JetBlue: Making its unique LCC business model pay off at last? June 2014

After years of underperforming its peers in terms of profit margins and ROIC and seeing its share price languish, JetBlue Airways has suddenly become the hottest airline stock on Wall Street. The stock surged by more than 30% in May and has continued to inch up in June, contrasting with the declines seen by airlines generally because of concerns about energy prices. Why the change in the sentiment for New York’s hometown airline? Could it be Mint, the attractive premium product JetBlue has just launched on the transcon? The sale of LiveTV? Is there now evidence to suggest that, having been a huge success in the marketplace, JetBlue can also be a financial success?

Until May, JetBlue was essentially out of favour on Wall Street. This was, first, because of its decision some years ago to focus on growth at the expense of profit margins, ROIC and free cash flow (FCF).

The decision to focus on growth was understandable, because JetBlue had some unique growth opportunities. In 2009 it was able to take advantage of a sharp contraction by American and other legacy carriers in Boston and quickly build itself into Boston Logan’s largest airline. Thanks to another gift from American, JetBlue was also able to grow San Juan (Puerto Rico) into a sizeable focus city operation.

More recently, JetBlue has taken advantage of Fort Lauderdale’s “very rich demographic” and enormous cost difference with Miami by making FLL a staging post for significant new expansion to the Caribbean, Central America and northern parts of South America.

But the benefits have been slow to materialise. At the end of 2013 JetBlue’s ROIC was still only 5.3%, up from 4.8% a year earlier. For the second year running, JetBlue fell short of its (very modest) goal of improving ROIC by one percentage point annually. Although JetBlue expects to make up for those shortfalls in 2014, to achieve a ROIC of 7%, that would still be well below the 10-15% that other large US carriers are now achieving. Although JetBlue has continued to report satisfactory operating margins (7.9% in 2013), it has lagged behind its peers in terms of net margins.

Analysts have been tough on JetBlue because the other large US carriers (legacies and Southwest alike) have all maintained tight capacity discipline since 2009 and are intensely focused on FCF, ROIC and returning capital to shareholders. The spring saw a steady string of announcements from Alaska, Southwest and Delta about expanded share buybacks, dividends and suchlike. Some analysts said that they felt that JetBlue’s management was not interested in returning capital to shareholders.

Some people have blamed JetBlue’s lacklustre financials on the unusual “hybrid” business model, which, among other things, has meant JetBlue becoming a business traffic-focused airline in Boston and “primarily a leisure player” in New York.

And JetBlue has been viewed negatively because in late April its pilots voted to unionise. The pilots elected by a margin of 74% to 26% to be represented by ALPA.

But the sharp fall in JetBlue’s share price after the unionisation announcement was a turning point. Many analysts upgraded their recommendations on the stock, which is now rated mostly a “buy”.

In the first place, analysts realised that JetBlue’s stock was undervalued relative to its peers, in terms of projected P/E ratios and other measures. One analyst noted that JetBlue was the only major US airline stock that had declined in January-April.

Second, there was a feeling that the market had overreacted to the pilots’ decision to unionise. It had no material impact on the earnings outlook. JetBlue already faced a $145m hike in pilot costs in the next three years, after a January agreement to raise pilot pay. And, as Southwest and others have demonstrated, unionisation is not necessarily associated with weaker financial performance. JetBlue’s labour relations remain good, and the airline is committed to paying “peer competitive” pilot salaries.

Senior management changes have taken place. The late April announcement of the departure of COO Rob Maruster and the assumption of his duties by president Robin Hayes have been interpreted as a shift in culture that will focus more on costs and margins. Maruster oversaw JetBlue’s rapid expansion phase from 35 destinations to the current 85. Hayes is more financially oriented, having worked as JetBlue’s chief commercial officer until his promotion to president in January.

The shift in culture could be even more pronounced if CEO Dave Barger leaves the company when his contract expires in February 2015. Barger himself has not yet disclosed what he wants to do. JetBlue’s board is expected to start discussing the matter of post-February leadership in the autumn.

The long-awaited sale of LiveTV – the in-flight entertainment subsidiary that JetBlue spent a decade developing – to French aerospace company Thales was completed on June 10. It was solid good news to JetBlue: $400m proceeds, lower operating costs and capex, and maintaining full access to the product.

There has been excitement about Fly-Fi – the new-generation, superfast in-flight connectivity product that JetBlue is racing to install on its fleet this year. JetBlue believes that Fly-Fi will be a “key differentiator” in long-haul markets.

Mid-June saw the launch of Mint, JetBlue’s spectacular new premium product for the transcon market, which one analyst estimates could bring in as much as $300m in annual incremental revenues.

