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

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The Ryanair-style ultra-low cost carrier (ULCC) business model continues to gain traction in the US. According to Cowen and Company, the three airlines in that sector — Spirit, Frontier and Allegiant — are on track to achieve a combined domestic market share of 10% by 2020, up from 4.3% in 2013 and 8% currently.

Compared to Europe, the ULCC business model had a late start in the US, where low-cost pioneer Southwest and up-market LCCs such as JetBlue have dominated the scene. If Southwest is included the LCC/ULCC share is around 29%.

Spirit Airlines, originally an LCC, became the first true ULCC in the US after Indigo Partners acquired a majority stake and control in the company in 2006. Indigo is a US private equity firm and a serial developer of ULCCs around the world.

The Fort Lauderdale-based carrier has been a huge success story, achieving industry-leading profit margins while growing extremely rapidly. Spirit went public in 2011 and is now the seventh largest US airline, with around $3.2bn revenues in 2018.

Frontier Airlines began its LCC-to-ULCC transition in 2014, after Indigo Partners bought the Denver-based carrier from Republic Airways Holdings in December 2013.

Bill Franke, Indigo’s co-founder and managing partner, had first tried to persuade his fellow directors at Spirit to make a bid for Frontier. When Spirit’s board declined, Franke bid for Frontier himself, subsequently selling his stake in Spirit and resigning as its chairman in the summer of 2013.

Frontier attained strong profitability quickly and grew its revenues to $1.9bn in 2017. It filed for an IPO in March 2017, but those plans continue to be on hold because of a difficult situation with the pilots.

Las Vegas-based Allegiant Air — the tenth largest US carrier and publicly listed since 2006 — is also a ULCC, but it is a true niche carrier and has an unusual business model. Allegiant operates from small cities to large leisure destinations, utilising fully depreciated aircraft that give it flexibility to fly when demand dictates. It has no competition on 75-80% of its routes.

Allegiant has become a little more conventional in that it will have retired its old MD80s and switched to an all-Airbus fleet by year-end, but it has a new controversial $420m-plus project on the horizon: building its own hotel/resort in Florida.

The three ULCCs’ ultra-low fares have stimulated new traffic in the US, helping to boost growth in an already relatively mature air travel market. Their double-digit growth rates mean that they will continue to take share from the top-four US airlines (American, Delta, United and Southwest), which in 2013, after a decade of industry consolidation, accounted for around 80% of the market.

Spirit’s former CEO Ben Baldanza made the point that the ULCCs had proved that a passenger segment existed in the US that had been largely ignored by airlines. “The idea that everyone who wanted to fly could fly absolutely was not true.”

The fundamental reason why the ULCC business model is gaining traction in the US is that it is being more widely accepted by the travelling public.

Five years ago, Spirit was still fending off lawsuits, legislative threats and vitriolic national press coverage. But that has changed, in part because Spirit made its fares and fees transparent and educated consumers about ULCC-style pricing.

Frontier, in turn, sought to be a higher-quality ULCC with good customer service right from the start. Its slogan is “Low Fares Done Right”.

The ULCCs have historically been plagued by high levels of flight delays and cancellations, which caused customer complaints to soar. But Spirit has made much progress in tackling those issues in the past two years.

It is arguably also easier for US travellers to accept ULCC-type pricing now that the legacy carriers offer a similar product. In other words, the legacies’ basic economy offering has helped “legitimise” the ULCC business model in the US.

The ULCC business model is now also better understood and liked on Wall Street. The reasons are clear: consistently superior profit margins, huge cost advantages and much success in ancillary revenue generation.

Because of those attributes, airline analysts and investors in the US have been able to put aside concerns about RASM performance and accept that rapid growth is an essential part of the ULCC business model. However, analysts have never approved of ULCCs’ incursions into big legacy hubs.

According to Airline Weekly, Allegiant, Frontier and Spirit were among the world’s top-ten most profitable airlines in the 12 months to March 2018, with operating margins of 17%, 16% and 14%, respectively.

