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Speculation over sale of Frontier Airlines triggers questions over the ULCC evolution in the US

2nd August, 2013

The timing of Frontier Airlines’ parent Republic Airways Holdings disclosing that it had reached a non-binding deal in its long-awaited sale of Frontier followed by an announcement by Spirit Airlines that Indigo Partners was divesting its stake in the carrier, fuelled intense speculation that Indigo’s head Bill Franke was circling around Frontier. Mr Franke also resigned as chairman of Spirit’s board of directors.

It would seem logical for Mr Franke to make a move to purchase Frontier given Indigo’s ties to low-cost carriers Volaris, Wizz Air, Avianova and Tiger Airways. But the unfolding events pose an interesting question as to whether the mature US market really needs another ultra low-cost carrier (ULCC), and if Frontier can successfully transform itself into a true no-frills carrier based in Denver. Mr Franke, a shrewd operator, may think so.

Frontier needs to commit to targeting discretionary travellers to transform into an ULCC

Shortly after the Wall Street Journal reported that Mr Franke was pursuing Frontier, the Denver Post stated that both Indigo and Anchorage Capital were interested in the carrier. Whatever the outcome of the sale, it seems clear that Frontier is intent on following the ultra low-cost model executed by Allegiant and Spirit. However, both those carriers have distinct strategies, whereas Frontier, as it works to transform itself into an ultra low-cost carrier, has not offered a clear vision.

See related report: Frontier Airlines straddles ultra low-cost and hybrid profiles (or falls between them)

While Frontier does not operate in a completely bare-bones manner similar to Spirit – it still allows printed boarding passes at the airport free of charge – it has been gravitating towards following a model of charging for add-ons. The carrier in Jul-2013 began charging customers for soft drinks and starting in Aug-2013 it will charge up to USD100 for carry-on baggage for passengers that book travel through third-party sites.

At the time it announced the changes Frontier explained that its most loyal and high-yielding customers had made it clear it was getting difficult to find overhead bin space onboard aircraft. If Frontier aims to truly move into the ultra low-cost space, it will need to re-think the type of customer it is targeting.

“Most of the industry is out chasing sort of a higher ticket price-paying corporate traveller,” said Spirit CEO Ben Baldanza while discussing the carrier’s 2Q2013 financial results that included a nearly 22% rise in profits to USD42 million. “We’ve given up – we don’t chase that market. We’re chasing the discretionary play, and we see ourselves kind of uniquely positioned to be able to do that for the bulk of that demographic in the US.”

Fort Lauderdale gives Spirit a natural base for an ULCC

Spirit’s revamp of itself into an ultra low-cost carrier around 2007 was based on leveraging its position in Fort Lauderdale to seize on the opportunities to tap the discretionary passengers in that market. It began charging ultra low fares that appealed to the large visiting, friends and relatives (VFR) passenger segment in South Florida, undercutting American, who has a hub in nearby Miami.

Its evolving strategy of charging for essentially any feasible add on – soft drinks, overhead luggage and printed boarding passes at the airport has drawn criticism, but Spirit has turned an annual profit since its transition to an ULCC in 2007.

While it is uncertain if Frontier’s new owners will opt to keep the carrier headquartered in Denver, it would be an expensive proposition to move Frontier from Denver at any point during the next few years given that 90% of its scheduled 3Q2013 capacity is being deployed from Denver. Part of Frontier’s USD100 million-plus cost transformation scheme instituted a couple of years ago was to refocus the bulk of its operations back in Denver after shuttering the hubs once operated by Midwest Airlines in Milwaukee and Kansas City. Midwest was ultimately absorbed into Frontier after Republic purchased both carriers in 2010.

See related report: Frontier celebrates impressive turnaround but faces challenges in finding long-term suitors

It is not clear if Denver is conducive to the ULCC model

Key to Spirit’s strategy in building up Fort Lauderdale was targeting the VFR traffic in South Florida that is fuelled in part by the region’s large Hispanic population. Spirit has turned its growth away from Fort Lauderdale in recent years, opting to expand into large US metropolitan areas where it can essentially offer a low fare attractive to a traffic demographic no longer targeted by US legacy airlines. But it seems Spirit only diversified away from Fort Lauderdale once it was somewhat certain it could replicate its ULCC model on a larger scale, and the airport remains Spirit’s largest base in terms of seats on offer.

