What to Expect in 2009 From Low-cost Carriers

Low-cost carriers arguably have more challenges ahead of them than their legacy counterparts. LCCs must determine how to position themselves relative to legacies, in terms of expanding (or contracting) their route networks, expanding their amenity offerings, and boosting ancillary revenues in a very tough environment. LCCs no longer have significant cost advantages, and they appear to have found a niche flying customers between large markets while offering additional amenities at no charge.

But in this environment, with depressed fares and a limit to how much ancillary revenues can bring in, low-cost carriers will be searching for enhanced revenue opportunities, which could mean changes in route structure, market composition, and ultimately, the product they are delivering to customers. Therefore, three trends that have already begun in 2008 will continue in 2009: slower growth, moves by carriers into higher-yielding markets, both domestically and abroad, as well as possible consolidation of the low-cost carrier industry.

Slower Growth
The economy sucks, and will continue to do badly in 2009. LCCs, which have historically needed to grow in order to gain market share (and perhaps as importantly, scale, which helps bring down costs) are unlikely to grow significantly in 2009, and may even shrink. This means that plane deliveries that have not already been deferred may be in the near future. AirTran, Frontier, and JetBlue have sold off aircraft, and other LCCs may follow in the coming months. There are simply too many planes in the sky, and if LCCs want to profit (or at least minimize their losses) they have to risk losing a bit of market share and vigorously cut capacity.

Higher-Yielding Markets
Although LCCs will always have an advantage in leisure markets, because of their strength to transport large numbers of price-sensitive customers cheaply, more and more carriers will add new routes from higher-yielding business markets, or to international destinations where they face less competition. Southwest, the first LCC that prided itself on point-to-point flights and the use of alternate airports is now making inroads in larger business markets like Denver, Washington Dulles, Philadelphia, and in 2009, Southwest will enter Minneapolis and New York LaGuardia. The company plans to shrink this year, and its growth in new business markets will come at the expense of routes to destinations such as Las Vegas, which is heavily reliant on leisure traffic.

Meanwhile, JetBlue has focused most of its expansion efforts on the Caribbean and Latin America. JetBlue plans to open new routes soon to San Jose, Costa Rica and Caracas, Venezuela, routes which will face less competition from other LCCs, enabling the company to charge higher prices for its services. Not only will carriers like JetBlue move into higher-yielding markets, such as those in Latin America, but LCCs will likely use 2009 as an opportunity to shore up positions in their strong markets, making fewer capacity cuts in markets where they have a lot of share while trimming capacity in weaker markets. This will allow carriers to improve their pricing power in key markets, helping to boost yields at a critical time, while cutting excess capacity from the system. For instance, Southwest will probably minimize the number of cuts it makes in markets like Phoenix, Chicago Midway, Baltimore, and Houston, because the carrier has the potential to leverage its market share in those cities to force other carriers out and improve its yields.

There have been a couple bright spots--carriers which I do not think will be subject to consolidation anytime soon, but which have managed to thrive in this market. Allegiant Air is one. The company made ancillaries a key part of its business model even before the fuel crisis this past year, and has been expanding and recording tremendous load factors. Unfortunately, the upcoming slowdown will likely dampen leisure travel, which is nearly all of Allegiant's business. But because the company owns planes (so it can ground them indefinitely without having to use them to help make a lease payment) and doesn't have legacy labor contracts with its staff, the company can more easily contract during poor economic climates and expand when times get better.

Also, Sun Country, another leisure-focused airline, appeared dustbin-bound a few months ago, but the carrier has managed to turn things around lately, and they seem to be headed in the right direction, focusing mostly on leisure destinations and less on year-round scheduled service. If they keep this up, and stick very closely to their business strengths, I am cautiously optimistic about Sun Country's future.

