This isn’t the first time we’ve heard United management talk about the death of the ultra low cost carrier (ULCC), but it’s one of the more interesting discussions that has been rattling around in my brain for awhile now. In short, United still firmly believes that ULCCs are in serious trouble, and the numbers have been backing that up as of late. But will the numbers change over time? United would never say never, but it certainly thinks that the best days are behind the ULCCs. So, let’s talk about why.
We have to start with a little context. This year has really been confusing when you look at airline results. The ULCCs have struggled mightily and Q3 is not going to improve. In an update a month ago, Spirit said it would see deep losses in Q3 with an operating margin between -14.5 and -15.5 percent. Frontier will come in between -4 and -7 percent. These numbers are startling in their own right, but they are downright bizarre compared to the stellar already-reported numbers from Delta (12.8 percent) and United (12 percent).
If we extrapolate this out into the future, we get this chart which I completely made up. I’m pretty sure United would approve of this as being entirely correct, however.
Delta doesn’t really talk about these things since it’s not really Tom Brady’s forte, but United has been surging as of late and its management team is always happy to talk about its evolving view of the industry, including why the profit numbers seem to be inverted from what you might expect when comparing legacy airlines and ULCCs.
Right off the bat, I could come up with several reasons why the results would be different. For example, the ULCCs are hit much harder by the Pratt & Whitney engine problems. Also, there’s no question that some of the disparity is due to the make-up of international vs domestic flying. It’s the international markets that are absolutely booming this year. While Delta and United both have huge international footprints, the ULCCs do not.
So yes, you would expect to see a real impact from that difference, but it’s more than that. After all, United proudly proclaimed that its domestic network was profitable this past quarter, a very different outcome than what the ULCCs should be reporting shortly.
On the airline’s Q3 earnings call, it was Chief Commercial Officer Andrew Nocella who broke it all down in response to an analyst question. Though to be fair, it sounded like he was reading his response right off a prepared statement. So this was not off the cuff by any stretch.
Andrew says that the number one reason ULCCs are struggling is that costs between the ULCCs and the legacy carriers are converging. If you were to have taken a shot of whisky every time United talked about cost convergence on the recent earnings call, you might not remember even being on the call.
There’s more than one reason for this cost convergence, and the ones Andrew rattled off were:
- ULCCs relied on really high utilization to get a leg up in the past, but the post-pandemic world doesn’t allow that to happen.
I’m not sure exactly what he means when he says this, but I assume it’s largely due to longer ground times needed, work rule improvements in favor of crews, pilot shortages, and possibly fewer opportunities to make money flying on the back of the clock. This wouldn’t impact Allegiant — a ULCC that has low ownership costs and has never cared about utilization — but it woud certainly impact Frontier and Spirit. For what it’s worth, Spirit’s utilization in Q2 2023 was 11.3 hours per day per aircraft while it was 12.8 in Q2 2019.
- The days of paying crews peanuts are over, because if a ULCC does that, it won’t have pilots. Labor cost differences are narrowing between airlines.
This is true, at least for now. But I’m always just assuming we’re only one big downturn away from another round of bankruptcies and wage cuts. The other piece of this, however, is that the key to keeping labor costs low is growing fast. It’s what Delta CEO Ed Bastian calls “juniority.” Having a more green workforce is cheaper, but if you stop growing as fast, the labor groups age and wages rise with more seniority. Growth is something we’ll get to a bit later.
- ULCCs already fly really big airplanes, but now the legacies (United touts its own work, of course) are catching up, reducing unit costs.
The ULCCs have done some upgauging of their own but that’s largely already done. Spirit’s weapon of choice was primarily the A320, but now it’s increasingly the A321 (when the Pratts allow the airplanes to actually fly). Frontier used to fly A319s like crazy and even some A318s way back. Now those are gone and A321s are growing in importance. There isn’t anywhere further up they can go since widebodies are not on the table.
But United spent the 2000s downgauging, using smaller regional jets where it could. Now it’s going the other direction, upgauging nearly everything. That will absolutely lower United’s unit costs, bringing them closer to ULCC levels. It will never actually get to ULCC levels, but that’s not the point. United has much greater revenue-generating capability which it says is well worth the added cost to be able to create those opportunities.
And speaking of revenue, Andrew had plenty of to say on that front as well.
The ULCCs have minted money growing in the big leisure markets of Florida and Vegas (along with some Caribbean, Phoenix in the winter, etc). United’s belief is that there’s just not enough demand to support all the capacity that has flooded those markets. That may be true for now, but of course it will change over time as capacity gets absorbed. For now, however, it has made the ULCCs think about other markets.
The problem with smaller markets, however, is that they just can’t generate the same amount of demand. Because the ULCCs need to have the biggest airplanes to drive down costs (all those dense A321s), it might work in a couple markets from a mid-size city, but the marginal revenue will just not be as good, dragging down earnings. This of course does not consider Breeze which is trying to make it work with smaller airplanes, but so far Breeze has not shown that it can make money… that’s a conversation for another time.
This is certainly an issue, however. We have seen ULCCs move into smaller markets. For Frontier, it’s been more about that sub-daily model to try and fill those airplanes. But the further down you go, the harder it is to fill those big birds. The ULCCs will tell you they have hundreds of opportunities, but what we don’t know is just how profitable those opportunities will be. If revenue performance is ok but not great and costs are rising, the number of feasible opportunities will shrink over time barring a massive change in demand.
New markets inherently perform worse than more mature markets, and Andrew said that is part of the ULCC problem. He proudly noted that United has only 1 percent of capacity in new markets in Q4 2023 vs Q4 2019. I’m not sure I’d crow about that since it means United isn’t finding new markets to fuel expansion in the future, but it would certainly keep revenue performance higher now.
To sum it all up, Andrew says, “when capacity growth is designed as a strategy to maintain low cost without revenue accretive markets to add, the entire business model can break. And that is what we think is happening right now.”
United meanwhile is pouring it on, going with a model that creates “diversity of revenue streams” which helps United shift around strategies to cater to what’s booming at any given time. This can range from Basic Economy — which is actually growing at the airline and reached 12 percent of passengers in the last quarter — all the way up to Polaris long-haul business class. And there are many options in between.
With these options and bigger airplanes, United says it is spilling less traffic to other airlines. It can now accommodate the price sensitive traveler and the premium traveler well in a single tube, especially since it is using bigger airplanes with more seats to sell. That means ULCCs need to get their passengers elsewhere.
All of this comes together, Andrew says, to mean that United is coming out of the pandemic stronger and growing. In the past, legacies would shrink and shed airplanes, making it hard for ULCCs to NOT take advantage of the situation. That’s not what is happening this time around.
It’s a compelling argument and there is undoubtedly truth behind it. Is it overstated? Almost certainly. United is a very confident airline, and it is not shy about it. But ULCCs, well, they feel differently:
I can understand perfectly how the report of my illness got about, I have even heard on good authority that I was dead. Frontier, a cousin of mine, was seriously ill two or three weeks ago in London, but is well now. The report of my illness grew out of his illness. The report of my death was an exaggeration.’
Alright fine, that’s a Mark Twain quote, but you can see how it would be a applicable here. If any ULCC is dead, it’s Spirit… but only if JetBlue takes over the airline. (The trial is getting started, so stay tuned!) But for the others, there’s no question that the environment is bad right now. That, however, doesn’t guarantee there’s no way out in the future.