Spirit Airlines top 10 hubs/bases/stations by seats: 29-Jul-2013 to 4-Aug-2013

While Frontier does operate international service from Denver to leisure destinations in Mexico and Costa Rica, the reality is Denver is a largely domestic-dominated market with just roughly 4% of its seat deployment dedicated to international service (based on Innovata data for the week of 29-Jul-2013 to 4-Aug-2013). That compares with roughly a 21% international seat deployment at Fort Lauderdale.

Denver International Airport international vs domestic capacity share (% of seats): 29-Jul-2013 to 4-Aug-2013

Fort Lauderdale International Airport international vs domestic capacity (% of seats): 29-Jul-2013 to 4-Aug-2013

Denver's VFR base is not likely as strong as Fort Lauderdale's, which would appear somewhat necessary in building an ultra low-cost niche to counter balance the seasonality of cost-conscious leisure travellers.

But two so-called low-cost carriers have been able to operate from Denver since Southwest entered the market during the mid-2000s, and have managed to co-exist alongside United (although Frontier was purchased by Republic in 2010).

Statistics released from Denver International Airport for 2012 show it was the fifth largest US airport in terms of passenger enplanements. The latest data from the US Department of Transportation (DoT) show that Denver has experienced the third largest fare decrease since 2000. Fares at the airport fell nearly 47% between 1Q2000 and 1Q2013 to USD321, influenced in part by Southwest and Frontier. Denver’s average fare during 1Q2013 was USD58 below the US average of USD378. There might be some opportunity for further low-cost stimulation if Frontier is able to truly transform into a low-cost carrier.

Top US airports by passenger enplanements: 2012

Largest fare increases and decreases at US airports: 1Q2000 vs 1Q2013

Frontier has some work to due on its cost base to achieve true ULCC status

Frontier during calendar year 2012 served all of Denver’s top destinations, which gives it a strong foothold to build a ULCC base. But the key in carrying-out a ultra low cost strategy on those routes is ensuring it has cost low enough to start charging fares that are not feasible for Southwest and United, given their higher cost structure.

Denver International Airport top domestic destinations: 2012

Based on its 3Q2013 results, Frontier needs to buckle down to get its costs to a point where it can offer bare-bones fares similar to Allegiant and Spirit. Its USD7.27 unit cost excluding fuel during 3Q2013 (a 1.3% rise year-on-year) was more in line with Southwest’s USD7.87 cent cost and well above the USD6 cents recorded by Spirit and the USD5.43 cents posted by Allegiant.

Some of the cost pressure Frontier experienced during 2Q2013 resulted from a 10% capacity decrease year-on-year driven by its operation of six fewer Airbus narrowbodies. Its revenues fell 11.6% to USD328 million and unit revenues fell 1.6%. Those figures demonstrate the carrier and its new owners (which should come armed with a robust cash infusion) have their work cut out for them in the ULCC transformation.

Frontier's size allows for some network nimbleness

Frontier does have a bit of diversity outside of Denver through an east coast focus city established in Trenton, New Jersey (58km from Philadelphia) in late 2012. Presently the carrier offers service from Trenton to Atlanta, Chicago Midway, Detroit, Columbus, Fort Lauderdale, Orlando, Fort Myers, and Raleigh-Durham. Carrier executives stated during a recent earnings discussion that Trenton was performing in line with expectations, and that Frontier has seen steady growth in yields since it started service from the airport.

A similar experiment by Frontier in Colorado Springs was short-lived as the carrier could not generate enough demand to sustain year-round service. One positive aspect of ending the brief stint in Colorado Springs showed a certain nimbleness by Frontier to cut markets that don’t quickly reach maturity – a characteristic that Spirit often touts about itself.

More questions than answers linger over Frontier’s fate

The world will be watching to see if Frontier can fashion itself as a true ultra low-cost carrier under new management. But in the meantime some observers are predicting this could create new pressure for Spirit. The reality is once a sale is complete much work will need to be done to bring Frontier to the level of profitability Spirit has achieved during the past few years. Mr Franke certainly has the track record to transform Frontier to a true ULCC should Indigo emerge as the carrier’s new owner; the question of whether there is room for a third airline brandishing that business model among the low-yielding discretionary passenger segment remains unanswered.

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