AirTran ready for anything, expects record income

AirTran's actions in the last two years have positioned it to weather any type of economy, according to Arne Haak, the airline's Senior VP Finance, Treasurer and CFO. Speaking to the Raymond James 2009 Boston Fall Investors Conference this week, Me Haak also noted the company expected record income this year.

“What is buoying the sector is everyone talking about the capacity discipline and we are all seeing we’ve hit bottom and yields starting to firm up,” he said. “We feel the economy has the potential to rebound and this capacity discipline has the potential to be very supportive. The hard part is going into next year. We have never seen a unit revenue decline this big before. So we don’t know what the recovery is going to look like. It could be a big rebound but could be much slower. Coupling a balanced fuel price and the revenue environment could be very good for this sector.”

Pulling back on growth

He hedged on whether or not a stronger recovery would mean resuming aircraft deliveries. “The hurdle to make that decision is much higher,” he said. “Aircraft are more expensive, capital markets are much tighter. If you go back 2-3 years, AirTran, as a single B- credit, could borrow 85% of the purchase price at an interest rate less than 5%. Today, it would be only 70% of the purchase price with interest rates 200-400 basis points higher'

Mr Haak added, "we also need to commit money to hedging, so we would need to see better margins than we have today, and see an opportunity that is not being served that will produce returns in the near term not five years from now. The great thing is we can do asset allocations. Aircraft are easy to move before we need to refleet. We also have the option to replace 737-700s deliveries with -800s which would go from 137 to 160 seats. Of course, a bigger aircraft means more revenue risk but it also brings lower unit costs. We also have flexibility in our current pilot contract to outsource flying if we need to move quickly to react to an opportunity.”

Haak outlined the airline’s strategy in pulling back on growth, increasing liquidity, restructuring fuel hedging and diversification which is behind its profitability expectations this year. He stated, “that record profitability paves the way for use to have a more manageable growth plan, a more disciplined fleet plan, a more diversified network and a more effective hedge portfolio and we are better capitalized so we are position for both weak and strong environments". He added, “we also think there will be opportunities out there for us as people reduce capacity and adjust their business.”

In the past year, Haak noted, the company has restored its record of profitability that was unbroken since 1999, with the singular exception of 2008. “Customers are very value oriented and that plays very well for us and our brand,” said Haak. “We have seen softer demand but the lower yield has been offset by softer fuel, the significant capacity reductions and the strong growth in ancillary revenues. We have a significant non-fuel cost advantage and we have strengthened our balance sheet. I also think we have a very good industry back-drop story. We’ve seen a lot of capacity discipline in the industry and, along with ancillary revenue and other initiatives people are looking at this year to increase revenue. That is what he what recovery going to be about will be about –improved revenues.”

Capital base strengthened, cost base reduced

He noted that in late 2007, the industry thought that if it needed money it was easily obtainable, but this has changed. “We have now put into place two significant pieces of capital that gives us the financial stability to reposition ourselves should oil prices go high,” he said, adding it is no longer a question of whether the airline would have time to accomplish that. “We’ve done a USD175 million credit facility and have raised USD170 million in capital.”

Haak pointed to a 7% increase in Q4 capacity, but noted that unit revenues were down 7-8%. However, 4Q2008 was the highest unit revenue in company history because the economic meltdown had not impacted airline unit revenues which only came at the beginning of 2009. He stated, "while we are not getting back to 4Q2008 levels, we are getting closer and the trend in yields is improving, adding, "we are profitable across multiple markets and no longer dependent on just one market. We can compete on both a hub and point-to-point basis whether in small, medium or large cities to Florida. We have a really big cost advantage which is valuable especially in leisure markets which have the potential to grow this year.”

In the last 12 to 18 months, AirTran has restructured for better results and now has the lowest costs of any major airline in the US, according to Haak. It has a fleet of 137 Boeing 717s and 737s, flying more than 700 flights to over 60 destinations and carrying 24 million passengers annually.

“Inspired by high oil prices we diversified and cut back on our expansion plans,” he said. “We diversified our network that was largely based on Atlanta and the Southeast so we are not so subject to our largest competitor – Delta – and what it would do to undermine our profitability. We continue to be committed to hedging since it is our largest input costs and it is so volatile.”

