Frontier: Taking the ULCC model nationwide in the US? October 2013

It was announced on 1st October that Indigo Partners, the US private equity firm, had agreed to buy Denver-based Frontier Airlines from its current owner, Republic Airways Holdings, in a \$145m transaction (\$36m cash plus assumption of debt). The deal, which requires the formal blessing of Frontier’s two key unions by 31st October (among other conditions), is expected to close in December.

This is a highly positive development for Frontier, which has been through painful restructuring in recent years, is grossly undercapitalised and had been on the sale block for over two years.

The deal brings to an end an interesting (failed) experiment by a US regional carrier to diversify into the LCC sector. Republic, which has owned 100% of Frontier since 2009, will now return to its roots of operating only fixed-fee feeder services for the US legacies.

But most interestingly, Indigo’s investment in Frontier could mean a significant expansion of the ultra-low-cost-carrier (ULCC) business model in the US, where it has so far only been utilised by two niche carriers — Spirit and Allegiant.

Indigo plans to inject additional funds into Frontier and is looking to build the carrier into a “leading nationwide ULCC”. It expects to take over Frontier’s 80 A320neo orders (reimbursing Republic \$32m for pre-delivery payments made), which will start arriving in 2016. Indigo’s co-founder and managing partner William Franke has said that Frontier will continue to be based in Denver, expand to new markets and improve efficiency.

History of losses, recent turnaround

Frontier, which began operations in 1994, has struggled financially through much of its existence. That can largely be attributed to the decision to be a hub-and-spoke carrier at Denver International (DEN) — a relatively high-cost location, a key hub for United and today probably the most competitive aviation market in the US.

Frontier did manage to coexist with United by building a loyal customer base and maintaining high efficiency. But Southwest’s January 2006 entry into Denver and subsequent rapid expansion there hit Frontier hard. Counter-strategies such as expanding into Mexico, operating a regional feeder and signing up Republic as a feeder partner, had mixed success. A surge in fuel prices and issues with a credit card processor forced Frontier into Chapter 11 in April 2008.

In 2009 Frontier nearly became a target for a bidding war between Southwest and Republic, but Southwest had to back off because it was unable to secure approval from its employees. Republic bought Frontier out of bankruptcy in October 2009 (for \$109m plus \$1bn of debt and lease obligations).

Republic wanted to secure its feeder contract (which Frontier had rejected in Chapter 11), diversify away from the regional sector (where demand and profit margins had been hit by legacy carrier contraction and hub closures, renegotiation of contracts, etc.), and it needed homes for idle RJs.

A few months earlier Republic had acquired Milwaukee-based Midwest Airlines, so it ended up combining Frontier and Midwest under the Frontier name, centralising their management in its Indianapolis headquarters and transferring many RJs to the new acquisitions. The strategy did not work. After briefly becoming profitable in 2009 thanks to cost cuts implemented in bankruptcy, Frontier lost \$52m and \$95.3m on a pre-tax basis in 2010 and 2011, respectively.

But in 2012 Frontier earned a \$23.9m pre-tax profit on revenues of \$1.4bn. In 2Q13 its pre-tax margin was a promising 4%. The management is anticipating a 10-12% operating margin in the third quarter. So 2013 is shaping out to be a nicely profitable year for Frontier.

The turnaround has been the result of two key developments. First, Republic implemented a very successful restructuring at Frontier in late 2011, achieving \$120m of annual profit improvements thanks to employee, vendor and lessor concessions, elimination of smaller RJs, network restructuring and a modest downsizing.

Second, Frontier has enjoyed a lull in competition. The United-Continental merger, the Southwest-AirTran merger and Southwest’s multi-year “no growth” mode significantly eased competitive pressures in both Denver and Milwaukee (though Southwest did continue to add flights in Denver).

The restructuring enabled Frontier to close the unit cost gap with the mainstream LCCs. Its ex-fuel CASM fell to around 7 cents, which analysts noted was comparable to Southwest’s on a stage-length adjusted basis.

But, in part because of its downsizing (ASMs were down 11.4% in 2Q13), Frontier has not been able to transform itself into an ULCC — a goal that Republic first mentioned in early 2012. In 2Q13 Frontier’s ex-fuel CASM was 7.27 cents — much higher than Spirit’s 6.00 cents and Allegiant’s 5.43 cents (not stage-length adjusted figures).

