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Southwest bids USD170 million for a new Frontier; the end of the beginning?

11-Aug-2009

Southwest Airlines announced in a teleconference call on 10-Aug-2009 that, as expected, it had submitted a binding bid for the bankrupt Frontier. But for an anticipated announcement, the call provided plenty of surprises. The first was that the bid amounted to just over USD170 million, roughly 50% higher than the USD113.6 million announced on 30-Jul-2009.

Spokesmen were quick to note that the smaller amount was non-binding and essentially represented a placeholder, allowing the airline more time to consider a firm offer. They said the USD113.6 million was never intended to be a “real” bid and had assumed from the outset that the firm offer would differ. There has clearly been a lot of pencil sharpening around the Dallas corporate headquarters since the original holding bid was published on 30-Jul-2009.

The carrier also announced a delay in the timeline and that the auction, previously scheduled for tomorrow, would be held instead on Thursday, following a Southwest presentation on Wednesday in New York to Frontier and its stakeholders. Any further bids start at the Southwest offer price and rise in USD1 million increments.

The binding bid included purchase of Frontier’s feeder carrier, Lynx, and Southwest affirmed that the long-term integration of the two carriers would substantively include the current Lynx network. Whether it will be outsourced to a third party is yet to be determined.  And there may be more to come. As Southwest announced yesterday, “At this point, it is premature…to release complete details of its offer, which may change during the auction process before a winning bid is approved by the bankruptcy court.”

International expansion inevitable now

After remaining solidly on home territory for most of its existence, a new Southwest under CEO Gary Kelly has made no secret that it sees international expansion as an inevitable part of the carrier’s future. A recent deal with the pilots imposed careful restrictions on expansion through codesharing into the Canadian and Mexican markets, but a purchase of Frontier could change this equation considerably, moving Southwest well and truly into new territory.

Frontier currently serves 50 destinations in the US from its Denver base, as well five in Mexico (with seasonal additions) and Costa Rica’s capital, San Jose.

When questioned on Frontier’s Mexican routes, Southwest spokesmen again confirmed that these were very likely to remain a part of the integrated and enlarged Southwest. They confirmed that Canada, too, was under consideration – and, moreover, that such expansion would not interfere with proposed codeshare operations with either WestJet or Volare.

Although this assurance may not thoroughly convince those carriers, it must surely preface a much larger entry into these cross-border markets for Southwest than previously planned.

Harmonising and expanding domestic networks

It is never easy putting the two airlines together. Frontier is for example present in all but two of Southwest’s 34 non-stop destinations from Denver, where Southwest commenced services some three years ago.

Southwest’s non-stop network from Denver

Competition between the two companies (and United, which also retains a hub in Denver) has been intense. Southwest has made Frontier’s existence extremely difficult since commencing service there, a clear sign that the route networks are less than complementary.

Frontier’s non-stop network from Denver

At yesterday’s teleconference, when quizzed on some current Frontier destinations, the spokesmen said that Frontier’s gate leases at Dallas-Fort Worth Airport, due to expire at the end of 2009, would be allowed to lapse and services would be moved to Dallas’ Love Field.

Due to the current Wright Amendment restriction (in place until 2014), nonstop service to Denver would not be allowed from Love. However, Southwest intends to use this merger to enter the Atlanta market and also believes that the perimeter restriction exemptions that were in place for Frontier from DCA would be transferred to Southwest, putting it into that market as well.

Southwest’s formal announcement yesterday meanwhile noted that the carrier “intends to maintain all existing markets, as well as add new nonstop routes from Denver that are not served by either Southwest or Frontier today.” And Mr Kelly expects that “A successful acquisition of Frontier Airlines by Southwest will expand a network of legendary low fares to additional cities, add jobs into Southwest through growth, and strengthen low-fare competitive pressure in Denver and other cities."

