26-Jun-2013 11:00 PM

North American hybrid airlines offer a range of possibilities as consolidation takes hold: Part 2

Analysis

This is the second report in a two part series examining the ultra low-cost carrier and hybrid business models in the US market place. The first part focused on ULCCs, including Spirit Airlines and Allegiant Air.

Similar to their ULCC peers, North American hybrid airlines stand at an interesting crossroads as consolidation creates opportunities for possible traffic, notably product differentiation. Carriers such as Alaska Airlines and JetBlue Airways that target higher-end leisure customers and more cost conscious business travellers will need to evaluate their products, and decide how to evolve as their competitive overlap with the three remaining legacy carriers (once American Airlines and US Airways complete their merger). The impact on them will be more pronounced than on ultra low-cost leaders Allegiant and Spirit.

JetBlue has already shown some signs of its potential evolution through its decision to create a premium section on daylight transcontinental flights in 2014 in order to cement its hybrid status and offer medium frills as its legacy transcontinental competitors all prepare to offer lie-flat seats on those flights and Virgin America already offers a dedicated first class.

Summary

North American hybrid airlines, such as Alaska Airlines and JetBlue Airways, are at a crossroads as consolidation creates opportunities for traffic and product differentiation.
JetBlue is evolving its hybrid model by introducing a premium section on daylight transcontinental flights, while Alaska is increasing seating density on its aircraft.
JetBlue's ancillary strategy focuses on offering attractive upsells, such as extra legroom and expedited security, while avoiding charging for unpopular unbundled products like checked baggage.
Alaska Air Group has built a successful business in the Pacific Northwest, capitalizing on its hub in Seattle and partnerships with other carriers.
JetBlue and WestJet are facing cost pressures, with JetBlue experiencing rising maintenance costs and WestJet transitioning from a pure low-cost carrier to tap into the business passenger market.
JetBlue, Alaska, and WestJet have strong market presence in their respective geographies, while Virgin America faces challenges in competing with major network carriers.

The various product developments amongst the hybrid airlines show a range of flexibility within the business model as JetBlue pushes the boundaries of a premium offering while, for the moment, retaining its policy of a free first checked bag.

Alaska is joining Southwest in increasing seating density on its aircraft without declaring any intention in the near future to offer an extended legroom product, while WestJet is introducing premium economy as an anchor to the highest level of its three new fare bundles. Virgin America has always operated under a hybrid business model, but its weak geography could give it less leverage over the long run than its fellow hybridised colleagues.

JetBlue's ancillaries intelligently leverage the love, rather than punishing the poor

There are two main ways of extracting additional non-ticket revenue from passengers: one that makes them pay extra for necessities, the other that offers a better life for a little more money. One ancillary strategy leverages the love, the other raises the wrath of consumers (and gives fodder for opportunistic politicians).

Few passengers will step forward to admire the USD3.5 billion that the majors made last year from charging extra for bags; or the many hundreds of millions of dollars extracted for no-cost ticket changes. But most consumers will gladly relay their happy experience of getting a reasonably priced and voluntary add-on.

JetBlue adopts the philosophy of offering customers attractive upsells - extra legroom and expedited security under its "Even More" branding - while attempting to avoid charging for more unpopular unbundled products like checked baggage.

But similarly to Southwest (who has previously built a vigorous marketing campaign around its stature as one of the few carriers not to charge for checked luggage), JetBlue often fields analyst questions about potentially leaving revenue on the table through its decision not to charge passengers a fee for their first checked bag. Recently Alaska Air Group estimated it records approximately USD125 million per year from its first checked bag fee.

Admitting he hears some, "very high numbers of what people think that [checked bags] could be worth", JetBlue chief commercial officer Robin Hayes recently remarked that while the revenue may be "pretty big", customer awareness that JetBlue does not charge for checked luggage is high. As customers price it into the fare, JetBlue's net promoter score could slip, which influences passenger willingness to repurchase.

The added operational costs of delaying an aircraft to gate-check bags is also a deterrent, said Mr Hayes. Those two elements have led JetBlue to conclude for now administering a first checked bag fee is not worth the time.

The positive sentiment JetBlue enjoys by not charging for a first checked bag is pertinent to its targeted "mixed wallet" passenger base of high-end leisure customers and more cost conscious business travellers. The dual passenger sets allow the carrier to smooth out demand during seasonal troughs, and have also mandated a hybrid model. Its extra legroom and expedited security offering - which is perceived as a product customers value versus something they feel that's been robbed from them - has grown steadily since 2008 from USD45 million to USD165 million.

