Republic reports double-digit 2Q loss with 631% swing

Guidance

With the fixed-fee business experiencing a 7% pre-tax margin in the first half, the company expects that to soften in the second half on lower maintenance costs for a resulting pre-tax margin in the 7.5-8% range.

Frontier's margins - assuming USD3.30 per gallon ex items - will be in the 3-4% range in the third quarter, slipping to negative 1-2% for the fourth quarter. The restructuring is expected to lower unit costs to the USD 6.9-7 cent range in the third quarter and the flat-7-cent range for the fourth quarter. That would put it lower than the 7.91 cents posted by Southwest in the first quarter.

Fuel CASM is expected to be USD4.85 cents in the third quarter and USD4.75 in the fourth quarter on different seating density in which it will have completed the replacement of E-170s with E-190s and the addition of two seats to its A319s for a total of 138 seats. Pre-restructuring CASM ex fuel was in the 7.3 range ex items.

For 2012, again assuming the competed restructuring, the USD3.30 fuel and no change in the revenue or capacity environments, Frontier is expected to produce operating margins in the 2-3% range on just under USD2 billion in revenues. It is expecting unit revenue in the 11.08-11.09 range for 2012. Fixed fee will be in the 7-8% pre-tax range on USD1 billion in revenue.

Third quarter passenger revenue per available seat mile (PRASM) is expected to be between 12 and 12.02 cents, up 8-10% year on year on flat capacity. It would have been a tenth of a cent lower had it not been for the USD10 million cost of the hail storm damage to 22 aircraft at Denver.

Fourth quarter PRASM will rise in the 11.5 to 11.7 range, up 7-9% over 4Q-2010 on a 1-3% increase in capacity. The company reported strong July traffic to best 91% load factor in 2Q-2010 for another monthly record. August is expected to be 2-3% compared with the 88% load factor posted last year. Similarly, September booked load factor is up 2-3 points from last year's 86%. It is expecting a 90% load factor for the quarter up two points from the 3Q-2010 quarter highest in company's history

Capacity in the third quarter is expected to be flat to down 1% and up 1-3% in the fourth quarter for a full-year capacity at flat to up 0.5%. Denver, 80% of Frontier production, will experience a capacity increase of 1-2% at Frontier in the third quarter and 2% in the fourth quarter. Frontier reported that same-store capacity will be down 1% in the third quarter and between 1-3% in the fourth quarter.

Milwaukee capacity is continuing its decline and is expected to be down 5.5-6.5% in the third quarter and 3-5% in the fourth quarter. Same-store capacity will be down 3-4% in the third quarter and 2-4% in the fourth quarter. It is benefiting from the end of SkyWest AirTran service which is helping to better match capacity in demand.

Kansas City, representing 7% of production, has seen competitive capacity increase with new Delta Connection frequencies in June. However, it is competing against the cost advantage represented by Frontiers Airbus aircraft versus the higher-cost, 50-seat regional jets. Frontier's same store capacity will increase 15-20% in the third quarter and 18-22% in the fourth quarter.

On the call

Interestingly, when asked if he would be interested in acquiring American Eagle, Mr Bedford said American knows what it will take to make that happen meaning the two companies have visited the subject. Mr Bedford noted American has been a long-standing partner making it a logical choice for a spin-off of the troubled regional operation. However, he made it clear that Republic is not "deep in the weeds on merger discussions".

"We've had conversations on what it might take to make the answer yes," he told analysts at yesterday's earnings call. "They have now made a decision that it will separate Eagle to shareholders but have kept the option open for acquisition. They understand how we think and what we could do to help. The Eagle management team has done a great job in building long-term shareholder value and we'd like to be a part of that. Regardless of how it is divested that might be an opportunity for us in the future."

Consolidation, although happening at regionals with the spin off of Mesaba and Compass to Pinnacle and Trans-States, respectively, and ExpressJet to SkyWest, becomes problematic since change of control clauses in capacity-purchase contracts means those contracts are subject to cancellation and, especially with Delta, it doesn't take much to trigger those clauses.

Analysts clearly showed concern about Frontier's impact on the company querying executives during the call on what would happen if fuel took a catastrophic rise. CEO Bryan Bedford would only say the end goal now is to return Frontier to sustained profitability in a high-fuel environment which would ultimately provide far more options than the company currently has with respect to Frontier. He also pointed to the capacity discipline in the industry, saying he expects that to continue.

He concluded by saying that Frontier is operated as a separate entity and should not affect the core fixed-fee business.

