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Republic and Frontier. More surprises ahead in Denver?

21-Aug-2009
Frontier CEO, Sean Menke
Frontier CEO, Sean Menke

A lot of important matters of principle have been playing out over the past couple of weeks, as Frontier Airlines’ future was under the auctioneer’s hammer. This quick review, from Ron Kuhlmann and Peter Harbison, looks at some of the new principles which are being chiseled out of the old rocks of US airline history. It is a fascinating story, with the ending yet to be written, we think.

Chapter 1: Republic beats Southwest and buys Frontier

There can be little doubt more surprises lie ahead in Republic’s already surprising deal to acquire Frontier. Some weeks ago, Frontier Airlines’ debtor-in-possession, Republic Airways, bid for the carrier as it exits Chapter 11. It was a new direction for Republic, which heretofore had operated as a holding company for three airlines that supply regional services to a variety of US majors.

Then, surprisingly, at the end of July, Southwest announced that it was going to bid for Frontier as well and submitted a non-binding bid exceeding the existing Republic offer. On August 10, Southwest finalized and upped its offer by roughly 50%, to USD170 million, indicating that it was going to use this purchase as a way of entering the “near international” (read Mexico) market. Furthermore by including Lynx, Frontier’s regional subsidiary, it also indicated for the first time a willingness to rethink its position with regards to feeder operations.

This would have been another big step in strategy for Southwest. Although it was planning to transition Frontier’s Airbus fleet into its own B737 operations, even though the Lynx fleet goes fairly neatly with Republic’s existing assortment of Embraers.

Both bidders were stepping into new territory but the broad assumption was that Southwest, cash-rich and known for few missteps, would ultimately prevail. But on August 13th, Republic won with a bid just shy of USD109 million, USD61 million under the higher Southwest bid.

Why did Southwest’s bid fail?

Southwest, during a conference call earlier in the week, had made its bid conditional on agreement between its pilots and those of Frontier. Since the pay and benefits package was better at Southwest, the assumption seemed to be that Frontier’s pilots would opt for the more lucrative opportunity.

But that did not happen and in retrospect it is not as surprising as one might think. A similar requirement of pilot agreement was part of the recent Delta/Northwest merger and while the issues were ultimately resolved, the process took months. Southwest and Frontier staff had just days, and hanging over the negotiations was the Republic promise to maintain Frontier in its present configuration and operate it as a stand-alone airline. The Republic pilots decided to stick with the status quo and, absent additional time being granted for further talks, the deal slipped away from Southwest.

Pilot-led decisions – at least in the commercial area – do not have a great track record of achieving the best corporate outcome. And here, with the usual seniority issues at stake (in both airlines), Frontier pilots would appear to have done themselves out of a tidy salary increase. But there it is.

Republic also changed its position in the final round by agreeing to waive the right of recovery on its USD150 million unsecured creditor claim. The Southwest bid, which included compensation for all unsecured creditors, would have paid Republic roughly USD20 million for that liability, had they won.

So after congratulations all round, Republic is the proud owner of not just Frontier, but also Midwest Airlines in a deal finalized July 31st. Its stated goal is to operate the two airlines independently but to capitalize on the synergy created by their Milwaukee and Denver based markets. No one has ever accused the airline business of being dull.

Chapter 2: A new direction for Southwest

This outcome leaves Southwest still seeking ways to enter the Mexican and Canadian markets; the carrier has also exposed its hand in that it is prepared to take on new acquisitions, even where to do so goes right to the heart of its model.

Southwest is on the prowl. It couldn’t chew at Frontier’s animals, but we would have to assume that, if it is prepared to enter into a proposal as large and potentially complex as this, then there is a whole new attitude internally that (i) it should grow, not organically this time; and (ii) international services, at least to Mexico are very much in the spotlight.

…and for a versatile Republic

 For Republic the big departure is that it has now firmly and unconditionally committed itself to operating airlines on its own, rather than on behalf of legacy partners. And it has entered the unpredictable world of making money directly from passengers as opposed to getting guaranteed payment per departure from an affiliate. This is a big and recent change.