Denver Airport and United unlikely to be beneficiaries

Denver’s International Airport last week reported a slightly less bad 2.5% reduction in traffic for Jun-2009, compared with the May fall of 5.8%, year on year. A purchase of Frontier by Southwest is being seen as likely to reduce the vicious competition which has prevailed at the airport this year.

And, even though Southwest is unlikely to increase fares noticeably, there must inevitably be some reduction in seats offered on overlapping routes. The airport recently announced it was considering a USD1 billion makeover, with plans for a new hotel and train station, so it will not welcome any further reduction in revenues.

A purchase would also give Southwest access to Frontier’s gates at the airport (as well as valuable slots at Washington National and New York’s La Guardia, for example), so there is an element in the transaction that was key for Southwest’s recent acquisition of ATA, which was purely a slot play.

And United, the biggest full service airline at Denver, could look forward to a much more coherent level of competition from a larger, more powerful low cost operation. Some of the heat may be taken out of the fare and route competition in the medium term, but even that cannot be taken for granted, as a bigger operator claws away at market share.

Integration of the B737-A319/320 fleets – and some nice cheap Airbus for sale?

Southwest anticipates that if its bid is successful, there will follow a 4-6 month review by governmental agencies until the deal is finally closed. That closure would represent day 1 of the new arrangement and at that time Frontier would operate with 80% of its current Airbus fleet – about 40 aircraft. The other 11 that are on less favorable lease arrangements would be returned under the bankruptcy provision.

Frontier’s fleet is all-Airbus:

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

With those orders originally due to arrive as shown:

Frontier fleet delivery schedule

Manufacturer

Type

Delivery Year

Total

Airbus

A320

2009

1

Airbus

A320

2010

2

Airbus

A320

2011

4

Airbus

A320

2012

4

Total

   

11

Full integration and retirement of Frontier’s remaining Airbus A318/319/320 aircraft is expected to take 24 months, at which point the integrated carrier would again be using all B737s. An exact schedule is not available at this time but Southwest believes that its strong financial position will expedite the acquisitions.

Southwest, the largest US domestic airline is some ten times the size of Frontier:

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

And, although it has recently been slowing its expansion plans, has plenty of capacity to add in new B737s to its fleet if it needs to. Boeing will no doubt be delighted to accommodate any variations, especially if it means displacing Airbus:

Southwest fleet delivery schedule

Manufacturer

Type

Delivery Year

Total

Boeing

737 (NG)

2010

10

Boeing

737 (NG)

2011

10

Boeing

737 (NG)

2012

13

Boeing

737 (NG)

2013

19

Boeing

737 (NG)

2014

13

Boeing

737 (NG)

2015

14

Boeing

737 (NG)

2016

12

Total

   

91

This will not only be good news for Boeing, but also for any existing or startup A320 operator. Frontier’s average fleet age is around five years, having dispensed with its last Boeing in 2005, so these are attractive aircraft, and they come with high density, single class configuration.

Lynx: a small sideline – helpful, or to hive off?

Lynx, a Dash-8 regional operation, is hardly core to the Southwest model and is unlikely to remain as part of the bigger player. But if the feed opportunities at Denver offer some competitive edge in the short term, it could have some value, but its future is, at most, probably at arm’s length.

Lynx Aviation fleet in service and on order

Manufacturer

Type

 In Service

On Order

Bombardier (de Havilland)

Dash 8

10

2

Total

 

10

2

And it has two more Bombardiers on order for delivery this year.

Merging the workforces: never plain sailing

As Southwest previously noted, Frontier would "operate as a wholly owned subsidiary, independently and separately from Southwest Airlines, for a period of time until the carrier could be combined with Southwest……Over time, Frontier employees would be hired into Southwest as needed to support our fleet growth and expanded operations."

No doubt “over time” Southwest management is banking on the larger combined airline being ready to catch the wave of (hoped for) recovery in 2011 or so.

