US major airlines recognise the ULCC threat. Marketplace dynamics will change. But beware cost creep

Spirit and American have been competing for a number of years in Florida and Dallas

Although the competitive dynamics between American and ULCCs, particularly Spirit, have garnered heightened attention in 2015, the reality is American and Spirit have competed for a number of years. As Spirit began migrating to the ULCC business model in 2006, it targeted Fort Lauderdale, which is 48km from Miami, a large hub for American and its main Latin American gateway. Spirit's logic was it could enter a market dominated by one airline with lower fares and stimulate traffic. Its build up in Fort Lauderdale occurred prior to American's 2011 Chapter 11 bankruptcy filing and the subsequent merger with US Airways.

Spirit's strategy worked well as it targeted cost conscious leisure and visiting, friends and relatives (VFR) passengers travelling from South Florida to the US and Latin America. Since its IPO in 2011, its annual profit growth has been above 25% and pre tax margins reached 19% in 2014, 17% in 2013, and 12% in 2012.

Spirit Airlines annual net profit and year-on-year growth: 2011 to 2014

Source: CAPA - Centre for Aviation and airline reports

During 2012 as American was entrenched in its bankruptcy reorganisation, Spirit began a significant US domestic push, and re-entered the Dallas market in a large fashion.

It is now Dallas/Fort Worth's second largest airline measured by seats, although American still holds a commanding seat share at DFW of 85%.

Dallas/Fort Worth International Airport capacity by airline (% of seats): 2-Nov-2015 to 8-Nov-2015

Source: CAPA - Centre for Aviation and OAG

Pricing pressure in Dallas drives American's unit revenue decreases deeper than its peers

The Dallas market has drawn significant attention in 2015 after Southwest Airlines began a massive expansion from Dallas Love Field, beginning in late 2014 with the expiration of the Wright Amendment. That regulation prohibited certain long haul flights from the airport, and with its dissolution Southwest has proceeded to add more than 30 markets from Dallas Love Field including key routes to New York, Washington, DC, San Francisco and Chicago Midway.

Added capacity by Southwest and lower fares have created pricing pressure in Dallas, which has been highlighted by American, Spirit and Virgin America throughout 2015. Virgin America launched service from Dallas Love Field in late 2014.

The loss of price traction has been particularly acute for American. Declines in passenger unit revenues have been wider than large network rivals Delta and United in 2015. During 3Q2015 American's 6.8% drop in passenger unit revenues was deeper than the 5.8% recorded at United and Delta's 4.9% decline. American's 7.6% decrease in domestic passenger unit revenue was much deeper than United's 1.6% drop and Delta's decline of 3%. American's steeper decrease was due in large part to the pricing environment in Dallas. Throughout 2015 American has stressed it is matching the fares of its low cost competitors.

See related report: The Big 3 US airlines continue capacity expansion in 2016. Domestic pricing pressure remains a worry

Among the three large US global network airlines, American has the largest network overlap with Spirit. At the end of 3Q2014, Spirit estimated it had 50% overlap with American, due in part to Spirit's expansion from Dallas/Fort Worth.

American decides that it cannot walk away from the ULCC threat and opts to match prices

American's decision to match the discounted fares in markets where it competes with lower cost airlines and ULCCs has generated questions from investors about how the price matching will affect the major airline's revenue generation. American's pledge of price matching is occurring against the backdrop of much lower fuel prices, which is also driving down domestic pricing, particularly on marginal flying that becomes more viable for American, Delta and United in a lower fuel cost environment.

Recently American president Scott Kirby outlined the logic for price matching and assured the airline's performance on routes where it engages in that behaviour is positive.

Roughly 87% of American's customers during the last year were travelling on the airline for the first time, said Mr Kirby. That passenger pool represents 50% of the airline's revenue. He also stated that roughly 85% of US domestic pricing is influenced directly or indirectly by low cost airline pricing. "It's not just the 2% or 3% of revenue in markets that they're in...it does affect a much bigger piece of the pie."

Spirit's share of US domestic seats is roughly 2.3% for the week of 2-Nov-2015 to 8-Nov-2015.

United States of America capacity by airline (% of seats): 2-Nov-2015 to 8-Nov-2015

Source: CAPA - Centre for Aviation and OAG

With roughly 50% of American's customers up for grabs, Mr Kirby declared: "We just can't walk away from the size of that business."

