Spirit, Frontier and Allegiant: ULCC sector nearing 10% market share in the US October 2018

Spirit: What’s next for the ULCC pioneer?

With CEO Robert Fornaro retiring at the end of this year and president Ted Christie (until recently CFO) taking charge, Spirit is seen entering its third distinct chapter as a ULCC.

The Baldanza years (2006-January 2016) were Spirit’s formative era. Described by Forbes as “one of the airline industry’s most successful, wildly unconventional CEOs”, Baldanza oversaw the development of the ULCC model and Spirit’s most rapid growth phase.

But Baldanza was forced to resign after he failed to communicate Spirit’s strategy effectively to the financial community in 2015, when the skirmish with American developed and many US investors lost confidence in the ULCC model.

Another problem was that as a result of Baldanza’s aggressive focus on costs, Spirit had the industry’s worst on-time performance and customer complaint rates in 2015.

Under Fornaro’s watch (2016-2018), the focus has been to improve operational reliability and customer satisfaction. Spirit has seen significant improvements in both areas. And there are many initiatives under way to improve the customer experience.

Spirit’s ASM growth slowed from an annual average of 22% in 2012-2016 to 16.1% in 2017. Although this year is seeing an uptick to 22.7%, annual capacity growth is expected to moderate to 13-15% in 2019-2021.

Incoming CEO Ted Christie said in a mid-September interview with Cowen analyst Helane Becker that, in addition to continuing Spirit’s operational, cost and ancillary initiatives, he would probably spend most time on the route network — “fleshing it out as the airline gets bigger”.

Spirit already has an extensive, diversified network with 67 cities and 500-plus daily flights. The management divides the markets served into three main types: big cities that generate large volumes of leisure travel (such as Chicago, Detroit, Dallas, Houston, Baltimore, Los Angeles, Atlanta and New York); large leisure destinations (Orlando, Las Vegas, Myrtle Beach, New Orleans and South Florida); and international destinations (27 in the Caribbean/Latin America).

Spirit would like to grow more in big cities, especially New York, but most are gate or slot constrained. The airline benefits from being already well-established in such markets; it serves 22 of the top-25 US metro areas — a position that newer ULCCs will find hard to replicate.

In recent years much of Spirit’s growth has focused on large leisure destinations, especially Orlando and Las Vegas. Growth in such markets will continue. Spirit has just launched international service from Orlando, adding 11 destinations in the Latin America/Caribbean region this autumn.

A sizable Latin America/Caribbean network, built gradually since 2003 and representing 15% of total ASMs by year-end, is one of Spirit’s greatest strengths. There are considerable further growth opportunities. Notably, Spirit now operates both FLL and Orlando as international gateways.

As Spirit has grown, it has naturally carried more connecting traffic — now 10% of total traffic. It is a fine balancing act for a ULCC: connecting traffic helps build international operations but puts downward pressure on ancillary revenues (for example, Spirit can collect a bag fee only once from a connecting passenger).

Spirit targets markets that can produce “mid-teens or higher” operating margins. The management has estimated that there are 500-plus such potential markets.

One important near-term task is selecting and ordering aircraft for post-2021 growth. Spirit’s currently scheduled A320ceo/neo deliveries only run through 2021. The management is evaluating Airbus, Boeing and Embraer aircraft and is expected to make a decision in early 2019.

It will not be an easy decision because Spirit has good growth opportunities in many different types of markets. The management is open to adding a new aircraft type to the all-A320 family fleet, such as the CSeries/A220, which would be ideal for small and mid-sized markets. But Spirit could also benefit from a larger, longer-range model such as the A321LR, which would facilitate expansion deeper into South America.

Financially, Spirit is well positioned for the future. As well as seeing a positive unit revenue trend, it has reversed an earlier negative trend in non-ticket revenue per passenger, which is expected to be $55-plus in 2018.

The management sees further opportunity to grow ancillary revenues through initiatives such as dynamic pricing, bundling existing products in new ways, better merchandising and developing loyalty-based programmes.

Spirit faces a hefty increase in labour costs, because the new pilot contract raised pilot pay by on average 43%. However, Spirit negated much of the impact on CASM by reducing aircraft leasing costs (via a deal to purchase 14 A319s off lease). Consequently, Spirit expects to reduce its ex-fuel CASM by 3.5-4% in 2018 and to keep it “flat-to-up-1%” in 2019.

With all major labour agreements set for a number of years, Spirit is currently in a happy position with labour.

Spirit enjoys a huge cost advantage over the US legacies and LCCs, and that advantage has widened significantly in recent years (see chart on the facing page).

With growing overlap with the legacy networks, maintaining the cost lead is imperative. The management believes that Spirit’s cost advantage can widen further due to improved operational reliability, higher aircraft utilisation, addition of more junior pilots and scale benefits from growth.

Current consensus estimates see Spirit achieving operating margins in the low-to-mid teens in 2018-2019, after a 15.2% margin in 2017 and 21-24% in 2015-2016. However, Spirit’s operating margin lead over its peers is expected to decline to “in-line with or slightly above industry average” in 2018-2019, according to Fitch.

As a growth airline Spirit has relatively high leverage, but it also maintains a strong cash balance (31% of LTM revenues in June).

Frontier: Labour issues delay IPO

Frontier staged its LCC-to-ULCC transition in record time — perhaps not surprising given Bill Franke’s vast experience with that business model.

Frontier reduced its adjusted ex-fuel CASM from 7.89 cents in 2013 to 5.43 cents in 2016 — roughly the same as Spirit’s. The reduction has been attributed to factors such as increased aircraft utilisation, upgauging from A319s to A320s and A321s, higher seat density, renegotiation of distribution agreements, replacement of the reservation system, increased employee productivity and extensive outsourcing.