JetBlue's earned and projected revenue from its Even More offering: 2009 to 2013

JetBlue is now pushing the hybrid envelope further into Virgin America's territory with a premium offering on select daylight transcontinental markets. These will be a step below the lie-flat seats American, United and Delta are planning to offer on those routes; but JetBlue's premium product will presumably be priced below its legacy competitors, allowing it to maintain its stature and resonance amidst its core passenger bases and, equally importantly, improve revenue on its transcontinental routes.

Mr Hayes believes JetBlue can execute its premium product strategy both profitably and at a favourable price point for customers. But as JetBlue's premium offering debuts and full service network carriers begin introducing lie-flat seats in the transcontinental markets, there will be some initial revenue dilution, because promotional pricing will push back the recoup on those respective investments, pressuring costs.

JetBlue's decision to stick with its current policy of not charging for checked bags while fleshing out its product offering for higher-yielding business customers that are looking for an enhanced experience at a price point below a full-blown business class offering, show just how flexible the hybrid business model can be. Carriers operating in that space appear to have the ability to choose how much of a mixed product they would prefer to offer based on their targeted customer segments.

Alaska quietly builds up an attractive niche and profitability in the Pacific Northwest

While Alaska Air Group is often categorised amongst the hybrid carriers, it is one of the oldest US airlines, with origins dating back to 1932. Alaska has built up a successful business in the US Pacific Northwest, capitalising on its commanding position at its hub in Seattle and using that stature to generate an array of partnerships. Alaska has some network carrier attributes in that it funnels passengers through hubs in Portland, Oregon and Seattle, but also keeps a keen focus on costs while making targeted investments in technology to improve efficiency in the passenger journey.

Alaska was the first carrier to truly introduce the return on invested capital metric (ROIC) into financial discourse and has delivered increased profitability since 2009.

Alaska Air Group adjusted net income and operating cash flow: 2009 to 1Q2013

Its nuanced offering includes Wi-Fi (something JetBlue plans to introduce at some point during 2013), the aforementioned first bag fee and higher quality buy-on-board meals. It has also stated it plans to make changes to its in-flight entertainment offering that currently entails the rental of portable devices to its passengers.

Similarly to JetBlue and WestJet, Alaska capitalises on its resonance in the Pacific Northwest to build up an arsenal of partners that contribute to its revenue generation. While Alaska does not frequently discuss partnership revenues, WestJet recently disclosed that its partnership revenue soared 139% year-on-year during 1Q2013.

Alaska's mixed product stops short of priority boarding upsells or extended legroom. The carrier is actually moving in the opposite direction by adding six seats to its 157-seat Boeing 737-800s and nine to its 737-900ERs presently configured with 172 seats.

Alaska and JetBlue try to fend off cost pressure

Alaska's increase in seat density is a means to lower its overall unit costs in order to compete effectively with its lower-cost peers. While Alaska's unit costs are well below its legacy colleagues, the carrier has the highest unit costs among the lower-cost hybrid airlines - JetBlue and Virgin America - and higher than Southwest, who does not fit neatly into any business model.

US carrier 2012 stage length adjusted unit costs excluding fuel: 2012

JetBlue too is battling cost creep largely driven by rising maintenance costs that have been plaguing the carrier during the last year. It has encountered maintenance expense challenges in both its Airbus A320 and Embraer E-190 fleet, as engine maintenance on the Embraer jets drove USD20 million in additional expense during 1Q2013.

The result was a 6.6% rise in JetBlue's first quarter unit costs excluding fuel; but the carrier believes its maintenance costs should ease during 2H2013. JetBlue now estimates its unit costs excluding fuel for 2013 will increase 2% to 4% from the USD6.98 cents it recorded during 2012 versus a 1%-3% rise the carrier estimated in Mar-2013, which will diminish the unit cost advantage it has over the US major carriers.

The 1%-3% rise it previously estimated would have kept its unit cost advantage with those airlines flat.

JetBlue actual and estimated CASM: 2008 to 2013

JetBlue could face some additional short-term headwinds as the increased maintenance costs of the investment in its premium class could dilute revenue traction. But over the long-term its decision to offer a premium cabin at attractive pricing levels (which should still help it recoup the investment) should create a revenue boost.

WestJet caps off an aggressive move into the hybrid space

WestJet's stature as Canada's second largest carrier has created a different dynamic, which has led the carrier to accelerate its transition from a pure low-cost carrier as it saw an opportunity to tap into a business passenger market that essentially was offered only one choice - Air Canada.
In early 2012 WestJet estimated it had only penetrated approximately 10% of the managed corporate market share in Canada, which the carrier believes offers a prime opportunity to fashion a product that falls between pure low-cost and the fully fledged business offering from Air Canada.