In the January/February 2008 issue of Republic’s Airliners: The World’s Airline Magazine, Brian Bedford, Republic’s Chairman, President and CEO was “asked what he sees in the future of Republic Airways, he simply said, ‘Read our mission statement. That says it all. Republic Airways strives to be the premier solutions provider of regional jet capacity to a diverse group of network airlines. We work closely with our partners to provide low cost high quality regional jet capacity. Republic Airways aircraft are deployed under our network partners’ brand to provide service to existing markets, open new markets and schedule convenient and frequent flights for our major airline partners.’”

Not much there about operating a stand-alone carrier with an Airbus fleet. Probably time for a new mission statement.

Republic’s complex (abridged) ancestry

Republic Airways, descended from Chatauqua Airlines, is the holding company for three regional, contract airlines Chatauqua, Republic Airlines and Shuttle America. It is the Airways parent that now also holds Frontier and Midwest.

The company was originally founded as Chatauqua Airlines and acted as a commuter partner for Allegheny Airlines, which subsequently became one of the component carriers that formed USAir. In 1994, along with renewing is code-share agreement with USAir, Chatauqua moved to its current base in Indianapolis.

In 1998 Chatauqua was purchased by Wexford Capital which provided the financial wherewithal to order 50 seat Embraer ERJ-145s. Brian Bedford, still chief honcho, joined Chatauqua in 1999 as its head. Also in 1999 TWA was added as a client carrier and Embraers were deployed on its behalf.

In 2001, America West also contracted with Chatauqua to be its America West Express provider. In the same year Chatauqua also became an affiliate carrier for American Airlines following American’s acquisition of TWA.

2002 brought the America West agreement to a close but the regional was able to transition those aircraft to Delta and operated them as part of the Delta Connection.

In 2004, partly due to scope clause restrictions, a new subsidiary was formed, Republic Airlines and both airlines were brought into a newly formed holding company, Republic Airways. An IPO for the Airways parent was completed May 26, 2004 and was now the holding company for Chatauqua and Republic Airlines. Wexford Capital remained as the new entity’s major shareholder.

Then United contracted for 50-seat aircraft under the Chatauqua certificate and larger, 70-seat airplanes against its Republic Airlines affiliate, all to be operated as United Express.

In 2005, Republic Airways, the holding company, purchased another of Wexford’s investments, Shuttle America Corporation which had been in partnership with US Airways. Shuttle America then expanded to operate services on behalf of both United and Delta. In that same year, Chatauqua began operating aircraft for Continental as Continental Express.

In 2007, Frontier selected the Republic Airlines subsidiary to begin operating 76-passenger Embraer 170 aircraft as part of its expanding network. Ultimately, this arrangement was undone in 2008 by Frontier’s Chapter 11 bankruptcy.

Now, in 2009, Republic Airways owns Midwest Airlines and is revamping its fleet with Embraers acquired from Republic Airlines and is the winner of Frontier. This is the abridged (and simplified) version of the company’s evolution!

The fleets of Republic Airways’ component carriers are as follows:

Chatauqua Airlines fleet

Manufacturer

Type

 In Service

Bombardier

CRJ200

20

Embraer

ERJ 140LR

15

Embraer

ERJ 145EP

2

Embraer

ERJ 145LR

58

Republic Airlines fleet in service

Manufacturer

Type

In Service

Embraer

170

0

Embraer

170

31

Embraer

175

38

Embraer

190

0

Embraer

190

1

Total

 

70

Shuttle America fleet in service

Manufacturer

Type

 In Service

Embraer

170

40

Embraer

170

2

Embraer

175

16

Total

 

58

Republic now also possesses 51 Frontier Airbus A320 family aircraft. Enabled by the bankruptcy proceedings, Southwest intended to return 11 of those aircraft that had “unfavorable leases”. Whether or not Republic will use this opportunity to amend the fleet size has not yet been announced. As an added bonus, it has the Q400 fleet of 10 aircraft (2 on order) operated by Frontier’s subsidiary, Lynx.

