MIAMI — Ben Baldanza is the CEO of Spirit Airlines, the nation’s largest ultra-low cost carrier (ULCC) and its most profitable one by operating margins. We sat down recently with Ben to discuss a range of topics including why Spirit’s business model is good for high oil prices and the competitive environment that Spirit faces. The Part 2 of our interview will cover the competition in markets like Dallas Fort Worth and Chicago, new legacy fare classes such as Delta’s basic economy, and how Spirit views the competitive threat posed by fellow ULCC Frontier Airlines.
Ben Baldanza (BB): It hasn’t changed anything really about our operation; it’s certainly helped us inflate our margins temporarily for a period of time which has been a good thing. But you know, we’ve been posting margins in the low to mid 20s for a couple of quarters now, even though longer term we don’t expect that the company’s going to always do that. We see ourselves, as we said in our earnings call, as a mid-teen to high-teen kind of carrier longer term. But we’ll take advantage of higher margins when fuel lets us.
But in terms of our planning; in terms of our capacity deployment, where we’re growing, the rate at which we’re growing, it hasn’t changed things at all. In fact, this year is a big growth year for us compared to 2014 and all of that growth was planned in a high fuel environment. Our growth is predicated on the fact that there’s always a market for customers who just want the cheapest fare. And it’s not based on the fact that, well, since I can charge low prices now, even though I’m going to have to raise them if fuel goes up, I’ll do that. So it has not really changed the focus of our growth or anything, but it has allowed us to post heavier kind of margins in the short term.
On the competitive front, we believe it has changed some things. What it’s done is it’s allowed higher cost carriers to start growing again. And the rate of that growth, even though they’re small numbers, given that four airlines now control eighty plus percent of all seats in the US, three percent growth on those bases is a huge number of seats. So the reality is with the larger, higher cost carriers growing again, it’s dumping an enormous number of seats in the market. And that’s really pushing fares down everywhere because the only way to fill those empty seats is going to be with lower fares.
So what it’s done is it’s made the competitive environment a little more aggressive; more people can profitably sell low fares today in this fuel environment. That’s pushed fares down everywhere. But it hasn’t changed our view of Spirit’s value in the marketplace. We’re still continuing to grow. And we just released the third quarter, where we earned almost twenty seven percent operating margins. So overall, that’s kind of how we see the world.
AWN: So you mentioned legacies, and the way fuel prices have emboldened them to do some things with capacity that they wouldn’t normally do, or that they haven’t done in the past few years. At a high level, would you characterize this as healthy competition from the legacies? Or is this something that is unsustainable and driven by where fuel prices are at?
BB: A lot of the flying being done by higher cost carriers today, not all, but a lot of it, just won’t be sustainable with higher oil prices. So at that point they’ll either decide to subsidize that flying with routes that can be profitable with higher fuel. Or they’ll have to dial back some of that flying. Whereas in Spirit’s case, there’s always a market for our customers, in a robust economy or a weak economy, there’s always a segment that looks for that cheapest fare.
So again, I see our growth as just more steady – not depending on the energy environment at any time. Whereas some of the flying you see today is certainly opportunistic. And there’s nothing wrong with that. And carriers should take advantage of what they can do. If they can make more money in the near term, then they should do that. So, I’m not criticizing anyone for doing that at all. But realistically, [amongst] routes that make money only when oil is forty dollars a barrel – some of those aren’t going to make money when oil is eighty dollars a barrel.
AWN: In the past, you have said that Spirit is built for higher prices of fuel and tougher economic environments, and you hinted at that in your answer to my first question. Can you expand on those comments? What specifically makes you guys well positioned for high oil prices and bad economic environments?
BB: There are a couple of things. I’m not saying that Spirit would make more money in a higher fuel price environment – I don’t think I’ve ever said that. But what I have said and what I do believe is that the relative margin outperformance Spirit can do is probably greater in a high fuel price environment than in a lower fuel price environment. In low fuel price environments, high cost carriers can post these high teens, maybe even twenty percent kind of margins. I mean Delta just posted like a twenty percent margin for the third quarter. And we’re at twenty seven [percent margins], they’re at twenty [percent margins] for the third quarter, so we’re still outperforming them a bit. But in a high fuel price environment, as we saw in the last high fuel environment of 2012-2013, the legacy industry was earning mid-single digit kind of margins and Spirit was earning fifteen percent kind of margins. So my point is that in a higher fuel environment, we’re likely to outperform the industry by more than we will outperform them in a low fuel environment. But that doesn’t mean [that] we’re in absolute making more money.
The other thing that’s true is that when fuel prices get higher, ticket prices get higher. And in a higher ticket price environment, a higher percentage of the consumers tend to look for the value kind of play. When prices for all consumer goods, McDonald’s does better business; Walmart does better business than when prices are low everywhere, and everybody’s flush. So the advantage if you will to Spirit in a higher fuel price environment – and again I’m not saying we want the higher fuel price environment – but the advantage of the business model is that I think we would likely outperform the industry more than we will outperform in a low fuel price environment. Even though, we’ll make more money in a lower fuel price environment.
