By a multiple, the most widely read swelblog.com post ever read was the piece entitled: Is Republic Changing the Face of the US Domestic Market? I wrote the piece thinking about the regional carrier holding company’s play for each Midwest and Frontier. In that piece, I suggested that technology was a, if not the, most important attribute supporting Republic’s decision to make the play for Frontier: “Now Frontier provides Republic with something it previously lacked: a technology infrastructure that gives it long-term viability in the market. A technology infrastructure not tied to a legacy system.”
Most importantly, the technology would give Republic the opportunity to begin selling tickets directly to air travel consumers, something it does not and cannot do today.
Last week as I was walking off of the eighteenth green at the storied Butler National Golf Club in Chicago with dear friends Jack Ginsburg, Pete Robison and Ro Dhanda, I turned on my iPhone and noted dozens of messages. The news had just broken that Southwest Airlines was considering upping the ante over Republic and will prepare its own bid for Frontier.
For Southwest, the Best Offense Is a Good Defense
History is not clear whether someone actually said that the best offense is a good defense. It is believed to be a misstatement of a quote attributed to Carl van Clausewitz, military strategist and the author of On War, a book, published in 1832, that was required reading for me in a graduate school marketing class. Clausewitz was quoted as saying the best defense is a good offense. Either way, Southwest’s motives for this deal had me thinking.
If Republic is successful in gaining control of Frontier, it would produce, overnight, a new and potentially threatening competitor to Southwest’s domestic dominance. This past April, I made a presentation to the 34th Annual FAA Forecast Conference entitled: Cost Differences Suggesting a New Mid-Term Structure. There, I warned of the difficulty of analyzing cost differences between carriers, particularly in light of Southwest’s unique influence on the market. I believe it is now wrong to include Southwest among the group traditionally known as “low cost carriers” because its sheer size distorts the results. It was clear to me then, as it is more so now, that Southwest is losing the significant cost advantages that have historically been its primary competitive weapon and driver of its organic growth.
My analysis relied on MIT's Airline Data Project. When I prepared the analysis for the FAA Conference, final fourth quarter 2008 data had not been filed but has now been updated. The story remains the same. In order to make an apples-to-apples comparison of cost per available seat mile, adjustments must be made.
First, transport-related expenses (largely the fees paid to regional carriers for capacity) must be removed as there is an offsetting revenue account. Second, fuel cost per available seat mile should be removed as varying hedging strategies make for distorted comparisons. This is particularly true of Southwest where I estimate that its fuel hedging strategy accounted for 53 percent of its cost advantage versus the network carriers for the first nine months of 2008.
I also compared unit costs of the network carriers (American, Continental, Delta/Northwest, United and US Airways) to Southwest and a group of carriers I refer to as Midscales (AirTran, Frontier and jetBlue). Absent removing transport-related and fuel expenses, Southwest has a cost advantage versus both groups of carriers –in the case of the network carriers, a 6.4 cent advantage. When transport-related expenses are removed, then Southwest’s cost advantage is nearly halved. When fuel expenses are removed, the advantage versus the network carriers shrinks to 1.6 cents.
Now consider this: When transport related and fuel expenses are removed Southwest has a cost disadvantage versus the Midscale group. Just imagine what Southwest’s cost disadvantage could be if Republic were to get its hands on Frontier? Southwest non-labor costs are the envy of any carrier, and it still has an advantage versus the network and Midscale carriers. But Southwest now has a labor cost disadvantage against those carriers. In fact, the unit labor costs of the Frontier, AirTran and jetBlue sub grouping are nearly a full penny per seat mile lower than the unit labor costs at Southwest. Pennies in this instance can quickly add up to tens of millions of dollars in cost to Southwest when competing directly.
Adding To the Speculation
Many observers already question whether Southwest would be adding to its burdens and its costs in acquiring Frontier’s airplanes and thereby introducing different aircraft to its famously one-sized-fits all fleet. That can be addressed.