He stressed in the markets where American has matched pricing, its unit revenue performance is the same as the rest of its system. One tactic American has used is running higher load factors on off peak flights, which is a more favourable proposition in a low fuel cost environment.

Mr Kirby stated there are other ways to fine tune revenue managing its matching of low fare competitors, and stated American is devising a product to more effectively compete with those airlines. Delta undertook a similar exercise in late 2014 when it debuted it Basic Economy product that features a low base fare, with items such as seat selection, change fees and baggage charged as add on items.

American in some ways has not had the full capability to devise a competing ULCC product, but with the recent completion of its passenger reservation system cutover, it now has freed up resources to dedicate to its strategy of competing with low cost competitors.

Spirit believes pricing pressure is widespread in the US market, downplays Dallas

In Dallas, Spirit is American's number two competitor, larger than either Delta or United. Spirit transports all local passengers, said American's Mr Kirby. "So one Spirit flight is the equivalent of about three American Airlines flights, because we carry so many connecting flights. So if they fly a market twice a day, that's the equivalent of American Airlines flying six times a day in terms of the amount of passengers they carry."

During 2015 Spirit too has been challenged by the lower pricing traction in the US domestic environment. Its unit revenue degradation has been greatly deeper than the US network airlines, contracting 17.5% in 3Q2015 and 14.4% for the 9M ending Sep-2015.

More tellingly though, Spirit delivered pre-tax margins of 26.9% during 3Q2015. Yet its unit revenue declines appear to have spooked investors, which has resulted in pressure on its stock price. The airline's share price was USD70.9 at the end of Oct-2014 and USD37.13 at the end of Oct-2015.

Spirit Airlines share price late Oct-2014 vs late Oct-2015

Source: CAPA - Centre for Aviation and Bloomberg

Spirit maintains that it has not grown in Dallas since 2013, and "we are actually a smaller percentage of Dallas today in the city than we were a couple of years ago as a result of the two largest carriers in Dallas hav grown individually greater than Spirit's capacity in the last two years," Spirit CEO Ben Baldanza recently declared.

Data from CAPA and OAG for the end of Oct-2015 show that Spirit served roughly 20 markets from Dallas/ Fort Worth. Its seat count year-on-year was down in seven of those markets - Atlanta, Chicago O'Hare, San Diego, Fort Lauderdale, Oakland, Detroit and Kansas City.

It posted flat growth on service to Denver, New Orleans, Las Vegas and Baltimore-Washington. During the last year it has entered the DFW-Cleveland market and relaunched flights to Boston.

Changes in seat deployment from Spirit's markets from Dallas year-on-year as of late Oct-2015

Market	Seat change	By airline	Seat share as of late Oct-2015
Atlanta	19,870 down 9%	American down 5% Delta down 3% Spirit down 52%	American 42% Delta 53% Spirit 5%
Baltimore/Washington	5,146 down 12%	American down 16% Spirit flat	American 76% Spirit 24%
Chicago O'Hare	24,947 down 2%	American up 1% Spirit down 9% United down 9%	American 72% United 18% Spirit 10%
Cleveland	4,429 up 9%	Spirit entered in the last year American up 14% Frontier and United have exited	American 77% Spirit 23%
Phoenix	14,885 up 1%	American up 71% (assumed some of US Airways' seats) Spirit up 2%	American 92% Spirit 8%
Las Vegas	13,929 down 10%	American down 13% Spirit flat	American 76% Spirit 24%
Boston	11,348 up 11%	American down 2% JetBlue up 22% Spirit (market re-entry)	American 74% JetBlue 18% Spirit 9%
Orlando International	11,785 up 3%	American up 2% Spirit up 11%	American 84% Spirit 16%
Philadelphia	12.123 down 3%	American up 8% Spirit up 3%	American 90% Spirit 10%
New York LaGuardia	17,063 down 13%	American down 5% Delta down 3% Spirit up 22%	American 74% Delta 17% Spirit 9%
New Orleans	7,770 up 1%	American up 2% Spirit flat	American 87% Spirit 13%
San Diego	11,542 up 10%	American up 12% Spirit down 6%	American 91% Spirit 9%
Kansas City	7,625 down 5%	American flat Spirit down 43%	American 92% Spirit 8%
Fort Lauderdale	8,847 down 1%	American flat Spirit down 4%	American 69% Spirit 32%
Oakland	1,015 down 19%	Spirit down 19%	Spirit 100%
Los Angeles	25,831 up 19%	American up 15% Spirit up 4% United down 28% Delta entered the market	American 81% Spirit 9% Delta 7% United 3%
Minneapolis	11.279 up 7%	American up 6% Delta up 11% Spirit up 19% Sun Country down 17%	American 51% Delta 32% Spirit 11% Sun Country 5%
Detroit	9,228 up 1%	American up 7% Delta down 7% Spirit down 7%	American 61% Delta 28% Spirit 11%
Tampa	7,956up 2%	American up 2% Spirit up 3%	American 84% Spirit 16%
Denver	17,699 up 1%	American up 4% Frontier down 11% Spirit flat United up 5%	American 56% United 21% Frontier 18% United 21%