While fixed fee is stable, Frontier is the wild card

Despite its projections for profitability in the second half, the company is in a pitched fare war at its Denver hub where Southwest has been aggressive in pricing and where the world's largest carrier - United Continental Holdings - has one of its major hubs. Frontier's growth there was on the back of Continental's departure from the airport in the 1990s which was also before Southwest grew to become the number two carrier in the market. Denver has never been able to sustain three carriers and it remains to be seen whether its rapid growth in the last decade will change that scenario.

Frontier has long since lost any pricing power in a market where it has to compete on price, which means it has few avenues to bolster its balance sheet. Frontier's strategy is to play the middle ground between legacy United and low-cost Southwest keeping its Denver fans loyal to its low-fare/good-service model.

Denver International Airport capacity (ASKs per week, to/from) by carrier
(01-Aug-2011 to 07-Aug-2011)

Source: Centre for Asia Pacific Aviation and Innovata

Denver International Airport capacity (seats per week, to/from) by carrier
(01-Aug-2011 to 07-Aug-2011)

Source: Centre for Asia Pacific Aviation and Innovata

Its market share in Denver has dropped from 24% in Oct-2009 to 19% in March, despite the fact that is reputation has been described as almost like a religion. United is about 27% including feed from regional partners, dropping from 31% while Southwest has grown from 23% to 15%.

Its ability to achieve its goals rests on the price of oil and the strength of its loyalty base at Denver. Milwaukee is also losing money in the face of competition from Southwest/AirTran as Frontier seems to be putting more emphasis on Kansas City at the cost to Milwaukee, not a bad move considering its competitive advantages in what is really a regional jet market. Frontier acknowledged competition at MKE is unlikely to go away and while traffic from Northern Illinois is increasing, the fare must be discounted by about USD60 to attract that traffic. The key then is return traffic.

Milwaukee General Mitchell Airport capacity (ASKs per week, to/from) by carrier
(01-Aug-2011 to 07-Aug-2011)

Source: Centre for Asia Pacific Aviation and Innovata

But key is also creating code-sharing partnerships, the development of which has taken a back seat to survival. Such partnerships will give it traction, and an advantage over Southwest, if it can piggy-back on alliance or legacy frequent flyer programmes. CEO Bryan Bedford has been clear that success relies on codesharing either through becoming a member of one of the alliances or following JetBlue's strategy in codesharing with many partners. But first, it must complete the restructuring to make that more likely.

Low-cost carriers have not been a big part of the global alliances, especially in the United States although that may be changing with American and Delta seeking access to Canada via WestJet via codesharing relationships. But that is likely a one off to access the interior Canada market where the two are weak. The question is whether they will be equally welcoming to the feed from a carrier on the domestic front. The way things are changing, the increasing focus on costs containment and the rising costs of regional lift, could change the equation. It is more likely that Frontier will target the international services coming into Denver from overseas carriers.

Denver International Airport international capacity (seats) by region (01-Aug-2011 to 07-Aug-2011)

Source: Centre for Asia Pacific Aviation and Innovata

Denver International Airport top 10 international routes (seats, 01-Aug-2011 to 07-Aug-2011)

Source: Centre for Asia Pacific Aviation and Innovata

Denver International Airport capacity (seats) share by alliance (01-Aug-2011 to 07-Aug-2011)

Source: Centre for Asia Pacific Aviation and Innovata

CEO Bryan Bedford addressed worried Frontier employees pummeled this year by falling market share and the recent hail storm. In a note to employees, Mr Bedford expects Frontier to be profitable in the second half thanks to savings extracted from employees and suppliers including Airbus and CFM. But profitability also depends on oil at USD100 per barrel and USD30 crack spreads.

After saying it wants to become a minority owner by 2014, the company is clearly positioning Frontier for sale with its USD120 million cost-cutting programme coupled with its intent to raise liquidity by USD70 million which was part of the deal when pilots signed a concessionary contract that will eventually give them an ownership position. It must raise it before the end of the second quarter, according to the contract, but fully expects to be able to achieve that goal. It is expected the increased liquidity will be raised in debt markets.

It's costs are lower than United but Southwest does not report until Thursday. Southwest CASM ex fuel and special items in the first quarter was 7.91 cents. Frontier had a significant cost advantage when it first acquired Midwest and Frontier.