LCC Consolidation
Unfortunately, not all LCCs will survive 2009, particularly if the economy continues to bite. I still am concerned first and foremost with Frontier, which is making some strides towards leaving Chapter 11, but is still being hammered by Southwest. Frontier continues to lose money, and the company still has minimal cash balances. Unless Frontier can raise revenues quickly, through higher fares and more ancillary charges, it could go bust. Southwest continues to expand rapidly in Denver, and even though Frontier has a loyal contingent of travelers who are sticking by the company, those new Southwest flights aren't leaving empty. Moreover, Southwest has put immense downward pressure on fares in Denver, damaging Frontier's yields, and because Southwest has minimal ancillary charges, Frontier arguably has less room to maneuver in terms of adding ancillary charges and fees.

Midwest will continue to be downsized further, and I don't know how much of that carrier will really be left anytime soon. Northwest's ownership has helped to minimize turnaround prospects for the company. That, combined with slowing travel demand in Milwaukee and Kansas City, as well as competitive pressures from AirTran, signal that Midwest's days are numbered.

Although LCC mergers have been rare historically, because capacity is simply so bloated right now, I suspect some merger that cuts capacity needs to occur. One wild card is Virgin America. They have been quite mum about their traffic and financial figures, and even though the carrier is slowly expanding, I suspect that it is not doing nearly as well as its founders anticipated. If this downturn continues, Virgin America could look to merge with JetBlue, even though those two carriers have worked tirelessly to differentiate themselves. This would trim capacity minimally, but perhaps more importantly, it would minimize the capacity that could have been added, had Virgin America remained a separate carrier.

One potential combination that I've always liked is a Alaska and AirTran merger. Although this is unlikely, it could actually offer significant benefits to customers on both coasts. Alaska is very strong on the West Coast, AirTran on the East. And AirTran is starting to make stronger inroads in the Midwest, such as its Milwaukee minihub, which could help avoid the potential "barbell" result of a merger (strong route structures on both coasts, but a minimal presence in the middle of the country. A combined carrier could help reduce Alaska's reliance on legacy airlines as codeshare partners to help feed traffic into Seattle. If AirTran expanded its services, traffic could be brought in to Seattle from hubs at Milwaukee, Baltimore, and Atlanta, while traffic from Seattle, San Francisco, and Los Angeles can more easily get to cities like Philadelphia and Charlotte (not served by Alaska), as well as other key East Coast destinations that both carriers currently serve. 

Moreover, a fleet combination would allow AirTran to use some of its 717s on thinner West Coast routes where they would be much needed, such as from Spokane, Portland (Oregon), or San Jose, while Horizon could add service from Atlanta to smaller cities in the Southeast with Q400 aircraft that have some of the lowest costs in the industry. These service additions would be compensated for by reductions elsewhere. There would be issues to resolve, granted, but it could very well be a partnership that would pay significant dividends well into the future, and for better or worse, appears to be one of the easier mergers to resolve when contemplating merger scenarios for US LCCs.

2009 will be a year that tests all airlines considerably. But those that stick to their strengths and work tirelessly to boost yields will be those that can strengthen their cash positions and weather this recession. Hopefully, most US LCCs can make it through intact.

What Will 2009 Bring for Legacy Airlines?

This post will be the first of two year-end posts regarding the future of US airlines in 2009. Once again, my apologizes to those who have been gnawing at me to update. I've been extraordinarily busy of late, and apologize for not being able to post in a timely fashion.

2008 In Brief Review

The biggest issue that clearly has been a game-changer this year is fuel. As the global economy heads into 2009 in a recession, fuel prices will continue to remain depressed for the foreseeable future. However, I suspect that most airlines have learned their lessons with regard to fuel pricing, and will be more careful about how they hedge themselves. In a recession, cash is an extremely desirable asset to have, given that nobody knows just how long or painful this recession will be. Unfortunately, hedging drains cash balances, even with low oil prices, and so while airlines would love to lock in some low prices for the foreseeable future, it doesn't appear that many will take that route. But, there should be no illusion that oil prices will go significantly higher in the long-term, and that airlines which do not hedge will be exposed to the explosive costs that put some airlines on the brink this past summer.

A secondary issue with hedging is that it's not merely airlines learning their lessons regarding fuel price spikes. Those investment firms who sell hedges are increasingly worried that rising commodity prices could make hedging a sucker's bet for them. As a result, some airlines have had recent difficulties finding institutions who are willing to sign in hedging contracts. If oil prices rise, I suspect that hedging will become increasingly important, yet increasingly difficult for airlines to do.

