Economic Analysis: The Low-cost Airline Industry (LUV,DAL)

Occasional recessions and market crashes notwithstanding, there is little doubt that living standards for the majority of people around the world have improved steadily in recent decades. One consequence of this improvement in living standards is that products and services that were previously the province of the rich or upper-middle-class are now available to the hoi polloi. In this regard, no industry better exemplifies the democratization of a previously-exclusive service than the airline sector, driven primarily by the rise of the low-cost carrier (LCC). Read on for an analysis of how the LCC airline industry works and how it differs from its higher-priced peers, the "legacy" airlines.

In the "old days," when airlines primarily catered to affluent and business travelers, flying was an experience in itself. Airline travelers were a pampered lot, plied with food and wine by nubile stewardesses on flights that were seldom full, which frequently allowed one to stretch out on the adjacent empty seat and enjoy forty winks in the hushed passenger cabin.

While some of those benefits are still available to the relatively few who travel business or first-class, such amenities and service quality are a pipe dream for the vast majority of travelers who go economy or "cattle class". For these travelers, flying has become an experience that has to be endured, on par perhaps with a visit to the dentist's office. Air travel nowadays is characterized by overcrowded flights, inevitable delays, lengthy security procedures, noisy cabins and few freebies in the food and entertainment category.

But while many bemoan the deterioration in the quality of air travel, the number of complaints is not especially high in relation to the exponentially greater number of people who are now regular air travelers. This is because air fares have dropped very substantially on an inflation-adjusted basis, and consumers are well aware that you get what you pay for. The tradeoff for no-frills air travel in exchange for cheap fares is one that has been widely accepted by the majority of air travelers, and for those who pine for the glamor days of flying, there's always first-class.

While the commoditization of air travel was ushered in by pioneers such as Southwest Airlines Co. (LUV) in the U.S. in the 1970s, the widespread adoption of the LCC concept was accelerated by deregulation of the U.S. airline industry in the same decade. The 1978 Airline Deregulation Act partly shifted control over air travel from the government to the private sector and led to the termination of the all-powerful Civil Aeronautics Board (CAB) in December 1984. (For more, see: How Does Government Regulation Impact the Aerospace Sector?)

The CAB previously had an iron grip on most key aspects of the U.S. airline industry, as it controlled the pricing of airline services, their entry and exit, consumer issues, and agreements and mergers between carriers. This forced airlines to compete only on such tangible service factors like food, cabin crew and frequency, since their hands were tied (or rather, wings were clipped) concerning the most important determinant — ticket price.

The liberalization of the airline industry has yielded spectacular results. As a Bloomberg article notes, by 2010, the number of U.S. air travelers had more than tripled to 721 million, from 207.5 million in 1974. Over the same period, fares have come down significantly, with airline revenue per passenger mile down 61% from 33.3 cents (inflation-adjusted) in 1974 to 13 cents in 2010. Load factors — the percentage of filled airline seats, have risen from about 50% in the early 1970s to 74% in the first decade of this millennium.

The LCC revolution has spread worldwide over the past three decades, to Europe in the 1990s and Asia in the 2000s. The national airlines that are the flagship carriers for most countries still exist and are a significant presence in numerous European and Asian markets. However, their decreasing clout in the face of heightened competition and the growing reach of the LCCs may make national airlines a relic of the past in the years to come.

The ascendance of LCCs can be attributed to many innovations and developments since the 1970s.

• The point-to-point model: Airlines were quick to adopt the hub-and-spoke model — wherein a major airport become the hub, and other destinations become the spoke — after deregulation, but LCCs eschewed that system in favor of the point-to-point model. The hub-and-spoke system allows airlines to consolidate their passengers at the hub and then fly on to their ultimate destination (the spokes) in a smaller aircraft, which increases load factors and helps drive down fares, while increasing the number of destinations that can be serviced. However, it also has some drawbacks, such as the high costs required to maintain the complex infrastructure for such a massive, interconnected system; longer travel times due to the necessity for travelers of transiting through the hub; and susceptibility to cascading flight delays due to hub congestion.

The point-to-point system, on the other hand, connects each origin and destination via non-stop flights. This provides substantial cost savings by eliminating the intermediate stop at the hub, which means the huge upfront cost in hub development can be avoided. It also reduces total travel time—a priority or travelers — while enabling better aircraft utilization due to faster aircraft turn times. The major constraint of the point-to-point model is its limited geographical reach, since there are only a finite number of city-pairs for which direct flights are economically viable.