The other advantage is the relative value proposition of Spirit is more appealing when it’s a higher fare environment because all of a sudden there aren’t low fares available everywhere – they’re only available in a couple of places and Spirit is one of those places. So that’s why we’re not scared at all of fuel prices going up. We think we’ll do just fine if the fuel price is going up. Now, we’re not likely, and I’m just speaking rhetorically here, to have twenty seven percent margin quarters in a high fuel price environment either. So I’m not saying that the absolute profits are better. But the value proposition is clearer to customers in a high fuel price environment, and our likely outperformance is greater. And I say that based on what actually happened in 2012 and 2013.
AWN: What are some elements of your business model that enable this?
BB: One major one is the fact that we have more seats on our planes than our competitors that allows us to spread our fixed costs over more seats, which makes the seats cheaper. We are right in the top of the most efficient fuel per seat in the industry. So the other advantage of Spirit in a high fuel price environment is our ticket prices don’t have to increase as much. If you take for example a hundred and eighty seat A320 flying from New York to Florida, JetBlue flies that same airplane with a hundred and fifty seats on it.
They’re starting to add more seats now, but as it currently stands, ours have a hundred and seventy eight, while theirs are a hundred and fifty. If fuel prices go up, JetBlue has to cover that fuel cost over just a hundred and fifty seats. We can get it spread over a hundred seventy eight seats, so our ticket prices don’t have to rise as much. This, again, is one of the tactical reasons why our value proposition looks stronger in a high ticket price environment.
AWN: So the sense that I get is that with your operation, is that you have to make a lot of tradeoffs to get your costs and thus base fares so low. This is stuff like no frills, tight pitch etc., but also things like trading off some on-time performance and completion by not having a ton of spares in your schedule. And to your credit, you guys are very up front about that. But with the shift in oil prices and the legacy carriers can match you guys more, while not forcing those tradeoffs on passengers. Does that worry you, the fact that now the Americans, Deltas, and Uniteds of the world are going to be able to better match you on prices while not forcing passengers into those kinds of tradeoffs?
BB: No it doesn’t, and I’ll tell you why. It doesn’t because, just because they can make money at lower fares, doesn’t mean they don’t want to sell higher fares to customers that are willing to pay those higher fares. We have a chart in our investor deck, where we break out the US [air] fares into five bands: the lowest twenty percent of all tickets, twenty to forty, forty to sixty, all the way up to the highest twenty percent. And then what we do is we look at how carriers’ traffic maps against that.
So the lowest fare buckets, based on full year 2014 data, the lowest twenty percent of fares in the US, the average fare is about fifty two dollars. And [for] the highest twenty percent of fares in the US, the average price is about three hundred eight dollars. And what you see is that if you look at Spirit’s traffic, over eighty percent of our traffic falls in that lowest twenty percent of the ticket prices in the US. So our business is built on that lowest twenty percent of ticket prices.
If you look at the four largest airlines in the US: American, United, Delta, and Southwest, who collectively carry over eighty percent of the traffic in the US – what you see is that more than eighty percent of their traffic pays higher rates than that. So, almost thirty percent pays in the highest bucket, the three hundred eight dollar bucket, over twenty percent pay in the second highest bucket, which is an average of about one hundred ninety dollars, and eighty percent of their traffic base is paying something more than the lowest prices anyway.
So just because they can profitably sell some of the lowest fares, doesn’t mean that it’s in their economic interest to sell those low fares. It’s because of their features; because of their legroom, because of their frequent flier miles, because of things like that they can attract a little higher dollar customer. Now maybe, what that means is that they rejected sales in the twenty to forty percent bucket that now they’re selling more of. But they still would rather sell that bucket than the lowest twenty percent bucket.
Our business is based on the lowest twenty percent, and if we just fill our planes with that lowest twenty percent, we’re going to make money and we’re going to be profitable because our costs are so low and they’re getting lower over time. They’re not getting higher while our competitors’ costs are getting higher. So, just because a somewhat temporary fuel price dip has occurred… and who knows what temporary means. It might mean a year, it might mean five years. By saying temporary, I’m not trying to suggest that fuel prices are going to go up quickly.
But it still on a macro basis is a temporary thing. Fuel prices have been higher than they are now; they’ve been lower than they are now. I would guess most people would say that five years from now fuel prices are going to be higher not lower. So just the fact that they [legacy carriers] can make money on lower prices today, doesn’t mean that what they want to do is sell more of the lowest prices in the US. What they do want is to fill their airplane, and they’re always going to try and fill their airplane with the highest revenue they can fill it with.
Let me give you a simple analogy. Say that the cost of beef got cut in half because of oversupply of cows. That’s not going to make Morton’s [Steakhouse] want to sell one dollar ninety nine cent hamburgers. Morton’s is still going to sell an expensive steak. Maybe the fifty dollar steak, because of competitive pressures with Frisco’s and Capital Grille, becomes a forty dollar steak – that’s possible. But that doesn’t mean all of a sudden that they want to be in McDonald’s business.
That’s kind of what I was saying before. American, United, and Delta, and even Southwest increasingly selling just the bottom barrel fare, that’s still not necessarily in their economic interest to do, just because they can make some money doing it because they can make more money doing something else.