While fuel has affected all airlines, legacies have been most aggressive about responding to the fuel crisis by cutting capacity rapidly. And they have trimmed capacity so significantly that most expect to be profitable in 2009. However, businesses have cut travel expenditures significantly in this latest downturn, and airlines are hurting. Load factors have been down, so although capacity is falling, demand is falling faster. Capacity cuts will help airlines be profitable, but they are only one part of the story.

Legacies have also been very aggressive at adding ancillary revenues to their pricing structure. Ironically, it's "full-service" airlines in the US that have been most aggressive about this, whereas "low-fare" carriers have resisted the temptation to add as many fees. The reverse is true in Europe, where Ryanair and easyJet charge many more ancillary fees than their legacy counterparts. Miraculously, most customers in the US have grudgingly accepted these new fees, even though they are adding significant sums to the cost of a ticket, and creating additional hassles for cabin crew who need to spend extra time fitting overstuffed cabin baggage into overhead compartments. But, fares have remained low, to the delight of many travelers who can avoid these fees and airlines have received relatively few complaints. It turns out that travelers really would rather not pay for someone else's meal or checked bag, and take a lower fare instead.

So what's going to happen in 2009?

The recession obviously makes any predictions very speculative, because if air travel demand continues to spiral downward, problems could ensue for airlines that have already made as many cuts as possible without trimming significant numbers of jobs. If this recession continues to bite, significant job cuts could ensue if airlines cut capacity further, and that could mean nasty negotiations with unions, and increased labor strife at many carriers. Unfortunately, these capacity concerns could exacerbate labor tensions which will already be higher than normal, given that many labor contracts are being renegotiated in 2009.

But who's going to benefit, and who will suffer?

I've said it before, and I'll say it again. I have significant doubts about the prospects of US Airways. The company has far less international exposure than other legacies, currently operating no routes to Asia nor South America. Although the company does brisk business on Latin America and Caribbean routes, US Airways mostly competes with low-fare carriers, especially Southwest. And US Airways has been most aggressive about adding ancillary fees and trimming costs, charging for onboard beverages and now offering no in-flight entertainment except on international and Hawaii routes. The company is not known for its service, and I suspect that it will continue to lose business travelers to Southwest, which offers more amenities than US Air. Moreover, in their most recent quarter, US Airways lost over $850 million, a significant sum for an airline of its size that only took in $3.26 billion in revenues for that same period.

As for other carriers, the Delta/Northwest combination made big headlines this year and will be significant in the coming years. I really have mixed feelings about this merger. I didn't like the idea because of a lack of fleet compatibility, heavy concentration of routes East of the Mississippi, as well as slightly different business models, but now that the deal is complete, the company is making some right moves, such as fleet adjustments to put larger planes (such as Northwest's 747s) on some Delta routes, and moving some smaller Delta aircraft (such as 767s) to routes Northwest operated with aircraft that were too large for the job. However, the company has not been aggressive enough with regard to cutting hubs. Cincinnati and Memphis appear to be the two most obvious targets, and while capacity has been trimmed in those markets, the hubs have not been dismantled. If the company wants to survive in this marketplace, it needs to focus on its strongest operations with the most originating traffic. This means keeping Atlanta, JFK, Detroit, Minneapolis, and Salt Lake City intact as hubs that can produce high load factors because of strong originating traffic loads (of high-yielding passengers).

American, United, and Continental, will slowly contract, but survive in the next year. These companies are making strides to expand their international presence and fend off low-cost competitors. The three have good business models that will not require significant tinkering anytime soon, and they should likely be profitable, barring extraordinary events, in most quarters of 2009. It remains to be seen what United and Continental's "strategic partnership" will look like, but overall, the structure of these carriers will not change dramatically anytime soon. Like most airlines around the world, they'll be hanging on, waiting, for things to tick upwards, and expand once more.

See Part II tomorrow on Airline Bulletin