Major US carriers' comparative financial results

2Q 2011 vs 2101	ALK	AMR	DAL	HA	JBLU	LUV	UAL	LCC	ALGT	Frontier
Profit USD	28.8 down 50.9%	(286M) vs (11M)	198M down 58%	(50M) vs (49M)	25M vs 31M	n/a	538M down 11.9%	92M vs 279M	11.9M down 32%	pre-tax loss of 39.2M vs 14.2M
Op Revenue USD	1.1B up 13.7%	6.114B up 7.8%	9.1B up 5%	395M vs 315M	1.1B up 22.4%		9.8B up 10.3%	3.5B up 10.5%	200.4M up 19.1%	461.8m up 11.2%
Op Expenditure USD	1B up 21.5%	6.192B up 13%	8.6B up 19%	465.1M vs 291.8M	1B up 26%		9.1B up 12.1%	3.3B up 18.8%	179.3M up 28.1%	NA
ASMs	7.4B up 7.2%	39.2B up 2.1%	60.1B up 2.5%	2.9B up 21.2%	9.4B up 8.7%		56.4B up 1.1%	19.1B up 3.3%	1.5B down 1.5%	3.8b down 0.2%
LF	84.3 up 2.4 pts	83.6% down 0.3 pts	83.7 down 1.3 pts	83.9% down 1.7 pts	81.5% down 0.5 pts		84% down 0.9 pts	83.8% up 0.9 pts	88.9 up 0.3 pts	87.4% up 1.5 pts
Yield cents	14.39 up 3.9%	13.90 up 4.6%	15.67 up 11.5%	14.12 up 7.2%	13.60 up 13.9%		14.46 up 10.3%	16.30 up 6.5%	10.8 up 27.3%	NA
PRASM cents	13.58 up 6.8%	11.62 up 4.9%	13.12 up 9.9%	11.85 up 5.1%	11.08 up 13.2%		12.15 up 9.1%	13.66 up 7.6%	12.71 up 20.9%	11.47 up 10.4%
CASM cents	NA	14.52 up 9..8%	14.42 up 15.7%	15.59 up 31.6%	11.28 up 16%		12.97 up 10.7%	14.59 up 15%	11.40 up 30.1%	TCASM 12.69 up 17.6%
CASM ex fuel/ cents	8.46 down 3.1%	9.36 up 1.4%	8.46 up 4.8%	11.05 up 27.6%	6.62 up 1.7%		8.17 up 3%	9.14 up 0.9%	5.92 up 21.6%	7.56 up 4.6%
Ancillary/Other revenues USD	66.9 up 7.4%	659M up 5.5%	998M up 50%	41.6M vs 38.1M	105M up 17%		780M up 0.9%	345M up 3.9%	54.2M up 7.2%	21.6M up 13.1%

Source: Centre for Aviation and company reports
Consolidated operations except AMR, Alaska Airlines
ALGT yield for scheduled service only, PRASM # is actually RASM, CASA #s are total system

Its balance sheet is the deciding factor in staying power. The company finished the quarter with cash balance dropping USD3.5 million compared to the December 2010 quarter, on rising fuel. Between its acquisition of Frontier in June-2009 and today, the price of fuel has jumped more than USD35. Restricted cash increase USD96.4 million to USD235.5 million on Frontier seasonality. The company's unrestricted cash balance declined USD99.9 million to USD191.3 million from December.

Debt also declined to USD2.44 billion compared to USD2.58 million in December with about 84% of debt now fixed rate.

Restructuring nearing completion

After only 90 days since it announced Frontier's USD120 million restructuring programme, the company said it is now 75% complete. Executives expect the balance to be completed in the third quarter. It is currently negotiating with six to eight stakeholders who have yet to come on board the restructuring but expects that to be completed in the third quarter. Frontier also expects to realized USD10 million in restructuring benefits in the third quarter and an addition USD15 million-20 million in the fourth quarter before realising the full annual benefits in 2012.

That program includes USD25 million in network and fleet adjustments which will see the full benefit in the fourth quarter. It has also achieved the USD25 million in labour savings which will see the full benefit in the third quarter. Its USD25 million aircraft lease restructuring is now 80% complete while USD15 million fuel conservation programme is just 10% complete. Eighty percent of its USD10 million in maintenance reductions is complete along with 35% of its USD10 million other reductions programme.

Airbus order positions it for long-term viability

Mr Bedford also discussed its Airbus order for 80 split between the A319neo and the A320neo. He did not mention its 40-aircraft, 138-seat Bombardier CS-300 order which are scheduled for delivery as current A319 leases expire in 2015. The A319neo is due to begin deliveries the following year. It is in the process of increasing capacity without increasing shells by adding two seats to its current A319 fleet making them 138 seats as well.

He wouldn't detail the specifics of its deals with CFM and Airbus but noted both provided significant assistance in restructuring efforts. He pointed out the deal also satisfies provisions in its amended pilot contract. The company negotiated near-term benefits to reduce overhaul expenses on its existing CFM engines and reduced leases on 22 of its A319s. GE and Airbus also provided tangible assistance in Frontier's fuel-conservation efforts.