Haak reported AAI has to lowest non-fuel unit cost of an US airlines. “What we have done is adjusted that to our overage flight length of 740 miles for the first nine months to produce an apples to apples comparison. We’ve always had low costs but 12 to 18 months ago we finally passed Southwest in terms of non-fuel unit costs which is quite an accomplishment to be in the same category as Southwest.”

While admitting that AAI marketing does not like his description of the industry, Haak said that he views it as a commodity business. “People who buy airline tickets are shopping largely on price,” he said. “If the price is USD100 you may chose to fly JetBlue because you like the television or Delta because of the frequent flyer program or AirTran for the upgrades or the internet. We were the first US carrier to complete the installation of WiFi on our entire fleet. But if another airline charges USD90, they will forget everything else and buy the USD90 fare. So, that initial purchase decision is hyper competitive. On an undifferentiated produce you have to have the lowest costs and that is why we are hyper focused on costs.”

He noted that AirTran has the fewest people-per-aircraft ratio at 60 compared to 80 to 100 at the legacies. He also pointed to gate utilization noting that it turns aircraft six or seven times a day per gate. “You go through airports and you see lots of empty gates that someone is paying a lease on but really only using it in the morning and peak at the end of the day not all day,” he said.

He also noted that while the airline sells through all distribution channels, over 70% of sales are from its website or call center. “We want to offer broad distribution but we prefer customers come directly to us,” he said.

Haak recounted AirTran’s strategy and how it has changed with the shifting economic conditions. Between 2005 and 2007, its growth was over 20% as its major competitors were in bankruptcy. “We had a plan that we would have 188 aircraft by the end of 2011 but last year we made dramatic changes selling or differing 47 aircraft, taking them out of the fleet plan,” he said. “This reduced our cap ex by over USD1 billion to the point where we have no permanent aircraft financing requirements until the second quarter of 2011. Our ASM growth rate is much more manageable and will be in the low-to-mid single digits as we go forward.”

Ancillaries to keep growing

Ancillary revenues will not grow at the pace they have been over the last year, simply because most were imposed in the past year or so. However, he predicted they would grow “in the double digits".

Haak stated, "we are in an environment where you see an unbundling of products whether at the phone or cable company so you pay for only the services you want. We have offered product services such as seat fees, upgrades to business class, pay for the extra room on the emergency exit row seat or to use call centre. What we like is the net margin on this type of revenue is very high. We let our customer choose what is valuable to them and what services they are willing to pay for. The result is that, while capacity has slowed, we’ve seen 30-45% growth in past two years in this area".

But he cautioned, "we have to be careful so that don’t want to make passengers feel that we’re nickle and diming them. A lot of people don’t like baggage fees but baggage requires more fuel and more employees and, the customer doesn’t have to pay for those who want to bring bags. It makes a lot of sense for us, since people are looking to us to tell them how to save money.

“What is interesting,” he continued, “is we are finding things that would never produce revenues are producing revenues like seat assignments. We always gave that away until someone checked in. But two years ago we offered it at USD6. We didn’t promote it, but put it as part of the check-out path. Today that produces 25 to 30 million dollars in revenue a year and, again, it is a very high net margin business option. We are not forcing people to do it. They see value in it.”

Diversifying away from Atlanta

AirTran has also spent the last 18 months diversifying from 90% of flight going to and from Atlanta to only 50%, despite the fact the number of flights have doubled there to 200 daily. This diversification came at the cost of legacies. Haak stated, "the last few years have highlighted the market shift to low cost carriers, especially in leisure markets", adding, “Florida has grown tremendously and low fare airlines now serve half of the market when they were only a fraction in the past. Florida represents 40% of our flights.

As for expansion opportunities, he discussed AirTran’s growth at both Baltimore/Washington and Milwaukee. “At BWI, US Airways was the largest in the market with over 200 flights per day,” he said. “Then Southwest came in the early 90s and US Airways didn’t have the cost structure to compete so after 9/11 it closed the hub. For us, that meant there were 200 departures that came out of the Baltimore market. We new we didn’t need all 200 but we have 60 departures there daily today that were put in because we knew Southwest would not serve them or, with our cost structure, could be served complementary to Southwest. Today, Baltimore is our third largest city after Atlanta and Orlando and our cost structure allows us to compete side by side with Southwest and not many airlines can say that.”