The two airlines do have similarities in their cost focus and Southwest and Frontier’s revenues over the past three years reflect a similar growth path from their respective bases, although recent growth for Frontier has been in the shadow of bankruptcy:

Southwest and Frontier operating revenue: 2006 to 2008 (USD billion)

Noting that Frontier will continue to operate and that the larger Southwest will add destinations currently unserved by either carrier, Frontier employees are likely to have ample opportunities within the ranks of its new owner. Pilots’ unions are required by Federal law to discuss seniority but the spokesmen pointed out that Southwest’s salary and benefits package is more generous than that of Frontier, making the change an attractive option for current Frontier crew. 

This salary discrepancy is more than just a few percentage points, and well into double figures, so the numbers will have to be crunched pretty thoroughly if Frontier’s spell in bankruptcy is to be capitalised on. But at least the Frontier pilots should be kept happy.

However, not all Frontier employees feel the same way. According to the Denver Post, a hundred or so Frontier staff marched in downtown Denver on Monday, chanting “save the animals”. There is a belief in some quarters that the airline would remain more or less intact if Republic were the winner in the auction process. Gary Kelly notes however that “Frontier is up for sale. The bankruptcy process will lead to change at Frontier in any scenario.”

Meanwhile Republic Airways can walk away with a tidy profit

Republic had been the first Frontier bidder to step, up, with an opportunistic offer of just under USD109 million. Assuming it does not raise its offer, so that Southwest is the winning bidder, Republic stands to gain a nice windfall (technically, no other bidder may now enter the race, so the likelihood of another candidate miraculously emerging tomorrow is limited).

The carrier upped its payments for uninsured creditors from USD0.087 cents to USD0.12.0 cents on the dollar and, since Republic holds roughly 30% of that claims pool, its reimbursement would be in the neighborhood of USD20 million. This is in addition to the debtor-in-possession payment to Republic of about USD40 million. Southwest would also pay Republic an unspecified breakup fee.

So, even if it does not continue in the race, Republic can feel that its relatively small investment has been well rewarded in the short term. Whether longer term aspirations will encourage it to try to outbid a cashed up Southwest is still not clear, but the betting would have to be on Southwest right now.

And will the Southwest culture endure?

When the Frontier bid was announced two weeks ago, Mr Kelly confidently saw “a strong fit between our company cultures, a mutual commitment to high quality Customer Service, and similar entrepreneurial roots."

And yesterday, when asked if the character of Southwest and its business model might be changed through this acquisition, the spokesmen noted that they were ready to learn from the successful practices of others and would gladly incorporate Frontier practices and policies that benefit the traveling public. They also said that the Southwest business model has been evolving for years (but nowhere near as fast as it has over the past couple of years!).

Repeated customer surveys have shown that Southwest travellers value, in this order: schedule, low price and customer service – with special appreciation of on time performance. Anything that improves the customer experience and reinforces these primary business goals is open for consideration. The goal of the enlarged Southwest at Denver remains to be to provide reliable, low-cost service as an alternative to the predominant carrier, United.

This goal may be made easier by adding Frontier to the mix, but merging the two head to head competitors will necessarily provide a cultural as well as operational challenge over a period of two years which promise to be the most challenging ever.

Frontier staff in Denver, trained to confront Southwest at every turn and in danger of losing their distinctive animal tails, will need to be tamed and won over. Extra money may be a useful medicine, but that is a risky drug to be offering in the low cost airline business right now.

Whatever the case, co-founder of Southwest, Lamar Muse will be turning in his grave at the thought. And Herb Kelleher is hardly a fan of mergers, having experienced one of his worst management headaches after the then-young Southwest bought Morris Air – which Southwest was later forced to close down when it became clear that was the only way the two would ever be one.

But those were different times. Southwest today faces a vastly more competitive environment within its own sphere of operation and as legacy airlines intrude further into its territory (and vice versa).

Southwest has spawned dozens of imitators around the world over the past 20 years. Whether the Frontier purchase marks the end of the beginning of the old Southwest – which now becomes a more complex animal (even without the tails) and enters international markets for real – or, as some might fear, the beginning of the end, is a drama which LCCs in every region will watch with fascination.


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