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US low-cost carriers offer little insight beyond 3Q as they attempt to contain cost creep

3-Aug-2012

Low-cost and niche carriers in the US enjoyed robust 2Q2012 earnings growth fuelled by solid demand that is carrying over into 3Q2012. But at the same time the country’s top LCCs are facing challenges in their core strength as nearly every airline in that category recorded rising unit costs during 2Q stemming mainly from a spike in maintenance spend. As is the case with demand projections, most of the low fare carriers are not offering insight of when the cost creep might abate.

US leading low-cost carriers JetBlue, Alaska Air Group and Spirit Airlines grew their 2Q2012 profits by 108%, 24% and 35% (Alaska and Spirit’s rise exclude special items), respectively, joining 42% profit growth at Southwest Airlines. The strong year-over-year profit growth was driven by what the carriers deemed a solid demand environment, which helped to drive solid unit revenue growth at all four of the airlines.

US low-cost and niche carrier year-over-year PRASM change: 2Q2012

Carrier Passenger unit revenue growth
Allegiant (-5.6%)
Alaska 4.8%
JetBlue 6.1.%
Southwest 5.5%
Spirit 7.7%*

June was a particularly strong month for JetBlue as it recorded 6% growth for the month in passenger unit revenues, which the carrier concluded was in part driven by close-in demand near the end of the month. The airline continues to build out its strategy of attracting corporate travellers in its Boston focus city, which has a stronger economy than other regions in the US, noted carrier chief commercial officer Robin Hayes. “We do look at Boston and the New England economy as sort of one of the areas in the corporate travel segment is probably doing better than a lot of parts of the rest of the US,” said Mr Hayes.

Alaska Air Group CEO Brad Tilden concluded that despite ongoing concerns about the macroeconomic environment, demand remained strong, evidenced by a 2.4 ppt rise year-over-year in load factor to 87.4% and a 6.3% rise in passenger unit revenues on a 6% rise in system-wide capacity. Mr Tilden concluded that performance gives Alaska “confidence that we are managing capacity effectively”.

A rapid expansion by Spirit Airlines in the US domestic market place did not pressure the carrier’s total unit revenues, which grew 7.7% (including ancillary revenues) on a 9% increase in yield. During 2Q2012 Spirit launched 14 new routes, of which seven were from Dallas/Fort Worth. The carrier has quickly built up at the airport after determining the market was an ideal stimulation candidate for its ultra low fares.

See related article: Spirit continues rapid expansion from American’s stronghold of Dallas/Fort Worth

Southwest also enjoyed a 5.5% rise in passenger unit revenues during 2Q2012 driven by a 5% increase in average one-way fares year-over-year that lifted yields 6%.

See related article: Southwest remains cautious as it records strong 2Q2012 earnings

Cautious optimism of sustaining solid demand

US low-cost carriers do not see any immediate threats of weakening demand during 3Q2012. Although like their legacy counterparts they caution that year-over-year comparisons will increasingly become difficult as revenue growth during 3Q2011 was particularly strong, aided somewhat by a break in certain ticket tax collections triggered by the shutdown of the US FAA’s administrative offices due to political gridlock over the agency’s funding in the US Congress.

Spirit CEO Ben Baldanza remarked he was pleased overall with how 3Q2012 is shaping up. Noting that the carrier does not have deep visibility passed the US Labour holiday due to Spirit’s shorter booking curve, he did conclude the airline’s bookings for July and August look stable.

JetBlue has seen some capacity creep in its US transcontinental markets for the summer time period, but Mr Hayes assured that is not necessarily a concern during summer peak months as demand is holding up under higher fares. He stated it will be interesting to see if that capacity remains intact during the upcoming lower-demand months of Sep-2012 and Oct-2012.

JetBlue continues to remain on the high end of US industry capacity growth, as it expects supply to increase 7%-9% during 3Q2012 and 6.5%-8.5%. The carrier’s full-year capacity guidance has risen slightly from previous estimates of a 6%-8% rise resulting from higher than expected completion factors during 1H2012 and some additional flying into business-oriented markets in September and October.

Alaska estimated its Jul-2012 bookings to be flat year-over-year, but as of 26-Jul-2012 the carrier’s bookings for Aug-2012 were up 1.5 ppts year-over-year with September rising a single point. Carrier VP of planning and revenue management Andrew Harrison remarked that Alaska on the mainline level during the summer months would post loads similar to the 89% load factors the carrier recorded during the same period in 2011. The airline this year has made some conscious changes to its booking patterns during the summer of 2012 after determining it sold some seats too soon in the year prior. “We’re seeing nothing unusual at all other than our own manipulation, where we’ve learned from some lessons last year in demand patters,” Mr Harrison stated.

Recession-proof business models

Even as most executives at the major US low-cost carriers declined to offer insight into demand patters passed 3Q2012, they were unified in their view that the business models adopted by their respective companies were built to withstand downturns triggered by recessions.