The main challenges for the ULCCs are significant labour cost hikes, threat of labour unrest, substantially higher fuel prices and more aggressive competition from the legacies.

The two largest ULCCs currently have contrasting labour situations: Spirit is enjoying a rare respite after its pilots ratified a new four-year agreement in February, while Frontier faces a potential pilot strike in the coming months.

Legacy-ULCC battles

After many years of peaceful coexistence with the legacy carriers, US ULCCs found themselves in a much tougher competitive environment beginning in 2015. Two things have happened: first, the legacies began to aggressively match the ULCCs’ fares; next, they introduced basic economy — a bare-bones product offering aimed at competing with ULCCs.

In Spirit’s initial 7-8 years as a ULCC, the legacy carriers were restructuring in Chapter 11, consolidating mergers or dealing with high fuel prices. Their shrinkage in many smaller markets had created ample growth opportunities for ULCCs. In those days the legacies were not interested in the ultra-price sensitive travellers that the ULCCs targeted. Spirit was able to grow unfettered.

However, after initially focusing on non-hub markets, Spirit decided to take advantage of American’s 2011-2013 bankruptcy and expand aggressively into American’s Dallas DFW hub.

In May 2015, strengthened by its restructuring and merger with US Airways, American decided to start defending its hubs and matching ULCC fares. Spirit’s decision to “hunker down for the fight” (as one analyst put it) led to its share price losing almost half of its value in 2015, and it was forced to contract in Dallas in 2015-2017.

The ULCCs’ dramatic growth, the legacies’ improved cost structures and the decline in oil prices in 2016 made the Big Three carriers more interested in the type of passenger the ULCCs targeted.

Delta became the first legacy carrier to introduce the basic economy product in 2015, and American and United began rolling out their versions in early 2017. By 2018 the offering was broadly available nationwide. Now also Alaska and JetBlue are planning to bring out their versions of basic economy.

So far at least basic economy’s impact on ULCCs has been limited. Spirit executives have repeatedly described the impact as neutral or even slightly positive (because it tends to limit the number of seats the legacies offer at the lowest prices). The ULCCs view it merely as a yield management tool that helps the legacies manage revenues in their own networks. But the jury is probably still out on the longer-term impact, which one analyst not so long ago suggested represented a “secular threat to the ULCC business model”.

The summer of 2017 saw a resurgence of ULCC-legacy hub battles, this time being more widespread, involving United and affecting both Spirit and Frontier.

Claiming that it had lost connecting passengers to ULCCs after its contraction in the wake of the merger with Continental, United began to aggressively match ULCCs’ fares at its Chicago, Denver and Houston hubs. As a result, Spirit and Frontier saw their unit revenues plummet in 2017.

This year, though, the domestic revenue environment has improved, reflecting fare increases to cope with sharply higher fuel prices. Spirit has led the industry on unit revenue recovery: its TRASM rose by 5.5% in Q3 and is projected to rise by 6% in Q4, driven by network changes, better yield management and strong ancillary revenue growth.

But the longer-term challenges remain: basic economy is here to stay (and will be refined), United’s hub-strengthening will continue and the legacies will continue to defend their hubs. Possible implications for the ULCCs: slightly slower growth, somewhat lower profit margins, more thoughtful hub incursions, renewed interest in smaller markets and more international expansion.

Then again, the ULCCs have proved that they can achieve industry-leading profit margins even in periods of intense legacy fare matching. They can lean on their ultra-low cost structures, have better yield management and will reap benefits from a larger scale and nationwide presence.

Frontier’s nifty responses to United’s pricing moves have illustrated the nimbleness of the ULCC model. When United initially made its basic economy fares too restrictive, Frontier made its own fares more flexible. When United (among other carriers) recently raised its bag fees, Frontier reduced its change fees — a strategy that could allow it to pull traffic from United, whose basic economy fares are non-refundable and non-changeable.

