MIAMI — Canadian low cost carrier WestJet Airlines Limited (TSE: WJA) announced a full year 2013 net profit of C$268.72 million, or C$2.03 per diluted share on Tuesday, a 10.9% increase year-over-year (YOY). The Calgary based carrier also reported a fourth quarter net profit of C$67.81 million (C$0.51 per diluted share), up 11.3% YOY. The revenue effects of the new Encore regional operation, premium economy seating, and associated fare bundles offset an increase in operating expenses due to accelerated capacity growth.

Operating revenues grew 6.9% YOY to C$3.66 billion, led by excellent “other operating revenue” (including ancillary revenue) growth of 10.4% YOY to C$324.6 million. Passenger revenue from base fares grew 6.5% to C$3.34 billion. Ancillary revenue growth sizzled thanks to WestJet’s fare bundling and the Plus premium economy product, which were worth a combined C$60-80 million in 2013. Low cost carriers (LCCs) and airlines in general around the world have embraced bundles available for pre-purchase as a way of offsetting negative customer sentiment driven by essentially involuntary ancillary fees. Passenger revenue per available seat mile actually ticked slightly.

*All monetary figures from here on out unless explicitly stated otherwise

Passenger revenue per available seat mile fell 1.6% YOY to 15.28 cents, with yield falling a more muted 0.4% YOY to 18.69 cents. These fare declines were driven in part by a 7.1% decrease in the value of the Canadian dollar relative to the US dollar (since much of the carrier’s capacity is in trans-border markets to the United States). Capacity growth as measured by change in available seat miles (ASMs) also played a role in driving down fares with 8.6% growth YOY, including 4.7% YOY growth domestically and 13.8% YOY growth internationally. However, the fare reductions were muted by per guest ancillary revenue, which grew 13.3% to $8.94.

On the expenses side, total operating expenses rose 6.9% YOY to $3.26 billion, undershooting capacity growth. For an airline pursuing aggressive growth such as WestJet, the best way to evaluate expenses is on a per ASM change YOY. To that extent, operating expenses, or cost per available seat mile, declined 1.6% YOY to 13.61 cents. Pretty much all of the line items increased roughly in line with ASMs, though fuel costs declined 3.6% YOY on a per ASM basis.

The only expense line items to see increases outpacing capacity growth year over year were marketing/general/administration (likely tied to new markets added with Encore), inflight (likely tied to the launch of WestJet Plus), maintenance (due to a more aggressive path of engine overhauls, and profit sharing (due to higher profits). WestJet also noted that it reached a $100 million cost reduction target for the end of 2014 a year early thanks to increased flight attendant productivity (1 per 50 passengers), increased pilot productivity (multi crew base), and seat reconfiguration.

Turning to the balance sheet and cash flow, WestJet ended the year with $939.7 million in adjusted net debt, a massive 48.8% expansion YOY and tied to the purchase of 13 new aircraft over the course of the year. The company ended 2013 with a cash and cash equivalents of $1.26 billion, down from $1.41 billion due primarily to an elevated capital expenditures level of $715.2 million. Operating cash flow declined 15.9% YOY to $608 million, while operating margin declined more slightly YOY to 10.9% from 11.0%, still an excellent figure. The decrease in operating cash flow arose mainly due to the payment $148 million in cash taxes which had been offset the year prior.

The most alarming note from the entire set of results was certainly free cash flow, which swung from $453.3 million to $-107.3 million, a $560.6 million reduction YOY. This was a one year event due to the massive influx of aircraft and general capital expenditure increase due to the launch of Encore, but still not a positive sign for the carrier. That being said, WestJet actually raised its quarterly dividend 20% in the fourth quarter to $0.12 per diluted share, putting more stock in other financial results such as return on invested capital, which improved to 13.9% and came in ahead of the carrier’s stated goal of 12% ROIC.

On its quarterly earnings call, WestJet actually took some criticism for not setting that ROIC target higher at around 15% like many low cost carriers (really ultra low cost carriers) around the world. But such criticism is flawed, as CEO Gregg Saretsky pointed out on the call, because WestJet is not really a low cost carrier in the purest sense of the word, or even in the same way it was when first launched. Much like JetBlue in the United States, WestJet is a low cost startup whose cost advantage eroded as its fleet and workforce aged, and as it added operational complexity. And like JetBlue and Southwest, WestJet quickly realized that it had to grow revenue to counteract the long run rise in costs to maintain its profitability.

Stage one was evolving its network, growing from an airline with a focus on leisure markets in Western Canada into an airline with a nationwide network that appeals to business travelers (into business markets in Toronto and Vancouver) – both JetBlue (in Boston particularly) and Southwest (in many markets like St. Louis) have followed a largely similar strategy in the US. Stage two is attacking what are certainly Air Canada’s most profitable routes, monopoly small markets that are served with turboprops and regional jets.

This is where Encore is targeted, and looking at Encore WestJet has managed to stimulate these markets by 30-40% by adding competition against Air Canada’s monopoly pricing. The Encore operation is apparently turning a small profit as per the earnings call and while it is not yet margin-additive, 2014 should see a significant maturation process for existing Encore markets (though new ones will be added with 12 out of 20 Bombardier Dash 8 Q400s still to be delivered).

And Stage three is growing their lucrative revenue streams with longer haul international routes and premium cabins. The premium economy product “Plus” has ramped up pretty strongly, and is expected to reverse some of the RASM declines in 2014 (as it is intended). The trans-Atlantic launch is something that’s even more interesting, because it is one of the major frontiers (like the Mint transcon markets in the US) where legacy carriers drive a significant fare premium and was previously seen as a sort of economic moat for them. Now for WestJet in particular thanks to St. Johns’ location (Air Canada flies an A319 from there to London Heathrow) they can attack much of the UK which has lots of leisure passenger volume, and with their announced order of 65 737 MAX aircraft, eventually target continental Europe. It’s something of a perfect compromise where they can skim traffic away from Air Canada, the European legacies, and Air Transat as well, yet maintain the 737 centric fleet model that’s so beneficial for LCC costs.

Now all of this evolution of the business model takes time, even if it’s the right decision to ensure longer term profitability. 2014’s numbers will likely see margins improve, but at a pace that lags North American rivals who are set up for a bona fide year, especially on free cash flow due to the elevated capital expenditures. But investors should be willing to stomach the temporary underperformance as a precursor of business model evolution that will prevent a long term slide.