2016 opened with a bang in the airline industry, as Spirit Airlines announced that it was parting ways with CEO Ben Baldanza and bringing in former AirTran CEO Bob Fornaro, who had found himself with a lot of free time on his hands after selling his company to Southwest.
The Rise of Spirit Airlines
Spirit Airlines is the airline that everyone loves to hate. Known for its ridiculous advertising, low fares and annoying fees on just about everything, Spirit made its money on the extras. Consumers would find that, after selecting a seat assignment, checking a bag and carrying on another one, a $49 ticket could quickly become a $149 purchase. Customer service was “minimalist.” Based on high margins, fast growth and a never-ending line of passengers looking for cheap fares, the stock (Spirit Airlines, SAVE, $41.78) became an investor darling, rising from its low-teens IPO in 2011 to over $80 per share last year.
The Fall of Ben Baldanza
But it turns out that they had fallen victim to a classic blunder (not involving a land war in Asia): They messed with other carriers’ hubs, particularly US Airways’. Of course, it wasn’t US Airways at the time, it was the bankrupt American Airlines, who had other things to worry about than a carrier that was growing 8-fold in Dallas, its most profitable hub. But after US Airways bought American, the management team did what it had always done: It started matching fares. Given a choice of flying Spirit or AA, consumers picked the latter. Delta had already implemented “basic fares,” or no-frills fares, to compete with Spirit. AA and United are expected to do so later this year. The major airlines don’t make any money on these routes, but they have the income statements to support the temporary losses. Spirit doesn’t, and earnings for the company are expected to come in about 20% lower for 2015 than analysts had expected at the beginning of the year. The stock now trades at about $40.
There are other factors, of course, which led to the CEO’s dismissal. Mr. Baldanza had never had a great relationship with the board. Customer satisfaction, on-time performance and completion factors were all at the bottom of the industry. Spirit may have given up on customer service, but poor on-time performance and completion rate cost you real money. Those 2% of flights that you don’t complete force re-accomodation costs, while delayed flights snowball through the day, hurting efficiency. Either way, it was clear that he is an excellent marketer but a less-than-excellent operator.
The New Guy
Bob Fornaro is an interesting choice to replace him. He was elected to the board in 2014, so he already knows the company and, as the former CEO of AirTran, he had previously run a low-cost carrier (LCC) that had competed directly with a network airline in that carrier’s hub. Hopefully, he could stabilize Spirit.
But Mr. Fornaro’s task is not going to be an easy one. Improving operations is going to cost them money, which is anathema to the model of an ultra-low-cost carrier (ULCC), which has one, and only one, advantage over the majors; profitability at low fares. If it spends money, its costs go up. If its costs go up, ticket prices go up. And if ticket prices go up, passengers find another airline. Spirit could attempt to transition to a more traditional LCC, but Southwest and JetBlue charge minimal, if any, fees, whereas Spirit generates about 40% of its revenue from fees.
One option might be to pull back from competing directly in airlines’ hubs. Sure, you pick up some better-rated passengers at hubs, but the majors have shown that they are willing to fight back now, and they have more resources than you do. On the other hand, the majors don’t care about leisure carriers such as Allegiant. Why should they? It’s not as if Delta flies triple-dailies from Grand Forks to Las Vegas. Competition is like snakes: You don’t bother them and they don’t bother you.
Is a Merger in the Works?
A second option is one that I have seen a couple Wall Street analysts suggest: Merge with Frontier. On the surface, it makes perfect sense. Spirit is east coast, Frontier is west coast. They have a common fleet type with the A319 and 320. And they are both trying to expand the ULCC model. Added bonus: Mr. Fornaro also has experience with mergers, as he ended up selling his last airline to Southwest.
But a merger isn’t as easy as sticking two puzzle pieces together. For starters, no merger gets done without buying off labor (even at non-unionized carriers). There will be one-time savings from the elimination of duplicate costs, but permanent labor costs will take a step up. Additionally, there is the added complication of integrating systems. A major that messes up the integration will eventually win back its customers. A ULCC that does so could be committing suicide.
But, most importantly, there are very few revenue synergies to be had. Normally, carriers with this kind of geographic diversity would make a fortune by connecting all the dots on the route map. But ULCCs lack the ability to maximize the value of all their gates, since they have very little connecting traffic, concentrating more on the highly efficient O&D (origin and destination) traffic that does not involve a connection. Airlines with hubs have planes sitting on the ground for a long time, awaiting connecting passengers. LCCs and ULCCs, on the other hand, maximize their profits by keeping their planes in the air.
The Bottom Line
Ultimately, I think Spirit is forced to retrench and, if we do see a merger, it is out of necessity. Although Southwest now flies out of most major cities, it became the largest domestic carrier by avoiding head-to-head competition, instead flying to secondary destinations (e.g., Providence instead of Boston). Spirit would be wise to retreat from a battle that it can’t win.