Southwest Makes a Bid for Frontier

In an unexpected bit of news today, Southwest announced that it would make a bid for the assets of Frontier Airlines. Frontier, which is in the midst of exiting Chapter 11, received a bid from Republic Airways several weeks ago. It was not expected by many at the time that Republic would face much competition for Frontier, given that investors are hard to come by in this recession, particularly in the hard-hit airline industry. But Southwest announced that it would bid today, saying that, if it were to buy Frontier, it would initially operate the carrier as a Southwest subsidiary. Eventually, Frontier's Airbus planes would be ditched as Southwest received more 737s that it could integrate into the carrier's old routes. Some Frontier employees would likely be hired on by Southwest, but Southwest made no guarantees today as to how many Frontier employees would keep their jobs if its bid were accepted.

Southwest, has pushed aggressively in Denver, although Frontier has withstood most of the punches Southwest pulled, with United being the big loser in market share. Given that a Southwest purchase of Frontier would make Southwest the leading carrier in Denver, an unthinkable idea just a few years ago, United should be really scared. Southwest continues to run an efficient operation, and would present very tough competition to a weakened United. United is very popular with business customers, which Southwest is aggressively targeting. United's frequent flyer program, premium class service, and extensive route network are about the only things the carrier has to offer, but given the current weakness in the business travel market, those might not be enough to keep customers flying with United. This is especially the case if Southwest continues to lead the industry by offering no change fees, free checked baggage, and added amenities (such as Group A boarding and a free cocktail) to business travelers who book at the last minute.

As a result of this, don't be surprised if United makes a bid for Frontier, and this becomes a three-way bidding war. United has been a leader in Denver for years; it's only recently that the carrier has lost so much market share, and Southwest ownership of Frontier would create a huge headache for United. Unless United is willing to relinquish more market share, the carrier will either need to buy Frontier, or make aggressive changes in its scheduling, amenities, and pricing to compete.

But this deal is not a panacea for Southwest. Frontier has a different fleet of aircraft which it would dump, aircraft which are equipped with extremely popular (and revenue-generating) entertainment systems. Although Southwest is planning for in-flight Wi-Fi, the carrier lacks any electronic in-flight entertainment, and it may be hard to win over some Frontier loyalists who miss that, particularly on longer flights to the East Coast. But the flip side of this is that Southwest is more consumer-friendly when it comes to its baggage policies (Frontier currently charges for checked luggage), policies which would presumably be expanded to Frontier routes if Southwest's bid is accepted.

Another complication is that Frontier also has routes to a number of cities Southwest doesn't serve, and which don't make much sense in Southwest's current model. These cities are mostly distant, lower-frequency routes, some of which (eg. those to Mexico and Costa Rica) require additional turnaround time, hampering an efficient operation. Some of those routes generate very strong yields, but they might be ditched because of their incompatibility to Southwest's historic business model. Then again, given that Southwest has been making some unconventional moves of late, moving into busy airports they formerly shunned, it's certainly possible that Southwest would choose to keep these routes, even if they're to cities which would receive one daily, or a few weekly Southwest flights.

Southwest also has to deal with the issue of Lynx, Frontier's regional subsidiary. Lynx is Frontier's way of competing with United on short, regional routes from Denver, particularly to high-yielding destinations such as Aspen. Southwest has eschewed regional service throughout its history, and such service would of course generate added complications into Southwest's business. Like regional carriers at major airlines, it could also be the source of some labor tensions, since employees at regional carriers typically make less than their mainline counterparts. Southwest, known for being an employee-friendly company, might find it difficult to offer a different salary scale to its regional employees, which could potentially hurt the profitability of such a regional carrier. And unless Southwest were to scale up Lynx's regional operations to other cities, which seems unlikely during this recession, Lynx would be an anomaly in an otherwise efficient and simple airline.

And Republic, the regional jet contractor which allegedly bid for Frontier in an attempt to "diversify" its business model, may feel compelled to raise its bid. After all, it sees a lot of value in Frontier, and it's quite possible that if Southwest or United purchases the carrier, its opportunities to diversify and operate a mainline carrier will be limited. There are simply just few, if any, other small carriers which are available on the market right now, and Republic would have an extremely difficult time starting its own carrier given the checkered history of airline start-ups in this country. But then again, Republic doesn't have as much invested in the outcome of this saga as Southwest or United, they have profitable, albeit dwindling, contracts with major carriers, and they stand to lose relatively little in the short-term if they are unable to purchase Frontier. Therefore, I suspect that at the end of the day, they will not be interested enough in Frontier to win a potential bidding war with Southwest and United. However, they could still put in a revised offer or two, but I imagine that Southwest will follow suit.