Frontier fleet in service and on order

Manufacturer

Type

 In Service

On Order

Airbus

A318

10

0

Airbus

A319

38

0

Airbus

A320

3

11

Total

 

51

11

 

Southwest fleet in service and on order 

Manufacturer

Type

 In Service

On Order

Boeing

737 (CFMI)

206

0

Boeing

737 (NG)

340

91

Total

 

546

91

Southwest fleet delivery schedule 

Manufacturer

Type

Delivery Year

Total

Boeing

737 (NG)

2010

10

Boeing

738 (NG)

2011

10

Boeing

739 (NG)

2012

13

Boeing

740 (NG)

2013

19

Boeing

741 (NG)

2014

13

Boeing

742 (NG)

2015

14

Boeing

743 (NG)

2016

12

Total

   

91

Lynx Aviation fleet in service and on order

Manufacturer

Type

 In Service

On Order

Bombardier (de Havilland)

Dash 8

10

2

Total

 

10

2

Chapter 3: A proliferation of business models

Airlines, especially in the US have evolved and developed against a number of templates. All of the legacy carriers trace their roots to airlines formed early in the 20th century. As has been often noted, their culture and operating styles have amazing commonality. Merging does not change the structure but simply makes the survivor bigger.

The new generation carriers all in some way exhibit Southwest DNA in their common focus on low cost and new operating models. Over time, there has been a softening of the sharp edges of difference as the legacy airlines have tried to focus on costs while the new generation group has added amenities to the original, bare-bones idea.

 Frontier, Midwest and Republic financial highlights: 1Q2006 to 1Q2009

 

Revenue

Costs

Operating profit (loss)

Operating margin

Net profit (loss)

Net profit margin

Frontier

 

 

 

 

 

 

1Q2006

252.5

261.1

-8.6

-3.4%

-7.9

-3.1%

1Q2007

282.4

288.4

-6.0

-2.1%

-10.4

-3.7%

1Q2008

347.3

381.4

-34.1

-9.8%

-40.8

-11.8%

1Q2009

263.9

241.8

22.2

8.4%

-163.6

-62.0%

Midwest

 

 

 

 

 

 

1Q2006

129.4

135.7

-6.3

-4.8%

-5.3

-4.1%

1Q2007

144.9

133.4

11.4

7.9%

13.3

9.2%

1Q2008

175.5

226.2

-50.7

-28.9%

-51.8

-29.5%

1Q2009

92.6

111.2

-18.6

-20.1%

-25.4

-27.4%

Republic

 

 

 

 

 

 

1Q2006

17.7

14.9

2.8

16.0%

-200,600

-1.1%

1Q2007

40.1

31.4

8.7

21.8%

3.8

9.5%

1Q2008

84.9

61.2

23.7

27.9%

11.6

13.7%

1Q2009

98.6

70.3

28.3

28.7%

8.6

8.8%

The Republic/Frontier/Midwest amalgam is a first, comprising an interesting raw materials mix that has not been seen before. Time will tell whether or not it is a brave new experiment or a mix incompatible from the outset.

The company’s complex evolution smacks of ad-hoc-ism and therefore perhaps cause for concern. If it is profitable – an achievement itself in the current environment – why change it? But the constant factor has been Brian Bedford. He has been running a business, as well as the operational side of airlines. Most of this “business” has been B2B and, as an aircraft operator at the regional level, has at the same time been very much in touch with the grassroots of the industry.

This is a valuable combination. But, that said, taking on a large new airline like Frontier+Lynx will be a whole new challenge. One advantage Mr Bedford and his team have is that they will by now be intimately familiar with every moving part of Frontier. And they have “saved” Frontier from being digested by Southwest, so they should enjoy something of a honeymoon.

Chapter 4: And then……

But here comes the real unknown. Southwest’s arrival at Frontier’s main hub of Denver had a lot to do with Frontier’s bankruptcy – and even before that the carrier with the animals on its tails was losing money. Certainly, the high fuel prices of last year were a real setback, but there has to be more to the new equation than a bet on continuing low fuel prices.

What does Republic have up its sleeve? In today’s world, nothing is impossible. A standalone? – risky and not in Republic’s makeup, so far, at least; a deal with United, the other major operator at Denver? – could be good for United, but would need to skirt anti-trust approvals; a deal with Southwest? – similar issues and hard to imagine; or a quick turnaround and a resale? – the purchase price was a steal, so there is a lot of upside.

Maybe the strategy is mere opportunism of an entrepreneurial company which knows a bargain when it sees one, even if it doesn’t fit the core business. Alternatively, if Frontier does remain intact and in its current role, it will shift Republic’s centre of gravity substantially.

Chapter 5: The denouement

We opt for the “more surprises” option. 


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