The result is a premium economy offering of 36in pitch on four rows of its Boeing 737 narrowbodies spanning the 600/700/800 variant. WestJet's premium economy is the anchor of the highest tier of the new fare bundling scheme it is debuting - not only to refine its revenue management, but to also ensure it offers the right product to the customer range it is targeting: low-fare, mid-value and high-valued oriented passenger segments.

Those two large initiatives WestJet is undertaking in 2013 are almost a textbook example of hybrid evolution, pushing into the corporate space while ensuring core cost-conscious travellers remain content. Other initiatives providing further examples of hybrid evolution include a transborder push into Chicago and New York LaGuardia, its aggressive expansion during 2011 into Canada's business travel-oriented eastern triangle (Toronto-Montreal-Ottawa) and changes to its frequent flyer scheme to target business travellers.

Alaska, JetBlue and WestJet build on geographical strength that is a deficit at Virgin America

One distinctive characteristic that JetBlue, Alaska, and WestJet possess is a strong market presence in their respective geographies. JetBlue commands 38% of the domestic seat share at its largest base and headquarters New York JFK and a leading 26% system share at its focus city in Boston and a 40% system seat share in its Caribbean focus market San Juan. In its major Florida markets of Orlando it holds a 14% share (second behind Delta) and is essentially on a par with Spirit in Fort Lauderdale with a 21% share.

Alaska's position as the leading carrier in the Pacific Northwest - evidenced by its 51% share of total seats at Seattle Tacoma - has allowed the carrier to capitalise on that strength to forge partnerships with numerous foreign and domestic carriers that can gain access to Alaska's western network while feeding incremental traffic to Alaska that should help to lifts its revenues.

WestJet's status as Canada's second largest carrier that remains unaligned (Air Canada is an anchor member of Star) gives it significant leverage to partner with airlines that allow it to offer a broader international network while giving those carriers access to its Canadian domestic network. And, in a clear strategy designed to provide a more comprehensive corporate offering, its new regional arm Encore has officially made its debut with Bombardier Q400 turboprops.

The geographical leverage that JetBlue, Alaska and WestJet are able to exert is not an attribute that Virgin America can claim. The carrier offers a dedicated first class at a lower price point than its legacy peers and a distinctive guest experience that has garnered huge accolades but has not been able to achieve profitability.

Virgin America's main base and headquarters at San Francisco is dominated by United, and Los Angeles is arguably the most fragmented major metropolitan air travel market in the US. Virgin America seems to compete more directly for the same passenger base as the major network carriers that dominate most of its markets, putting it in a vulnerable position of possibly enduring long price battles with the majors as they aggressively defend their turf.

Of all the hybrid carriers, Virgin America faces the toughest climb to success as the industry awaits the carrier to post its first annual profit since inaugurating service in 2007.

North America embraces the power of three as new business model lines are drawn

As the lines are drawn for the distinctive business models emerging in North America - ultra low-cost, hybrid and full service carriers - the hope is that carriers falling within those three models have staying power to sustain the profitability the industry has recorded during the last couple of years.

While there is some overlapping competition amongst carriers operating in those three segments, most airlines falling into those segments are trying to distinguish themselves with respect to who they are and who they are not.

"If you want to pay a USD9 fare and you're willing to just kind of travel as you are with the clothes you're wearing, then they do it well," Mr Hayes concluded as he explained the distinction between JetBlue and the ultra low-cost carriers, making a reference to Spirit's USD9 fare club.

JetBlue's move into the premium space means it is pushing the limits of the hybrid model, which might not produce negative results, given that Alaska is not offering similar products and Virgin America can only be so disruptive due to its precarious finances.

For the short term a dynamic equilibrium appears to have been achieved in the US market, where two hybridising models - the former LCCs and the full service airlines - co-exist with the ultra-LCCs in a way that allows (almost) all to be profitable. Each of the former two continues to evolve; the third steadfastly remains true to its cost focus.

The US aviation jungle is now to be dominated by three very large airlines - the three biggest in the world. But it would be very dangerous to assume that their survival is guaranteed simply because of their size. While they currently enjoy profitability - a result of market concentration and their resulting power, as well as a timely shift to extracting previously unimaginable revenues from bags and booking changes - they retain considerable flaws, most notably much higher and potentially rising costs.

While they are able to hold onto higher average yields, mostly attributable to their size, their advantage remains. But, in the middle, the smaller hybrids, with often-better products, are increasingly targetting the lower hanging business and corporate fruits - while the ULCCs are able to feast on the leaner pickings that become more and more available.

The equilibrium may be dynamic - but stable it is not.