And, thanks to efforts to tweak its successful “Even More” offerings and its TrueBlue FFP, JetBlue expects to grow its ancillary revenues by 10-15% in 2014.

Finally, JetBlue’s gradually improving earnings and modest efforts to pay down debt have been acknowledged by the rating agencies. In May S&P affirmed the airline’s ‘B’ credit rating and revised the outlook to positive, saying that it now expects JetBlue to maintain improved credit metrics through 2015, despite substantial capital spending.

Will Mint be successful?

Mint debuted on JetBlue’s first “premium version” A321 on the New York-Los Angeles route on June 15. It will be available on all JFK-Los Angeles flights by August and on the JFK-San Francisco route from October 26.

The product features 16 lie-flat first-class seats, including four private suites; tapas-style dining (choice from five menus), an upgraded LiveTV experience (15-inch flat screens with 100-plus channels each of TV and satellite radio), among other extras. The seats are supposedly the widest and the flat-beds the longest in the US domestic market. No other US airline offers private suites in regular commercial service.

The Mint seats are available at a significantly lower fare than other airlines’ premium services: $599 one-way. Passengers who book early can get the suites at the same price.

The product has attracted rave reviews. A Time

magazine journalist wrote that the seats “feel more luxury car than commercial aircraft” and “can accommodate anyone up to NBA height”, though the private suites are “not quite the Etihad or Emirates cabin”. The meals are “top rate” with a “distinctly Big Apple focus”. Overall, the review called it a “well thought out, distinctive product with a dash of whimsy that has been the airline’s trademark”.

Still, JetBlue faces stiff competition for the premium traveller in the transcon market, where flat-beds are now the norm, where the legacy carriers have all been upgrading their offerings, and where Virgin America has built a loyal following with its extraordinary product over many years.

The Time reviewer aptly concluded that it will depend on whether transcon business fliers will abandon their FF-mile accruing legacy carriers for JetBlue’s lower ticket prices (the reviewer thought they very well might), “whether the numbers that do will justify the airline’s investment”, and “how the people in the back, once JetBlue’s focus, will feel now that they’re in effect second class flyers”.

But Mint is only JetBlue’s response to the challenges in the transcon market; it does not represent a decision to become a two-class airline. The transcon between New York and LAX/SFO is a unique market. As CEO Barger noted, those two routes are among the few where passengers are actually willing to pay for premium, as opposed to being upgraded to it.

JetBlue introduced Mint because it has underperformed its peers in terms of PRASM on the transcon. Its average fare there has been only $247, compared to Virgin America’s $320. Its most loyal customers have been telling it for years that, even though they fly JetBlue to Florida and the Caribbean, they have switched to other airlines on the transcon because JetBlue does not offer premium service or Wi-Fi.

To illustrate the limited scale of Mint, only 11 or so of JetBlue’s A321s will be in the 159-seat “premium version” configuration by the end of March 2015. The rest of the A321 fleet will be in the 192-seat “core JetBlue experience” version that debuted in December 2013. JetBlue has ordered 88 A321s, of which five had been delivered as of March 31.

Cowen Securities analysts calculated that if JetBlue closes the PRASM gap with Virgin America on the transcon, it would mean $300m in annual incremental revenues. Barger has called that estimate “rather large”. The financial benefits would be realised from 2015 onwards.

The Wi-Fi race

Having fast and reliable in-flight Wi-Fi will be central to both the Mint experience and the core JetBlue experience. JetBlue was the launch customer for Fly-Fi, the Ka-band satellite-supported solution developed by LiveTV and ViaSat. First introduced in December 2013, JetBlue expects to have installed the product on its entire Airbus fleet by year-end, with the E190s following in 2015.

JetBlue has received lots of positive customer feedback to Fly-Fi. On some long-haul flights 80% of passengers are connecting to it, sometimes more than 100 people simultaneously. But evidently also complaints about performance have continued, because JetBlue has extended the free beta test period by several months to the autumn, when it also expects to disclose plans to monetise Fly-Fi.

The key competitor is Virgin America, which five years ago pioneered Gogo in-flight Wi-Fi and remains the only airline to offer Wi-Fi on every domestic flight. To retain its lead, VA is in the process of equipping its fleet with Gogo’s faster ATG-4 Wi-Fi service – a process that will be completed by the autumn.

Network and alliance plans

JetBlue continues to gradually moderate its ASM growth; currently a 4-6% increase is projected for 2014, down from last year’s 6.9%. And the growth will be highly focused: up 17% to the Caribbean/Latin America, up 15% from Fort Lauderdale, and relatively flat elsewhere.