It is hard to predict how large the US ULCC sector could eventually be. Because of Southwest, it may never account for 20% of the market. But 15% (by 2025?) seems well within reach based on recent trends.

Another pertinent question is whether there will be consolidation in the sector. When Robert Fornaro took over from Ben Baldanza at Spirit in early 2016, there was speculation that it would soon lead to a Spirit-Frontier merger (at AirTran Fornaro oversaw the 2011 merger with Southwest). But now the feeling is that any consolidation is years away. Spirit remains totally focused on organic growth. The ULCCs have ample further growth opportunities. And the current regulatory climate is probably not favourable to airline mergers.

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).

2017 2018 2019 2020 2021
A319 31 31 31 31 30
A320ceo 51 60 62 62 62
A320neo 5 7 21 37 55
A321ceo 25 30 30 30 30
Total 112 128 144 160 177

Note: Number of aircraft in service at year-end. Includes scheduled deliveries and retirements/lease expirations. Source: Spirit Airlines


Q1 Q2 Q3 YE
MD-80 32 27 19 0
A319 26 31 31 32
A320 30 35 44 45
Total 88 93 94 77

Notes: Correct as of July 25, 2018. Includes in-service aircraft, planned retirements and future aircraft under contract (subject to change). Source: Allegiant

On Order
2013 2014 2015 2016 2017 2018 2018-2021 2025-2029
A319 35 35 33 22 18 10
A320 18 20 23 27 24 21
A320neo 4 17 28 54 100
A321 5 13 19 19
A321neo 34
Total 53 55 61 66 78 78 54 134
gnuplot Produced by GNUPLOT 5.2 patchlevel 4 0 100 200 300 400 500 600 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0 500 1,000 1,500 2,000 2,500 3,000 Operating result Net result Revenues Operating result Net result Revenues

Note: Adjusted operating and net results since 2014; before that minor special items included in some years. Source: Company reports

gnuplot Produced by GNUPLOT 5.2 patchlevel 4 0 5,000 10,000 15,000 20,000 25,000 30,000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F 2021F -10% 0% 10% 20% 30% 40% 50% ASMs Pct Chg ASMs Pct Chg

Notes: 2018F = Spirit's estimate as of July 25, 2018. 2019-2021F = Mid-point of Spirit's forecast 13-15% range. Forecasts from Spirit Airlines presentation (August 27, 2018)

gnuplot Produced by GNUPLOT 5.2 patchlevel 4 0% 20% 40% 60% 80% 100% 120% 140% Southwest JetBlue Delta American United Adjusted ex-fuel CASM % higher than Spirit's 2012 2017 2012 2017

Source: Spirit Airlines presentation dated August 27, 2018

gnuplot Produced by GNUPLOT 5.2 patchlevel 4 0 100 200 300 400 500 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0 200 400 600 800 1,000 1,200 1,400 1,600 Operating profit Net Profit Revenues Operating profit Net Profit Revenues

Source: Company reports

gnuplot Produced by GNUPLOT 5.2 patchlevel 4 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F* 0% 5% 10% 15% 20% 25% 30% 35% ASMs Pct Chg ASMs Pct Chg

Note: *2018F = Mid-point of 9-11% range. Source: Company reports

gnuplot Produced by GNUPLOT 5.2 patchlevel 4 0 100 200 300 400 500 2014 2015 2016 2017 0 500 1,000 1,500 2,000 Operating result Net result Revenues Operating result Net result Revenues

Source: Frontier IPO prospectus (March 2017) and US DOT Form 41.

gnuplot Produced by GNUPLOT 5.2 patchlevel 4 0 5,000 10,000 15,000 20,000 25,000 2012 2013 2014 2015 2016 2017 -10% -5% 0% 5% 10% 15% 20% 25% ASMs(m) Yr-yr pct chg ASM PctChg ASM PctChg

Source: Frontier IPO prospectus (March 2017) and US DOT Form 41 (BTS)


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