Rapid growth has also helped: Frontier doubled its capacity in the four years up to and including 2017, growing its ASMs by 23.5% in 2015, 20.6% in 2016 and 19.2% last year.

Transitioning to the ULCC revenue model was equally swift. In 2016 non-ticket revenues already accounted for 42% of Frontier’s total revenues (up from 17% in 2014) and amounted to $48.57 per passenger (up from $21.69).

And Frontier’s efforts to position its brand as a “premier ULCC” in the US paid early dividends: it generated a unit revenue premium over Spirit in 2016.

But Frontier has had its issues with operational reliability and customer complaints. While Spirit has improved, Frontier appears to have deteriorated: in April and May it led the major carriers for complaints and had the second-worst on-time performance rate.

As a ULCC, Frontier has seen a dramatic improvement in profitability, achieving adjusted operating margins of 17.2% in 2015, 18.5% in 2016 and 16% in 2017.

But Indigo Partners has to wait longer than it would have liked to recoup its investment. The IPO was shelved in July 2017 after Frontier disclosed a $45m hit to revenues from a work slowdown by pilots and intensified competition from United.

The pilot situation is alarming. In July ALPA, whose contract became amendable in March 2016, sued the airline in federal court for “bad-faith bargaining” and asked the federal mediator to declare an impasse; if the NMB agrees, a strike would be possible after 30 days.

Frontier will almost certainly have to agree to hefty pay increases. The pilots claim that they make 40% less than the industry average. Also, in 2011 Frontier pilots agreed to $53m in pay and benefit reductions after former owner Republic promised that they would share in the gains when profitability was restored. Other US carriers that asked labour for concessions kept such promises when they began to earn strong profits.

Like Spirit, Frontier should be able to retain its cost advantage through continued ASM growth and cost optimisation in non-labour areas.

Frontier’s network strategy as a ULCC has, first, reduced its dependence on Denver. The percentage of Frontier routes that touched Denver fell from 90% in December 2013 to 45% in December 2016. However, since mid-2017 Frontier has added some 21 new routes from Denver to take advantage of its “natural share of connecting passengers”, according to CEO Barry Biffle.

Second, Frontier has targeted medium-sized markets (1m-4.7m population), growing significantly in cities such as Orlando, Las Vegas, Philadelphia, Cincinnati, Cleveland, Atlanta, Trenton, Chicago and Phoenix.

Third, Frontier has sought a “broad geographic footprint” in the US. It now serves almost 100 destinations (more than Spirit), but it operates very limited frequencies and numerous seasonal services.

Frontier’s international network is currently very small: Calgary, Puerto Rico and a few cities in Mexico and the Caribbean. Frontier did test the Denver-Havana route (insufficient traffic) and this year has begun codesharing with Mexico’s Volaris (another Indigo-backed ULCC), said to be the first such alliance between two ULCCs.

Frontier has estimated its long-term growth opportunity in the mid-sized cities niche at over 650 new routes. It has orders in place to facilitate growth through the mid-2020s.

In mid-October Frontier operated 78 A320-family aircraft and had another 200 on firm order. The orders include some 66 aircraft (mostly A320neos) from 2011/2014 purchase contracts that deliver by the end of 2021, and 134 aircraft (100 A320neos and 34 A321neos) ordered in December 2017 for delivery in 2021-2026. The latter was part of a mega Airbus order for 430 aircraft that Bill Franke negotiated for four Indigo-owned or affiliated airlines.

Allegiant: Resort developer or an airline?

Allegiant is famed for trying out many new strategies and exiting them at great frequency. One recent example is termination of Hawaii and 757 operations in 2017 (see Aviation Strategy, April 2015, for Allegiant’s earlier adventures).

Currently there are two key strategies of interest: transition to a single-type, all-A320 family fleet, which should produce dramatic cost and efficiency improvements from 2019, and diversification into hotel/resort operations.

Allegiant is on track to complete the retirement of its MD-80 fleet in late November. It will have an aircraft deficit for a few quarters until more A320s have been delivered (from both Airbus and lessors). The plan is to operate 125 aircraft by the end of 2022.

The airline expects the all-A320 fleet to enable it to “maintain the same corporate model and nimbleness” it had in the past. Each A320 is projected to drive a roughly $5m EBIT contribution.

The past two years’ profits have been negatively impacted by the fleet transition and new labour deals, with higher fuel costs and A320 delivery delays also hurting the 2018 results. But Allegiant has continued to achieve strong operating margins, including 17.5% in 2017 and 17.9% in first-half 2018.

Historically, Allegiant’s capacity growth has fluctuated depending on fuel prices. The fleet transition and the A320 delivery delays have temporarily reduced this year’s ASM growth to only around 10%.

Allegiant expects to break ground on its Sunseeker Resorts project on Florida’s Gulf Coast in February and currently targets opening in late 2020. Described by management as an “important step in Allegiant’s evolution as a travel company”, the project takes advantage of the airline’s strong growth to Florida, its dominant position in Punta Gorda, its ability to package vacations and lack of other hotel investment in the area.

Allegiant held an investor day in mid-September to try to sell the resort concept to a mostly sceptical Wall Street. Analysts are concerned that the concept has changed several times (the previous version included selling condos), and they would prefer Allegiant to focus on the much larger core airline business, given the promising prospects after the fleet transition.

If Sunseeker is successful, as most people expect it to be, Wall Street will no doubt be won over. Also, perhaps the idea is not so outlandish, after all, as Canada’s Transat too has acquired land to build a beachfront resort (on Mexico’s Yucatan Peninsula).