So work remains to be done on the cost front. Franke has mentioned the potential to improve aircraft utilisation, maintenance management and fuel efficiency. The return to Republic of the five E190s in Frontier’s fleet should also help CASM, as will the continued switch to larger A320-family models and the future A320neo deliveries. Frontier recently eliminated its last A318s and by year-end expects to operate 35 A319s and 18 A320s.

Frontier should also benefit from Indigo’s expertise in developing an attractive ULCC revenue model. It has introduced new up-sell products (including five rows of seating with extra legroom) and begun charging extra for numerous items, but the complicated fee structure could benefit from simplification.

On the network front, Frontier’s new strategy has been to reduce exposure to Southwest. First, Frontier pulled out of lossmaking routes in Milwaukee and Kansas City and retreated to its Denver core, which it can defend more easily. Second, it has added service from Denver to many smaller cities where Southwest does not fly (Knoxville, Bismarck, Sioux Falls, etc.). Third, it is now courting more connecting passengers at Denver.

Fourth, in the past year Frontier has entered and aggressively added service from obscure places such as Trenton-Mercer (New Jersey) and Wilmington/Philadelphia (Delaware). By February 2014 it will be serving an amazing 11 destinations from Trenton. These airports are low-cost, small but strategically located (so they attract sufficient traffic), offer alternatives to congested hubs in the Northeast and enable Frontier to be the only airline in most markets.

As evidence that the new network strategy is working, Frontier has been outperforming its peers in terms of RASM improvement fairly consistently in the past 2-3 years. Frontier currently serves 75-plus cities in the US, Mexico, Costa Rica, Jamaica and Dominican Republic.

Frontier’s ULCC prospects?

The deal with Indigo was possible because of Frontier’s successful restructuring. But what makes Indigo think that the ULCC model could have wider appeal in the US? When the deal was announced, Franke put forward a very simply argument: “As airline fares continue to move up, passengers need affordable travel alternatives”.

Domestic air fares in the US have indeed increased in recent years. A May 2013 study by the Boyd Group found that the average true price of a one-way ticket has increased by nearly 30% since 2008 and that low-cost airline entry was “no panacea to lower air fares”.

It is also clear that many mainstream US LCCs have moved in the opposite direction. JetBlue has just added a first class transcon product in a bid to attract high-yield traffic.

US travellers need access to low fares, so it is plausible that, after years of scathing attacks in the media, criticism from consumer organisations and government attempts to introduce legislation to ban ancillary fees, public opinion may now start switching in favour of the ULCC model.

Spirit and Allegiant have been the fastest-growing and highest-margin airlines in the industry. Spirit has had four consecutive years of profitability (basically since it switched to the ULCC model); in 2Q13 its adjusted pre-tax margin was 17.8% and ROIC was 28.8%. Allegiant had a 16.8% operating margin in 2Q13, its 42nd consecutive profitable quarter.

Indigo has a strong record of building successful ULCCs. It held significant stakes in Tiger Airways (Singapore) and Spirit Airlines, and it remains a lead investor in Hungary’s Wizz Air and Mexico’s Volaris. (Franke sold his stake in Spirit and resigned as its chairman this past summer after Indigo began exclusive talks with Frontier.)

One of the big concerns for Frontier is its exposure to competition. As one analyst noted in 2011, “few hubs can support two, let alone three competitors”. Frontier has fallen into third place in Denver.

But it is possible that as an ULCC Frontier might find it easier to co-exist with United and Southwest in the long-term, because the business model would be more different. Spirit has found that to be the case with American in Florida, because the legacy (being the snob that it is) is not interested in the type of traffic that an ULCC attracts.

Likewise, Southwest and Frontier would cater for different passenger segments. Southwest represents the extreme in the avoidance of ancillary fees — a strategy that it believes has been instrumental in fuelling its rapid growth in Denver. Frontier would represent the other extreme, catering for the travellers that seek the rock-bottom fares and total control over what they pay for.

By Heini Nuutinen email: hnuutinen@nyct.net