Low-fare, low-frequency leisure carrier Allegiant Air had the strongest view that its model is recession-proof. Company president Andrew Levy reminded analysts that Allegiant during periods of economic weakness in 2008 and 2009 recorded some of the best operating margins in the company’s history, and he sees no reason why that pattern would change if another recession ensues. “During a slowdown business demand is fast to contract. But leisure demand can always be stimulated, albeit at lower prices,” Mr Levy concluded. Allegiant’s 2Q2012 profits soared 111% to USD25 million as revenue increased 15% to USD231 million. The carrier got a unit cost reprieve during 2Q2012 as those costs excluding fuel dropped nearly 14% in 2Q2012 as an engine maintenance bubble the carrier faced for most of 2011 has flattened out.

Spirit, which somewhat like Allegiant offers low bottom-line fares and charges for nearly every other part of the travel experience, also believes its ultra low-fare model works favourably during downturns. Carrier chief marketing officer Barry Biffle remarked that Spirit also had its highest earnings from a margin standpoint during the 2009 weak period, noting in a recessionary environment “a larger percentage of the travelling population looks for the value play”. He believes Spirit’s model is actually somewhat counter-cyclical and a recession, “shouldn’t change our view that we can continue to grow and not compress our margins”. However, he did stress Spirit has seen any leading indicators showing a recession is near.

Medium-frills hybrid carrier JetBlue also concludes that customers retreat to the value segment when the economy toughens. “We saw that back in 2008 and 2009,” said Mr Hayes, “And I think we’re going to continue to see that here if that [a recession] happens.”

Combating unit costs creep

Accompanying strong 2Q2012 revenue performance at JetBlue and Spirit was an uncomfortable rise in unit costs driven by maintenance cost pressures at both carriers.

US low-cost and niche carrier year-over-year PRASM change: 2Q2012

Carrier Unit cost change (ex-fuel)
Allegiant (-14%)
Alaska (-0.3%)
JetBlue 5.6%
Spirit 11.8%
Southwest 1.7%

JetBlue throughout 2012 has been battling escalating maintenance costs stemming from a group of its A320 narrowbodies delivered in the mid-2000s. Company CFO Mark Powers noted that maintenance expense during 2Q2012 jumped 50% on a unit costs basis, but the line item only accounted for 7% of the carrier’s overall unit costs. He explained that as JetBlue’s fleet ages, repairs have become more expensive. To alleviate some of the cost pressure the carrier sold six older A320 spare engines during 2Q2012 that were replaced by newer powerplants. The airline also negotiated long-term power-by-the-hour agreements covering the GE CF34-10E engines powering its 100-seat Embraer E190s, which should create more predictable maintenance expense in the future. Mr Powers also remarked that JetBlue is making progress in finding replacement vendors for component repairs after Canadian MRO Aveos sought bankruptcy protection in early 2012. “In the mean time, of course, we’ll continue to pay higher rates on the related aircraft component repairs,” warned Mr Powers.

The cost pressure on JetBlue will continue throughout 2012 as third quarter unit costs excluding fuel should rise between 4.5% to 6.5% year-over-year and 2.5% to 4.5% for full-year 2012 driven by continued higher maintenance expense and profit sharing.

Spirit had the most dramatic rise in its unit costs excluding fuel year-over-year at 11.6%, driven by a 3.2% decrease in stage length and costs related the start-up of a seat maintenance programme, which should total USD7.5 million for full-year 2012. Airline CFO Ted Christie explained Spirit is working toward completing the programme during 3Q2012, but some of the work could spill into 4Q2012. The carrier estimates 3Q2012 unit costs to rise 5.2% to 6.1% year-over-year, but expects those costs to drop in he mid-single digits year-over-year during 4Q2012.

Despite a 0.3% decrease in unit costs during 2Q2012 Alaska Air Group has warned that its full-year 2012 unit costs excluding fuel will now be flat compared to previous estimates those costs would fall slightly due to higher incentive pay. The company stated it was disappointed it was not better able to leverage its 6% full-year capacity growth to lower unit costs. Alaska’s management remarked the carrier needs to keep driving its unit costs down as it moves into the 2013 budget cycle.

Southwest also predicts its 3Q2012 unit costs will grow more year-over-year than 2Q2012, as an aircraft reconfiguration project that includes adding six seats to its Boeing 737-700s will drive those costs in the mid-to-high single digits during 3Q2012.

US low-cost carriers are keeping their supply growth projections for 2012 intact, even though the demand outlook beyond September appears fuzzy and cost pressures will remain at least throughout 3Q2012. For the moment, they remain confident that their growth prospects will sustain the revenue momentum they’ve enjoyed during 1H2012. But any negative shift in demand patterns could disrupt the balance they are trying to preserve between revenue and cost growth.

Capacity guidance from US low-cost carriers: 3Q2012

Carrier 3Q2012 capacity growth estimate
Allegiant 14%-18%
Alaska 6.5%
JetBlue 7%-9%
Spirit 22%

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