The newest focus of activity is Washington DCA, where JetBlue won 12 slot pairs thanks to the AMR-US Airways divestitures. It will essentially mean reallocation of aircraft from Washington Dulles long-haul flying to more attractive underserved, high-fare shorter-haul markets.

JetBlue expects FLL to be its fastest-growing focus city in 2014. After last year’s rapid international expansion from there, which included Lima (Peru) and Medellin (Colombia), this year JetBlue is adding Cartagena (Colombia), among other destinations. The plan is to expand FLL to 100 daily departures by 2017 (about 60 at year-end 2014).

Growth in Boston has moderated somewhat in 2014, so JetBlue is seeing some maturation benefits there. But JetBlue is still committed to growing the Boston operation to 150 daily departures.

Almost a third of JetBlue’s capacity is now in the Caribbean/Latin America markets (compared to 25% on the transcon). Expansion in that region is easy to justify, because those markets mature very quickly and are nicely profitable.

On the alliance front, JetBlue recently suffered the blow of American terminating their cooperation (because after the merger AAL no longer needed the East Coast feed). Otherwise, JetBlue has continued to sign up new interline partners (now 30+) and evolve some of those into codeshare relationships. JetBlue says that from now on the emphasis will be on deepening existing relationships, rather than signing up more partners.

Monetisation of LiveTV

The LiveTV story is a great example of how JetBlue has innovated in the airline business. JetBlue acquired the small Florida-based company in 2002 for $41m in cash and assumption of $40m of debt, which gave it a “really nicely priced” live satellite television feature, enabling it to differentiate its product. LiveTV has always been offered free-of-charge as part of the “JetBlue experience”. The management describes it as “core to the brand”.

In the mid-2000s JetBlue began selling LiveTV products to other airlines. Initially it was careful not to give direct competitors access to the product, but that changed in 2008 when Continental signed a long-term contract for its 737s and 757s. The shift in strategy came when JetBlue’s management realised that LiveTV no longer offered a distinct competitive advantage; rather, having a LiveTV-type product would soon be necessary just to keep up with competition.

LiveTV has not been a huge money-maker because of the late-2000s recession, the high cost of installing the systems and the weight of the equipment. But it still had a respectable $72m in sales in 2013. At year-end, it had been installed on 461 aircraft, with another 196 in firm orders through 2015. Customers include United, WestJet, Frontier, Alitalia and Azul. But some analysts believe that LiveTV’s sales could really take off now that it is no longer owned by an airline.

The $400m proceeds represented five times the original investment. JetBlue executives have noted that it was hard to say what a good payback was, because LiveTV had brought such enormous benefits to the brand at low cost, though JetBlue also invested a lot in R&D for the unit (something it never fully disclosed).

The sale enables JetBlue to simplify its business and reduce operating costs and capex. JetBlue has not yet released revised figures for 2014, but analysts say it had earmarked $75m capex for LiveTV this year.

A crucial part of the decision to sell was that JetBlue managed to structure long-term agreements with LiveTV that “will preserve our access to both Ka and the TV and the satellite radio and developments to those items thereafter”.

Shifting priorities?

When the sale of LiveTV was announced in February, some in the investment community thought that it might lead to capital returns to shareholders, such as a dividend or stock buyback. But it is clearly too early to talk about that at JetBlue.

Rather, the proceeds will be used to prepay $200-300m of debt in 2014 and to help fund aircraft deliveries. JetBlue is taking nine A321s this year, and total aircraft capex is estimated to be $600m. Because of the desire to reduce debt, the aim is to buy aircraft and other assets with cash.

JetBlue needs the A321s not just for profitable growth but to keep unit costs in check. However, the airline remains committed to keeping the level of invested capital relatively flat as it expands margins through profitable growth.

Interestingly, JetBlue is now at the point where its network growth calls for larger gauge aircraft. In a fleet restructuring move in October 2013, the airline deferred 24 E190 deliveries, converted 18 A320 positions to A321s and placed an incremental order for 15 A321s and 20 A321neos. At the end of March, JetBlue operated 195 aircraft – 130 A320s, 60 E190s and five A321s.

A combination of slightly slower ASM growth, maturing markets, new products, ancillary revenue initiatives and keeping costs in check should enable JetBlue to improve its operating margins and eventually start returning capital to shareholders.

But will it be soon enough to keep shareholders happy? It will be interesting to see what position, if any, the board will take in the autumn. Specifically, is it time for JetBlue to focus on investor returns over customer satisfaction and network growth?

By Heini Nuutinen
hnuutinen@nyct.net