Independence Air: Regional to LCC? May 2004

Atlantic Coast Airlines (ACA) is about to formally launch its Washington Dullesbased low–fare operation, Independence Air — the first new LCC–hopeful in the US since JetBlue in early 2000. The company will be throwing a big party some time in May to announce details such as destinations, fares and schedules. Flying operations are due to begin on June 16, initially with 50–seat CRJs and from November with A319s.

The business model, (examined in Aviation Strategy, September 2003) is intriguing. ACA is voluntarily giving up its stable and profitable United Express and Delta Connection businesses. It is transforming itself from a regional fee–for–service provider into a low–fare carrier with a large independent hub operation at Dulles. In other words, it is opting for the riskiest form of existence (an LCC) in the most competitive part of the country.

ACA has to be commended for its determination — it has had an unusually tough time getting the venture off the ground.

The challenges have included nonstop criticism from analysts and investors, an unsolicited bid for ACA from Mesa (terminated in December but only after costly legal manoeuvres) and six months of uncertainty about whether or not United would release it from the feeder contract.

However, both the United and Delta exit deals were signed last month, enabling Independence Air to start operations one month ahead of the original schedule (just 11 months after the initial announcement in late July 2003).

The transition plans look good from ACA’s point of view. Its 86 CRJ–200s and 24 J–41 turboprops will exit United Express between June 4 and August 5. The CRJs will enter service with Independence Air after refurbishment, while the J–41s will be retired immediately. ACA’s 33 328JETs will go to Delta or one of Delta’s partners later this year.

The Delta agreement was terminated only because Delta’s mainline pilot deal prohibits the use of feeder partners that have large jets in their fleets. However, this will simplify ACA’s overall operation and allow its management to focus properly on the LCC brand.

The A319 revenue operations will start in early November. Firm orders currently total 27, with four scheduled for delivery in September–December, 18 in 2005 and the last five in 2005. Twelve of the aircraft currently have operating lease commitments from ILFC and CIT, the rest are coming directly from Airbus.

The product and selling methods will be JetBlue–style, including single class, leather seats, live satellite TV and 100% direct bookings.

The key difference from other LCCs is that it will not even file for the minimum level of CRS participation, preferring instead to focus heavily on marketing and selling itself through its own web site (FLYi.com). The plans include changing the holding company name to "FLYi Inc" and the ticker symbol to "FLYI".

Independence Air makes a fascinating study in that it has the classic prerequisites in place to be a success — a solid niche, good management team and ample start–up funds. But it is proposing such a strange and risky business model that Wall Street analysts continue to have serious reservations about its future.

This is a pity because good market niches are extremely hard to come by. As an added strength, ACA is already well established at Dulles and will have considerable critical mass there almost from day one. The plans envisage 300 daily flights by the end of the summer, growing to 700 flights and a 50- point network by early 2006.

Analysts are mainly concerned about the RJs' high unit costs, which make it hard to operate them profitably in a low–fare environment. In Raymond James analyst James Parker’s estimates, ACA will have to charge 25–30% fare premiums over LCCs that have150–seaters. There is some merit in ACA’s argument — which is basically the same JetBlue used to justify the E190 — that the RJs and 150- seaters would typically not be present in the same markets. Therefore the fare premiums over 150–seaters will not matter (after all, the new fares will be significantly lower than those United Express currently charges).

But these are just theories, and the marketplace is changing rapidly — it will be interesting to see who is right, ACA or Wall Street.

The A319 strategy is getting a general thumbs–up on Wall Street, with Parker suggesting that those operations could generate a 5% operating margin already in 2005. Of course, it is only thanks to the 50- seaters that Independence Air will have an immediate formidable presence at Dulles.

Merrill Lynch analyst Michael Linenberg suggested recently that the scale "should act as a financial barrier to entry for any newcomers".

Competitive response

However, there is significant concern about escalating competition from established operators. The biggest worry is that United might add significant amounts of capacity in the Dulles markets in its efforts to defend its key hub. It has already brought in low–fare unit Ted, lined up an army of new feeder partners and is starting to deploy the powerful FFP weapon. Then again, United does not have the resources for a prolonged battle. In Linenberg’s estimates, an aggressive fare war at Dulles could cost it several hundred million dollars over the course of a year and potentially disrupt its plans to emerge from Chapter 11.

The other key competitors that Independence Air should worry about are Southwest (Baltimore), AirTran (Dulles) and US Airways (all over the region).

In JP Morgan analyst Jamie Baker’s view, US Airways' competitive response and fate are likely to be significant drivers of Independence Air’s profitability in the longer term.

Because of the escalation of competitive pressures since last summer, ACA believes that a higher level of marketing activity will now be necessary to launch Independence Air. The marketing budget for this year has been more than doubled from $15m to $30- 35m.

The other implication is that Independence Air’s unit revenues are likely to be weaker than expected. Baker is now predicting RASM of only 9 cents in 2005 — a level that would be similar to major carriers' RASM but significantly below the CASM that the new venture will achieve with a sizeable RJ fleet.

The switch from the fee–per–departure to the LCC model will affect ACA’s earnings in two ways. First, there will be a period of losses.

Second, earnings will become more volatile because under feeder agreements the major carrier partners assumed most risks, including fuel prices and sale of seats.

With the growing cost pressures and worsening revenue outlook, ACA now expects to report a net loss of around $50m for 2004 — twice its previous estimate.

The current consensus forecast is even higher losses in 2005. In comparison, the company earned a $70.5m net profit before special items on revenues of $876m in 2003 and could have expected to continue achieving perhaps 10% operating margins from feeder operations.

While reducing near–term estimates, ACA has kept its original forecast of an 8–10% profit margin in 2006.

As many analysts have noted, such a swing from 2005 is not realistic. The company is not helping build confidence in its plans with targets like 14–15 hour average daily A319 utilisation (that includes lots of transcontinental red–eyes, but exceeding JetBlue’s 13.3 hours could be tough). The stock is likely to remain on "sell" lists for the foreseeable future.

ACA raised $122m from the sale of convertible bonds in February, which boosted its already strong cash reserves to $376m (excluding aircraft delivery deposits) at the end of March. A low point in cash of $175- 200m is currently anticipated in the first quarter of 2005. Nevertheless, the company clearly has staying power to try to make the unusual LCC concept work.