Can the labor issues also be managed? In my view yes, even if that means Southwest buying labor’s favor. Independent unions represent the pilots at each airline, so the always-difficult task of integration would be made easier by the fact there is no national union constitution and bylaws to deal with. Frontier, through its bankruptcy, has moved toward more maintenance outsourcing and that fits Southwest’s current model. And because the Frontier flight attendants are not unionized, there are minimal labor hurdles there.
No doubt, the financial transaction would be accretive to whichever airline ends up making the play. I believe, though, that the most value from Frontier would be garnered only by another airline that could leverage its assets - a local market following and its IT platform – not by financial players that won’t see the same advantages.
Frontier would provide Republic a tremendous opportunity to transform not only itself but the US domestic market. For Southwest, the Frontier play is not so much transformative as it is defensive, by:
- Removing a local market competitor for a company struggling to find new markets (and there are no profitable 3-carrier markets in today’s revenue environment)
- Providing a solid technology foundation and expertise in value-added pricing
- Thwarting future competition by ensuring that Republic remains a capacity provider to the nations’ legacy carriers – at least in the near term.
Ding: The “Southwest Effect” is Dead
The Denver market is unique in that there are few alternative modes of transportation that can compete with air travel because of sheer distances in the western US. Boulder, Colorado Springs and other surrounding cities’ traffic already access the air transportation system through Denver. The truth is today’s stimulation is largely diversion from another market or another carrier.
Many point to the pain a Southwest takeover would impose on United. But there are two sources of traffic: local and connecting. United runs a large connecting operation in Denver. Onboard United airplanes is a traffic mix of 1/3 local passengers and 2/3 connecting passengers. On the other hand, each Frontier and Southwest are highly reliant on local passengers. Before we count United dead in Denver as a result of this combination, this fact needs to be examined.
Fares for local traffic in the Denver market are largely dictated by the competition between Southwest and Frontier. Publicly available data would show that nearly half of Frontier's traffic at Denver is local and Southwest's is near 70 percent. Therefore which direction do you think fares will go if Southwest is successful in taking out an important competitor for Denver local traffic? And after reducing certain duplicative Frontier capacity? Southwest’s fares will prevail, even though Southwest is not always the low fare provider in each market.
Southwest Showing Its Age
Southwest built its Denver operations quickly at a time when Frontier’s future was in doubt and United was struggling. As Southwest’s organic growth slows because of the anemic revenue environment in the US domestic market, then buying the carrier that competes largely for the same local traffic makes good sense. With a cost structure that no longer sets them apart from the crowd, it is clear why Southwest continually talks of the need to augment its revenue streams.
To be fair, some will say that analysis of Southwest’s cost advantage shrinkage is flawed because it does not account for stage length -- the length of the average flight. But in comparing one airline’s performance and costs to another, adjusting for stage length is somewhat arbitrary.
Rather, what is most important is the relationship of [system] cost per available seat mile to [system] revenue per available seat mile. It is this relationship that finds Southwest struggling at Denver where load factors have been in modest decline as the airline has grown and has been increasing fares from the carrier’s initial offerings. The net effect has been a modest decline in RASM - as CASM has been increasing.
The network carriers are challenged in this regard because of the black revenue hole created by the downturn in first and business class travel on international routes. Just as the network carriers have to adapt for shrinking revenue relative to costs, so does Southwest – without the magic of stimulating a mature market replete with competition from low cost and network carriers alike.
Southwest just celebrated its 38th birthday. It is a mature and maturing carrier operating in a mature domestic environment where it is no longer an innovator. What I find most interesting in Southwest’s potential bid for Frontier is that the carrier is being forced to act just as the network legacy carriers. Southwest is seeking a consolidation scenario that could and should lead to an improved revenue line in Denver where it has significant capacity deployed and where Frontier, a beloved (not LUVed) carrier in the region is all but assured of emerging from bankruptcy protection with its loyal local following in tow.
Keep tuned. I can’t wait to hear the arguments Southwest uses in Washington to gain regulatory approval, particularly as it will be hard pressed to make the argument that acquiring Frontier would lower airfares in the Denver region.
Funny how things change.