• Discount pricing: The higher efficiency and better fleet utilization of LCCs, coupled with lower overheads, means that they can offer prices that are significantly discounted to the prices offered by legacy airlines for the same route. As the vast majority of consumers want to reach their destination in the most economical and fastest manner possible, and are willing to forego in-flight food and entertainment in their goal to get the best price, ticket pricing is now the biggest competitive factor for airlines. This drive for economy also extends to business travelers, as companies increasingly clamp down on travel costs. In recent years, the advent of ultra-low-cost carriers like Spirit Airlines Inc. (SAVE), which give the passenger a seat and nothing else may put further downward pressure on ticket prices.

• Technology adoption: The widespread adoption of ticket-less travel and Internet distribution has been a boon for LCCs, since it lessens the need for complex and expensive ticketing systems used by legacy airlines to handle their complicated pricing structures, or for reliance on travel agents to sell tickets. The emergence of the Internet as the primary medium for booking tickets has greatly increased transparency of ticket pricing, which works to the LCCs' advantage because of their lower ticket prices.

• Fleet uniformity: A significant benefit of the point-to-point model is that LCCs can use a single fleet type, since they may not have much variability in passenger demand between the major city-pairs that they serve. This fleet uniformity leads to lower training and maintenance costs.

• Motivated staff: A number of LCCs such as Southwest in the U.S. and WestJet Airlines Ltd. (WJA.TO) in Canada pride themselves on the high motivation levels of their employees, achieved through competitive compensation, incentives like profit-sharing, and a strong corporate brand identity. The fact that most LCCs fly short-haul routes, which only keep employees away from home for a few hours —as opposed to a couple of days or longer for long-haul flights — is also positive for morale.

LCCs hold an estimated 30% of the U.S. airline market, of which about half (15%) is held by LCC powerhouse Southwest. The biggest U.S. LCC airlines are listed below.

Southwest Airlines Co. (LUV): Dallas-based Southwest has been in operation since 1971, and operates a network of 97 destinations in the U.S. and seven additional countries. It is the largest U.S. carrier in terms of originating domestic passengers boarded, and also operates the world's largest fleet of Boeing aircraft. Southwest has had 43 consecutive years of profitability and had a market capitalization of $25.5 billion as of January 29, 2016.

JetBlue Airways Corp. (JBLU): JetBlue, which bills itself as "New York's Hometown Airline," commenced service in February 2000 and had grown to become the fifth-largest U.S. passenger carrier based on revenue passenger miles by the end of 2013. It operates from six focus cities in some of the largest U.S. travel markets. JetBlue differentiates itself by offering the most legroom in coach class, as well as free TV, snacks and broadband Internet service on its flights. It had a market capitalization of $6.7 billion as of January 29, 2016.

Spirit Airlines Inc. (SAVE): Spirit operates more than 360 daily flights to 56 destinations in the U.S., Latin America, and the Caribbean. The airline's strategy is to offer an unbundled, stripped-down "Bare Fare" and make customers pay for options like baggage, seat assignments and refreshments. Spirit had its IPO in May 2011 and had a market capitalization of $3.0 billion as of January 29, 2016. (For related reading, see: Is Spirit Airlines a Real Threat to Southwest?)

Allegiant Travel Co. (ALGT): Allegiant Travel is the parent company of Allegiant Air, which was founded in 1997. Allegiant focuses on the U.S. domestic market, flying passengers from small and mid-sized cities to top holiday destinations like Las Vegas and Honolulu. Allegiant Travel had a market capitalization of $2.7 billion as of January 29, 2016.

The three biggest LCCs have had similar stock performances since Spirit's IPO in May 2011, to year-end 2015. Over this period, Southwest and JetBlue have generated total annual returns of 33.3% and 33.2% respectively, while Spirit Airlines has returned 30.4% annually.

However, these three LCCs had very divergent performances in 2015, with Southwest up less than 2%, while JetBlue surged 43% and Spirit plunged 47%. Southwest's profitability in 2015 was hindered by the fact that it had hedged fuel costs at higher prices.

Legacy airlines such as Delta Air Lines Inc. (DAL) haven't lagged either in terms of market performance in recent years. In the five-year period from 2011 to 2015, Delta— the largest U.S. airline by market cap — had annual returns of 32.7%, while United Continental Holdings Inc. (UAL) returned 19.2% annually. Over this period, the S&P 500 had total returns of 12.5 annually, while Southwest returned 27.8%.

Airlines, in general, are expected to continue benefiting from low fuel costs in 2016. Delta expected fuel costs to tumble by about a third from the fourth quarter of 2015 to $1.20-$1.25 per gallon in the first quarter of 2016, saving it more than $3 billion in 2016. The boost from lower fuel costs is expected to offset intense fare competition domestically, as the largest carriers focus on the U.S. market due to poor yields on international routes from overcapacity and the strong greenback. The biggest LCCs expect to expand aggressively in 2016, much faster than their legacy peers.

LCCs have become dominant players in the airline sector globally as cost-conscious consumers embrace their no-frills approach, and can be expected to continue grabbing market share in the airline industry in the years ahead.