriers.

Some, such as AirTran and Spirit, have separate business class cabins. The race continues to provide more advanced in–flight entertainment systems — LiveTV, XM Satellite radio, Internet access, etc.

There is evidence that, like Southwest, JetBlue is building a "cult following", which is enabling it to attract price premiums and considerable customer loyalty.

Which markets?

Over the past decade, most of the new–entrant growth opportunities have been on the East Coast — as illustrated by Southwest’s heavy focus there and the rise of AirTran and JetBlue.

However, as a post–September 11 trend, there has also been an influx of LCCs to the transcontinental market. It started as just one useful way for a north–south East Coast carrier to boost aircraft utilisation (JetBlue’s initial red–eyes); over the past year it has become the nation’s hottest bastion of competition.

This summer is seeing a 31% year over- year increase in daily flights, about half of which is coming from LCCs. While all agree that the current level of capacity is not sustainable, no airline is budging because the markets are so important. As the most efficient producers, LCCs have a pretty strong claim to those markets.

Transcontinental services have helped keep LCCs' unit costs low, but unit revenues have fallen by a greater extent. For JetBlue, which has the lowest costs but the highest exposure to the transcontinental market (35% of ASMs), the situation has led to a decline in overall profit margins this year (even before any impact from fuel).

US LCCs do not generally compete with one another. It is a vast country with numerous large markets, so the airlines have been able to stick to the Southwest principle of only going for "under–served, overpriced" markets. In other words, once one LCC is present in a market, that market is no longer overpriced, so other LCCs lose interest in it. That said, as LCCs grow, they will increasingly come in contact with each other.

As regards to future opportunities arising from industry restructuring, all eyes are now on US Airways. If it disappears, the most likely outcome is that its markets are quickly taken over by other legacy carriers and the largest LCCs.

In a recent report on LCCs, Raymond James analyst Jim Parker made the point that, in addition to legacy carriers' hubs, the two remaining areas for LCCs to conquer are medium–to–lower density domestic and long haul international markets.

Smaller markets will see low fares, for the first time, with Independence Air’s service this month and JetBlue’s E190 service from mid–2005. Parker suggested that long–haul flights to Europe, which would logically follow hub development by LCCs and a US–EU open skies treaty, "may be five to seven years out".

Financial outlook

Throughout the post–September 11 crisis, JetBlue and Southwest have consistently posted double–digit operating margins and AirTran has not been too far behind. However, the margins — and in some cases profitability — have come under pressure this year from dismal yields and high fuel prices.

Southwest and JetBlue, which have the industry’s best fuel hedges in place, will probably get away with margin declines of a few points. AirTran is still expected to remain profitable in 2004, but the current consensus forecast for Frontier is only break–even.

To keep things in perspective, a couple of years of reduced profitability would not do much damage, and the LCC model is certainly not being called into question. LCCs are the best–positioned airlines to weather the current challenges also because of their strong cash positions and healthy balance sheets.