U.S. Airlines Release Earnings: The Good, the Bad, and the Ugly

Airlines reported second quarter earnings results this past week, and as expected, many airlines struggled. But first the good news. Southwest, JetBlue, AirTran, and Allegiant all reported profits, with AirTran reporting excellent numbers (making more money than Southwest in the quarter). Allegiant increased its profit nine-fold from Q2 2008 (though much of this is due to the fact that oil doesn't cost $140 a barrel right now, which hit Allegiant and its fleet of older, inefficient aircraft especially hard. But although these carriers reported profits, don't expect much capacity growth to follow. AirTran is cutting ASMs 4% this year, and Southwest has already cut hundreds of flights from its timetables (though the carrier has added a few as well in New York and Minneapolis). Allegiant will be the only carrier which will do much growing, and they have been very careful about not flying money-losing routes. The company has announced numerous cities in the past only to see lackluster initial bookings, and pull out even before service starts. Although this is frustrating at times for customers, it helps the company ensure that it is expanding into markets only where it is wanted, and where it will be profitable.

The legacies all reported losses (with the exception of United and US Airways, which made money on paper due to gains from fuel hedge contracts, but lost money when those were excluded), but they weren't terrible, horrible losses. Nevertheless, if airlines are losing money in the early summer months, which are typically quite profitable, then it doesn't bode well for the slower fall and winter months which lie ahead. If the economy, and business travel, fail to pick up soon, more layoffs and capacity cuts could be announced. Already, Continental announced job cuts along with its Q2 earnings, and United announced a further capacity cut with its earnings. Legacy carriers are continuing to suffer, and although planes got fuller, yields had to come down in order to get passengers onboard.

But these earnings announcements from the legacies should not be a sign of gloom and doom, which is how many media and analysts often view them. I recently saw an intelligent comment (see July 13) from airline consultant Mike Boyd, in between his tirades that the passage of the economic stimulus bill was the worst travesty this nation has had to endure since the invention of the Great Global Warming Hoax by some eco-fascist desperately seeking attention. He noted that consolidation is unlikely to occur, and that the legacies we have should all remain intact through this difficult period. Unlike in Europe, where the market is oversaturated with too many airlines, as I noted yesterday, in the U.S., there really aren't that many carriers, and consolidation or bankruptcies which may look good on paper are unlikely to happen anytime soon. But Boyd also noted that the capacity cuts which are occurring now will help make airlines much stronger in the future. Airlines will be quick to cut, but may be a bit more cautious when re-entering. And this could make for airlines which will be very strong, and very profitable when the economy recovers.

I think Boyd is right on this front, but given the very fragile state of the economy, airlines may still face continued pressure on yields, which could, along with the roulette wheel of oil prices, dampen any profitability streak. And to the detriment of airlines, businesses will be increasingly careful with their travel budgets in an environment of enhanced public scrutiny. Travelers who used to buy full-fare tickets may take fewer trips, and book those tickets farther in advance.

But, while Boyd acknowledges the possibility of bankruptcies, I would go one step further and say that, while most airlines are not likely to be headed into Chapter 11 anytime soon, some sort of significant reorganization, possibly bankruptcy, may be needed at US Airways. The company is doing what it can to pull capacity out of lower-yielding markets, particularly Las Vegas. But although the airline reported relatively good Q2 numbers, its low cash position and its dependence on higher cost 50-seat regional jets worries me. The company's labor issues, particularly with its contentious pilots unions, as well as the risk of losing close ties to United when Continental joins Star Alliance don't help matters either. Moreover, the airline is heavily exposed to certain business routes, and markets, which are likely suffering in this downturn. US Airways has already had to trim some capacity on its formerly lucrative east coast shuttle service, and the company's one hub which is relatively unpenetrated by LCCs, Charlotte, is suffering due to a downturn in that region's largest sector—banking. Plus, although some international routes have been hit hard by the banking crisis, they still offer airlines the opportunity to generate higher yields. Yet US Airways only flies a smattering of international routes in Latin America, Canada, and Europe, most of which face significant indirect competition from other American legacy carriers. The company has no flights to Asia, Australia, or Africa, which may be advantageous now, but will hurt the company tremendously when international travel picks up after this recession. Is this to say that US Airways will immediately run into trouble? No, but the company continues to be exposed to some of the worst competitive pressures of any airline, while experiencing less brand loyalty and pricing power due to its lower-than-average service standards, and the company has failed to demonstrate that it has found a sustainable, profitable niche in the market.

Myair Bites the Dust

Myair, an Italian-based low-cost carrier, ceased operations today after Italian authorities revoked its operating certificate, citing ongoing financial difficulties at the company which inhibited the airline from running a smooth operation. The airline, which operated A320 and CRJ900 jets, was suffering under the burden of rapidly falling demand and a stagnation in yields. It is unclear whether any of Europe's other LCCs will replace any of Myair's routes, and in this environment, it's all the less likely.

