Which Ultra-Low-Cost Carrier Is Right for Your Portfolio?

The past few years have seen a new innovation in American aviation: the "ultra-low-cost carrier", or ULCC. Spirit Airlines (SAVE 6.46%) has led this movement since 2007, when it began charging for checked bags and snacks, two items that had traditionally been complementary in the industry. However, Allegiant Travel (ALGT -0.82%) had already begun implementing some aspects of the ULCC model, and has continued down that road in recent years. More recently, Republic Airways (NASDAQ: RJET) has focused on converting its Frontier Airlines subsidiary to a ULCC model over the past year or so.

However, the ULCC model is not well-defined; Spirit, Allegiant, and Frontier actually have very different business models. While all three businesses are promising investment candidates, I think that Frontier parent Republic Airways could be the best of the group. Frontier has a much more customer-friendly fee policy than either Spirit or Allegiant, which makes it more likely to gain a loyal customer base. Moreover, the company trades at a significant discount to Spirit and Allegiant, even though management has made significant progress on the company's turnaround.

Low fares and high fees
Spirit's strategy is very simple; it finds the lowest-cost way to transport passengers from point A to point B, and then keeps base fares low while charging fees for a variety of optional services. "Non-ticket" revenue from fees for checked and carry-on bags, selling on-board food and drinks, charging for membership in a frequent traveler discount club, and similar sources accounts for approximately 40% of Spirit's revenue. Spirit keeps costs down by offering a single class of service, using a single fleet type (the Airbus A320 family), and fitting more seats onto each plane than other airlines. The company expects to continue reducing its cost structure (already the lowest in the industry) as it grows.

Spirit targets large existing air travel markets (more than 200 passengers per day each way) with high average fares. As a result, the company competes with legacy carriers on many of its newer routes. However, whereas the legacy carriers offer frequent service to cater to business travelers, Spirit only flies once or twice a day on most routes.

With its low fares, Spirit can attract many leisure travelers who are flexible about scheduling and are willing to sacrifice a little comfort to save money. Low fares also stimulate additional demand from people who could not afford to fly when fares were higher. Spirit serves roughly 125 markets today, but management estimates that there are more than 400 additional markets that meet its criteria for eventual service. This provides a nice runway for future growth.

Small cities go on vacation
Allegiant has many similarities to Spirit. Allegiant also offers a single class of service, charges low base fares, and derives a large and increasing percentage of its revenue from "ancillary" products and services. Furthermore, the company just finished adding 16 seats to each of its MD-80 aircraft to reduce unit costs. However, Allegiant's business model is fundamentally different from Spirit's. Whereas Spirit aims to break into large travel markets (typically served by big legacy carriers), Allegiant serves leisure travelers in smaller cities that do not have any other commercial airline service.

Allegiant's secret to success is buying older, out-of-favor airplanes cheaply. Whereas Spirit needs to utilize its aircraft heavily to spread its fixed costs over many flights, Allegiant can afford to concentrate its flying on days and at times when it is most profitable to do so, while leaving its jets parked during off-peak hours. Allegiant capitalizes on this flexibility by concentrating its flying on leisure routes from small cities to warm-weather destinations. These routes usually do not have enough traffic to support daily flights, but it is easy for Allegiant to serve those markets less frequently; Allegiant flies most of its routes just twice a week. This strategy allows Allegiant to profitably serve markets that are too small for other carriers. Accordingly, the company faces competition on only 10% of its routes, which is good for profit margins.

Allegiant also has ample expansion opportunities ahead of it. The company began serving Hawaii last year, after acquiring Boeing 757 aircraft that were capable of long-distance flying. Allegiant will begin receiving Airbus A319/A320 aircraft this year, which opens up even more new route opportunities, as these planes have a longer range than the MD-80 and can serve airports with short runways, unlike the MD-80. This will allow Allegiant to add flights to other underserved markets.

A new Frontier
Frontier is just now making the transition to a ULCC model. Its business model has some aspects in common with Spirit and Allegiant. Like both other ULCCs, Frontier is adding seats to many of its planes to increase capacity; however, Frontier offers more legroom in the front row and exit rows of its planes. It calls these seats "STRETCH" seating, charges extra for those rows, and allows STRETCH customers to board the flight early. In other areas, Frontier has not pushed as hard on fees: unlike Spirit and Allegiant, Frontier does not charge for carry-on bags.

Frontier is also similar to Allegiant in that it is attacking smaller markets. The company has recently begun flying from Trenton, N.J., to a variety of destinations, and last year Frontier began flying to a variety of smaller cities from Orlando. However, unlike Allegiant and Spirit, Frontier operates most of its flights in a hub-and-spoke arrangement at Denver International Airport. This puts it in sharp competition with the airport's two largest carriers, United Continental (UAL -1.82%) and Southwest Airlines (LUV 1.09%). This obviously creates some competitive challenges, but it also allows Frontier to offer many more connecting itineraries than Spirit or Allegiant. Denver is very well-situated for east-west connections within the U.S. Moreover, Frontier executives have stated that the company was profitable in Denver last year, and the company's continued cost cutting and route optimization plans should improve profitability.

From an investing standpoint, the biggest advantage of Frontier is that it is much cheaper than Allegiant and Spirit, which trade at 13.8 and 10.5 times forward earnings, respectively. Frontier parent Republic Airways trades at just 6.4 times forward earnings, allowing investors to get in on the ground floor of a new ULCC story. Frontier's changing route network indicates flexibility and a results-oriented culture at the management level. The company is currently in "experimentation mode", but when the cost structure and route network is optimized, I expect significant margin expansion.

Conclusion
I believe all three ULCCs are viable investment candidates today. Their low-cost structures and relatively nimble organizations should allow them to continue gaining share with respect to major carriers. However, I think the biggest opportunity today is in Frontier parent Republic Airways. It has not yet gotten credit for Frontier's transition to a ULCC model, and therefore trades at a very low earnings multiple. Success is obviously not guaranteed, but the company definitely seems to be on the right track for substantial earnings growth.