"While the economics of the neo and the early delivery positions were appealing in and of themselves, coupled with the near-term benefits, the decision by the board was pretty straightforward," Mr Bedford told analysts. "In addition the Airbus agreement helps build a viable airline for the future."

Republic cited the incentives offered by CFM in its order. In addition to a fuel-burn guarantee and a reduction in its overhaul costs, CFM gave future spare-engine pricing incentives.

In addition to the help from CFM, it should be noted that Frontier's current Airbus fleet is leased from GECAS, a sister subsidiary to the GE-partnered CFM programme. The deal calls for four A319s to be returned next year with the balance of the current fleet - 18 aircraft - extended another three years at a reduced lease rate. Airbus also loaned Frontier USD25 million in Oct-2009 to be paid back in 12 quarterly payments.

Republic has been active in ensuring its survival as regional prospects diminished and its theory behind the Frontier acquisition was to diversify beyond the restricted growth opportunities represented by being satellite, capacity-purchase operations. Its acquisition of Midwest and Frontier was an attempt to copy the rental car model in which the same company has both a premium and discount brand.

Midwest was set to be the premium product and Frontier the discount brand but the recession conspired to eliminate demand for premium products. Its customer research revealed that the premium part of the Midwest brand was not working. The abandonment of Midwest's West Coast markets is viewed as a huge mistake despite the fact that the fuel-burn was killing it with the MD-80s. It had little choice in ever diminishing number of choices.

The company is threatened by the consolidation of its partners as they restructure their networks and de-hub certain cities. It is a good-news, bad-news situation for the company. While it makes partners stronger, it diminishes the need for regional lift, especially as rising fuel makes it more and more unsustainable. As with the rest of the regional industry, Republic is facing diminished growth opportunities, especially for smaller jets. To counter that, it has moved to the more desirable larger regional jets and is beefing up its Delta program with the E 170s from Frontier. It is taking the first of 60 E190s beginning in September most of which will be dedicated to Frontier.

Results

Consolidated revenues were up 8.3% to USD739.7 million on an increase in Frontier's unit revenues while operating income dropped 72% to USD12.2 million. Its operating margin also dropped - 4.8 points - to 1.6%. It narrowed its ex-item loss in the quarter to USD8.9 million down from USD13.7 million year on year as it sold or returned aircraft to lessors.

Frontier revenues were up 10.4% to USD461.8 million on a 0.2% drop in available seat miles to 3.8 billion. Total RASM for the subsidiary also experienced a double-digit gain of 10.6% to 11.90 cents while PRASM rose 10.4% to 11.47 cents. TRASM results benefited from a 1.8% increase in stage length and a 4% increase in seats per departure from 100 to 104 seats.

Capacity was down two-tenths of 1% also in line with guidance which was flat to down 0.5%. Load factor was up 1.5 points to 87.4%. Yields were up 6.6% which contributed to an 8.3% increase in unit revenue per ticket.

It continues to build its ancillary revenues with a few new products including the ability to make name changes on reservations. It also enhanced it web site, offering a bag check discount for those choosing that option on the web site. It is also offering enhanced leg room which has seen a 30% increase in bookings for an annualised run rate of more than USD15 million

However, increased revenues was not enough to overcome a 17.6% increase in total cost per available seat mile at 12.69 cents. Operating costs per available seat mile ex fuel rose 4.6% to 7.56 with a average cost per gallon of USD3.48, much higher than its legacy peers, and 44% more than the USD2.41 paid in 2Q2010. That was higher than the 7.2-7.4 cents in its guidance and related to higher maintenance costs and lower utilisation.

While Frontier is much of the story behind Republic's woes, its capacity purchase experienced only a 1.7% rise in revenues to USD245.2 million in the second quarter including fuel reimbursement from clients. Income before taxes was USD17.6 million for the second quarter on an ex-item basis, down from the USD20.8 million earned in 2Q2010. It had a 0.6% increase in ASMs to 2.8 billion and a 23% increase in block hours. Load factor dropped 4.5 points to 74%.

Mr Bedford noted that part of the problem is the low inflation rate has restrained any unit revenue increases on the fixed-fee side. Cost cutting is also happening on that side to ensure the capacity purchase companies are competitively priced.

Total cost per available seat mile rose 5.9% to 9.03 cents in its fixed-fee operation with an increase in the change out of life limited parts. CASM ex fuel and interest rose 2.5% to 8.06 cents. Unit costs ex fuel but including interest rose 2.5% to 8.06 cents compared with 7.86 cents in 2010, on higher maintenance costs.

It reported a 6.5% pre-tax margin on the fixed-fee operation compared to an 8% pre-tax margin in 2Q-2010 on higher maintenance costs for its 50-seat aircraft which added USD2.7 million to its expenses during the quarter.