But I wouldn't post about the demise of a small, relatively unimportant low-cost carrier if it didn't illustrate something else about the industry. Throughout the world, airlines will need to reduce their capacity in order to cope with the repercussions of the financial crisis. But in the United States, this is unlikely to lead to any airline bankruptcies (with one or two possible exceptions, which I will get to in another post). In the U.S., most of the marginal LCCs have either been bought out (Frontier, Midwest), or they have profitable business models (Spirit, Allegiant), and will continue to thrive in their niches. There are simply fewer airlines to consolidate, and the leading LCCs (Southwest, JetBlue, AirTran) would have challenges integrating with another company.

However, in Europe there is a far greater potential for capacity to be taken out through consolidation or through airline failures. And Myair is only one of many rather weak European LCCs which I expect will soon run into trouble. The European LCC industry is rapidly consolidating, and while the largest players are finding their niches, the smaller ones are suffering. Of course, Ryanair is a ruthless competitor, and nobody is going to beat Ryanair on price. Nobody. But Wizz is certainly trying, and has carved out a nice niche for itself in Eastern Europe, especially on routes to countries which Ryanair has yet to commence service to. Easyjet has been successful at courting business travelers, and has cornered leisure traffic from the UK to certain leisure destinations in the Mediterranean. But there are myriad smaller LCCs in trouble, including bmiBaby, WindJet, Blue Air, Spanair, and of course, SkyEurope, which seems to be dying a slow, painful death. Weaker LCCs will continue to be forced to consolidate, because the market can't support their capacity, and they lack the scale which gives Ryanair and easyJet tremendous efficiencies (as well as brand recognition throughout Europe). There are some carriers which are a bit smaller than the leaders, and should continue to survive (a combined Clickair/Vueling, Air Berlin, and Jet2), but many of the industry's smaller players will continue to be marginalized.

Really, there are two more interesting questions that the airline business in Europe raises versus that in the U.S. The first has to do with the role of mid-sized carriers—carriers which are strong in one or two medium-to-large cities, but relatively weak elsewhere. The only airline like that in the U.S. which comes to mind is Alaska, and they've been careful not to overexpand and to focus on their core strengths in the Pacific Northwest. But in Europe, the end of the dominance of national carriers due to the advent of more efficient LCCs, as well as the capacity crunch, begs important questions. Certain mid-size legacy carriers, including Austrian Airlines, CSA Czech Airlines, and LOT Polish Airways are all vulnerable to takeover or liquidation. These carriers lack the cash to survive downturns that the larger carriers have, and they have higher cost structures. Many of these carriers could operate more efficiently if they were part of a European airline conglomerate, such as Lufthansa, Air France/KLM, or British Airways. While the carriers themselves may not be entirely dissolved (but instead run as a subsidiary of the parent), integration with a larger carrier allows capacity to be optimized (read: reduced to sustainable levels). Although such deals may be a blow to national pride, transnational airlines are likely to be more efficient, and are less likely to fly routes for reasons of prestige. This means that passengers from Vienna may have to connect in Frankfurt before heading to Delhi, but it allows airlines to run more efficient operations which facilitate stability, if not necessarily lower fares, due to less competition in a consolidated marketplace.

The second question is one I'd like to examine in more depth later on, so I won't go into it now. But it is this: Why is it, that airlines within airlines, such as Air France/KLM's Transavia, or Lufthansa's Gerrmanwings have been successful even when airlines within airlines in the States have been rather unsuccessful? These are really marginal players in the industry, and at a time of capacity and cost cutting, I wonder how much these carriers are contributing to their parents' bottom lines, and whether they're really more successful than their American counterparts were. I'll offer what answers I can in an upcoming post. Also, I hope to have a post tomorrow about U.S. airlines' financial results and what they may mean for the industry in the States. 

JetAmerica Cancels Flights Indefinitely

JetAmerica, the air carrier planning to use aircraft operated by a third-party for their own flights, has announced that it will cancel all future flights indefinitely. This announcement comes after the carrier has made nearly a million dollars in bookings and conducted exactly 0 revenue flights. JetAmerica announced a delay for the start of flights two weeks ago, citing the difficulty in obtaining affordable slots at Newark. It appears that those problems could not be resolved, and were one of a number of factors which led to the carrier's demise. But ultimately, even if JetAmerica had obtained the slots, the carrier would still have faced numerous challenges in this environment. Airlines are cutting capacity left and right, and doing their best to raise fares. JetAmerica's business model, low fares combined with new capacity in small markets where getting sufficient traffic is a dubious proposition, was not a recipe for success. Although some suggestion has been made that the carrier could come back in a new form, don't expect its successor to be any more profitable. The people running JetAmerica don't have a clear idea what they're doing, and I imagine that without a significant change in leadership and business model, JetAmerica II will die quickly as well.