Source: CAPA - Centre for Aviation and OAG
*Note: seats are approximate for one way

Spirit in 2Q2015 estimated that approximately 25% of its 14.8% unit revenue decline was attributable to pricing pressure in Dallas, and 35% from pricing pressure in other markets outside of Dallas.

See related report: Spirit Airlines foresees continued unit revenue pressure, but still delivers strong topline results

The airline estimated that 60% of its unit revenue decline in 3Q2015 was from price compression in a number of markets.

It opted not to break out the percentage attributable to Dallas, and concluded there are just more seats in the US domestic market. "Larger carriers have grown as well as our own growth. You need a lower price to fill those seats and that's what's happening around the US as bigger carriers are growing in this environment as well as smaller carriers."

Assessing the best business model for both high and low fuel cost environments

Low fuel prices in general have created an interesting paradox for US airlines. The majority of those airlines are posting record profits while passenger unit revenues continue to sink. It obviously makes some sense to offer lower fares on marginal flying in a low fuel cost environment, but price reductions prepare the foundation for difficulties when fuel costs rise.

Although it doesn't look as if energy costs will rise rapidly in the immediate future, consideration needs to be given to the inevitable increase, and which airline business model is best positioned to thrive when fuel expenses grow. After all, nobody forecast the slump, instead focussing on the array of commercial and political factors which should have kept prices above USD100 a barrel.

American maintains that if fuel prices rise, its ability to compete is improved since fuel as a percentage of costs is much larger for low cost airlines, according to Mr Kirby. Spirit meanwhile would argue that its unit costs excluding fuel of less than USD6 cents allow it to compete effectively when fuel costs rise.

Both airlines have been profitable during periods of higher fuel costs; but a real likelihood is that in future the difference will be that American has no intention of ignoring the passenger base that Spirit targets, and based on its actions during the last year to offer a fare level similar to Spirit, neither is Delta.

Legacies are working to compete with ULCCs effectively. How will the discounters respond?

An interesting by-product from the pricing pressure in the US domestic market in 2015 is the premise of the ultra low cost business model that ULCCs tout to investors - that they are largely ignored by the big network airlines since those companies have no interest in the low yielding passengers targeted by Spirit and Frontier - has essentially been disrupted by the large network airlines.

American and Delta have been the most active in countering that theory, and neither airline shows any signs of abandoning or ignoring the passenger base that Spirit and Frontier target. Those large airlines have acknowledged the threat posed by ultra low cost airlines, and are now devising strategies to compete with the ultra discounters for the long term.

As the major airlines refine and deploy their strategies to counteract the ULCC threat, the position of the ultra low cost airlines in the US could shift depending on the tactics Spirit and Frontier deploy to combat the increasing attention they are receiving from American, Delta and United.

This is likely to be a continuing dance. After all, in a broadly similar market profile in Europe, it is the LCCs that have prospered, to the detriment of the majors. A difference there is that the majors have not been able to wash out their costs through the bankruptcy laundry, so the unit costs of the big three Europeans are higher than the US big three's.

So the warning message is there for the US majors: it is fine now to allocate a percentage of seats to low yielding passengers, but once cost levels start creeping up again, vulnerability to ULCCs increases exponentially.