30-Apr-2014 10:50 PM

JetBlue Airways’ hybrid model remains enigmatic as cost creep outpaces revenue production

Analysis

JetBlue finds itself at a crossroads during 2014 as it rolls out its highly touted Ka-band supported Wi-Fi connectivity, debuts a new business class product dubbed Mint and resolves itself to the fact that its pilots have voted in favour of unionisation - which, judging by the pilots' celebrations, almost certainly points to higher crew costs, without necessarily the corresponding productivity gains.

The new product developments underpin JetBlue's strategy of creating a carrier that targets the mid-market passenger segment looking for medium-frills at a reasonable price. In some ways it is a model that is previously unknown, and JetBlue faces obstacles in executing its strategy effectively.

In the short term the carrier continues to battle cost creep and some revenue pressure in 2Q2014 from fallout over the winter storms that wreaked havoc in much of the US in 1Q2014. In some ways JetBlue is in the unenviable position of having to outline its long-term vision to investors and sceptics who are only seeking short-term rewards.

JetBlue cannot seem to get ahead of its cost headwinds

JetBlue's anticipated unit cost spike (excluding fuel and profit sharing) of 3.5% to 5.5% in 2014 is mainly attributable to an increase in salaries and benefits stemming from a new pilot agreement increasing pay by 20%. The cost to the carrier is about USD165 million during the next three years.

In addition to the new pilot agreement, which will be in place until negotiations with the Air Line Pilots Association (ALPA) conclude, JetBlue estimates that 1.5ppt of the projected cost increase is driven by lingering effects from the winter storm and by the cancellation of longer-haul flights to accommodate new operations from Washington National. JetBlue secured 12 slot pairs at National that the US Department of Justice (DoJ) required American and US Airways to divest in order to move forward with their merger. The carriers agreed to sell 52 total slot pairs at the airport.

To support new service from National to Charleston, SC, Nassau and Hartford, JetBlue is cutting service from San Francisco to Austin, Washington Dulles to Oakland and Long Beach, West Palm Beach to San Juan and Buffalo to Fort Myers.

JetBlue's unit costs excluding fuel and profit sharing during 1Q2014 increased 6.3% to USD8.10 cents. The carrier concluded the main drivers for its cost escalation were capacity reductions and larger non-fuel expenses triggered by the winter weather. The airline's management highlights that roughly 80% of its flights are centred in the US northeast, making it disproportionally affected by weather in the region.

For the last couple of years, JetBlue has battled ample cost creep, previously from sharp rises in its maintenance costs. For CY2012 its unit costs grew 3.2% to USD6.98 cents and increased 3.8% in CY2013 to USD7.25 cents.

See related reports:

JetBlue declines to make predictions of a more normalised cost structure

Queried if JetBlue's unit cost increases would fall below inflation rates beyond 2014, the carrier's management declined to make that promise, but noted that completion of the sale of its LiveTV subsidiary to Thales for roughly USD400 million should be CASM positive alongside higher-density A321s joining the carrier's fleet.

JetBlue's fleet projections show that JetBlue will operate 13 A321s by YE2014, but some of those jets are 159-seat aircraft dedicated to trans-Continental operations. Those jets are configured with the new Mint product that includes lie flat seats and private suites. The remaining A321s feature a 190-seat configuration compared with the 150-seats featured on JetBlue's A320 fleet.

Without making any definitive pledges about future cost projections, JetBlue's management simply concluded: "Over the longer term, we expect A321 aircraft and the Sharklet retrofit of our A320 fleet will help reshape our cost dynamic."

Cost control is one element cited by JetBlue in achieving its 7% return on invested capital (ROIC) target in 2014 as CEO Dave Barger stated: "Maintaining the relative cost advantage to our network carrier competitors is critical to our ability to offer an industry-leading product and a reasonable fare."

The problem is while so-called full-service carriers have generally higher costs, they have more comprehensive networks that produce larger revenue. JetBlue does not have that advantage so its creeping costs are more of an issue if revenue cannot keep pace.

During 1Q2014 its passenger unit revenues increased just 0.9% as yield grew 1.7%. Major carriers American, Delta and Southwest grew passenger unit revenues 2.9%, 3.2% and 3.5%, respectively, in 1Q2014.

Alaska Air Group generated the same passenger unit revenue growth as its fellow hybrid JetBlue, but Alaska's passenger unit revenues of USD12.45 cents were higher than JetBlue's USD11.80 cents. With its greater exposure to the east coast, JetBlue's passenger unit revenues were also affected by the storms.

JetBlue unit revenue and unit cost performance: 1Q2014 vs 1Q2013

Woes from winter storms are evident in JetBlue's 1Q2014 results

The effects of battling the winter storms were evident in JetBlue's 1Q2014 results as its net income fell from USD14 million to USD4 million year-on-year.

The carrier's operating income fell from USD59 million to USD41 million during the quarter. JetBlue estimates the winter storms reduced 1Q2014 operating revenue by USD35 million.

JetBlue financial results: 1Q2014 vs 1Q2013

JetBlue's top-line revenues grew nearly 4% year-on-year in 1Q2014 to USD1.3 billion, but expenses jumped 5% to USD1.3 billion, which also helped its operating income to fall. The carrier's expenses from salaries and wages jumped nearly 18% as the expense from the new pilot contract flowed through its quarterly results.

JetBlue maintains its third model philosophy amid mixed fortunes

Given JetBlue's mixed financial results in 1Q2014 it is not surprising the carrier is fielding questions about the viability of its business model, and hearing suggestions that perhaps it should more closely examine tactics from the more clear-cut traditional legacy and ultra low-cost carrier models.

Mr Barger reiterated JetBlue's conclusions that there is an underserved passenger segment seeking the medium-frills the carrier offers at lower fares. He remarked JetBlue has studied the playbooks of the more traditional models, but "I think the headline again, it's our path...we firmly believe there are three models in the airline industry".

See related report: JetBlue continues to see benefits and growth opportunities from its hybrid business model

JetBlue remains in a cost limbo, creating uncertainty around its model

JetBlue remains bullish on its model, and in many ways the evolving hybrid strategy remains mysterious in North America. The very term hybrid leaves ample room for interpretation, which can result in some scepticism among investors and industry observers alike.

Among the challenges JetBlue faces is an inability to communicate a definitive timeframe for either a decrease in its unit costs or some decline in annual unit cost increases.

For the moment it seems the cost creep is not leading to revenue premiums, which is not a viable scenario for the long term. Its results in 1Q2014 were definitely skewed by winter weather; but at some point JetBlue needs to issue reassurances that its particular hybrid strategy has staying power in the form of lower costs and higher revenues.

Hopefully the newly unionised pilots will see it that way too.