Haak said changes in Florida have reduced its seasonality. “If you look at our capacity in Florida it does move seasonally and we do make seasonal adjustments,” he said. “Fort Myers and Southwest Florida are very seasonal but other places, like Orlando and Tampa or South Florida are really growing markets. Orlando has 1.8 million people living there. People are moving to Florida and it is poised, in the next few years to overtake New York as the third most populous state after California and Texas. Historically development was around the coasts, which is very limited now. Development is happening inland and that is why we think the I4 corridor is a great place to be. We think there is a lot of opportunity as Florida matures and with that comes more business and everything else that makes these cities more year-round markets. In addition, Disney World and the convention and visitor bureau are getting more creative in making Orlando less seasonal.

No Midwest bid blues, fuel hedging

After the ill-fated attempt to acquire Midwest Airlines, AirTran’s cost advantage allowed it to expand into the market. “When we look back at the more than USD450 million in private equity investment in Midwest Airlines, we are very happy we didn’t get it. Instead, we chose to grow organically and today it is about 10% and will grow about 13 percent,” he said.

Haak also said that Caribbean was following Florida in a dramatic market shift to low cost carriers. “These are leisure markets and the legacies, with their higher cost structure, can’t compete,” he noted, adding that is why low cost carriers are focusing on these markets.

“In 2000 we had 31 cities and 40 routes,” said Haak of the changes. “Today we have 59 cities out of Atlanta, we have grown in the Midwest and West Coast and are now coast to coast out of Atlanta. At Orlando, we now have 43 different cities we serve and more destinations than any other carrier. At Baltimore, we now have 24 routes and, with 24 routes, we are the largest airline in Milwaukee, serving primarily east/west destinations as well as to our core network in Atlanta and Florida. We’ve gone from 31 to 69 cities and total routes have gone from 40 to 173 which has helped us drive down unit costs.”

He turned to carrier's fuel hedging strategy. With the hit from last year’s hedging experience, AirTran “unwound over 80% of our hedges and the restructuring the portfolio between 4Q2008 and 4Q2009 has saved the company over USD30 million this year”.

Haak added, “we are one of the few airlines that continue to actively hedge our fuel and we have just under 40% hedged for next year. Most of the benefit begin sat USD60 per barrel. If we buy call options or we buy wide collars we have paid for not costless collars as we’ve done in the past, there is a premium. And if you look at what we’ve done for about 40%  of our business next year will have a fuel price between USD60-80 per barrel. If oil is at USD50, 38 % of our fuel will be at USD62 and the remaining 62% will be bought at USD50. If oil goes to USD90 next year, 38 percent will be at USD82 and the other 62% will be at USD90 per barrel. So, if oil prices go down we benefit but if they go up we have no limits on upward protection. Our non-fuel costs rising only one to two percent year over year in the fourth quarter”.

US domestic capacity may finally grow again in 2010, but AirTran poised to gain

Haak pointed to the dismal profit performance of the legacies since 2000 during which time they lost a cumulative USD50-60 billion, making it even more difficult to serve leisure markets. “The year 2006 was a function of people coming out of bankruptcy and doing fair value accounting to restate balance sheets to produce gains, as opposed to any underlying core profitability,” he said.

The US market has the lowest domestic airline capacity in terms of seat miles in a decade; some two to three percentage points below 2003, which was the previous low. In 2009, the legacies dropped between five and eight percent while low cost carriers have only reduced by two to three percent. Haak noted the closure of facilities as part of the legacy retraction including US Airways at Las Vegas, American and St Louis and Delta and Cincinnati.

“Next year, I think we will see a slight reduction to a one to two percent gain,” he said. “But that will still give us one of the best capacity backdrops the industry has had in years. And you’ve seen that capacity shift from legacies carrying 82% to 56%. The low cost carriers and the regionals, because of their lower costs have benefited from this shift in capacity.”

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