Last week, Republic Airways (NASDAQ: RJET) subsidiary Frontier Airlines announced that it would change its fee structure, most notably introducing carry-on-bag fees for certain customers. Carry-on-bag fees have been a source of extreme controversy in the U.S. for the past three years. Supporters claim that the charges reflect the scarcity of overhead bin space and the cost to airlines of dealing with bulky carry-on bags, while detractors argue that the fees take advantage of customers.
However, while other airlines have used the carry-on-bag fee primarily as a tool for boosting revenue through price discrimination, Frontier's carry-on-bag fee is much different – at least for now. Frontier is only charging a carry-on-bag fee for passengers who book their tickets through third-party channels, such as online travel agencies like Orbitz (NYSE: OWW). The purpose of this fee is to entice more passengers to book through Frontier's own website, so the carrier can cut down on travel agency commissions.
Rise of the carry-on-bag fee
In April 2010, ultra-low-cost carrier Spirit Airlines (NASDAQ: SAVE) became the first airline in the U.S. (and possibly the world) to introduce a fee for carry-on baggage. Spirit's management decided that adding a carry-on baggage fee would allow them to reduce base airfares, stimulating demand, while improving efficiency by discouraging travelers from bringing large carry-on bags. Two years later, Spirit finally got some company as fellow ULCC Allegiant Travel (NASDAQ: ALGT) instituted its own carry-on-bag charge.
For Spirit and Allegiant, adding a carry-on-baggage fee had two main goals: speeding up the departure process by encouraging customers to check their baggage, and allowing the carriers to lower their base fares. Allegiant's management has specifically stated that customers are more likely to start the reservation process when they see a low base fare. Ultimately, customers may be willing to pay more if they are choosing all the "options" themselves than they would be willing to pay if everything was bundled in a higher base fare.
A different approach
Frontier's addition of a carry-on-bag charge was perhaps foreshadowed by Republic's decision in early 2012 to convert Frontier to an ultra-low-cost carrier model. However, Frontier actually has a different rationale for implementing a carry-on-bag charge, compared to Spirit and Allegiant. Frontier has a loyal customer base in Denver, which it does not want to offend by charging for carry-ons. Accordingly, customers who book their tickets on Frontier's website can avoid the fee. Since loyal customers are likely to book directly on Frontier's website anyway, this policy effectively exempts them from carry-on charges.
In fact, instituting a carry-on-bag charge for tickets bought through third-party channels is part of a broader strategy for Frontier to reduce distribution costs. Southwest Airlines (NYSE: LUV) has successfully followed a long-term strategy of minimizing its reliance on third-party distribution of tickets in order to keep costs down. Southwest does not participate in most of the global distribution systems and does not sell any tickets through online travel agencies.
Frontier doesn't have the same nationwide brand recognition as Southwest, so it is harder for the company to go "cold turkey" on third-party distribution. However, Frontier has been attempting to drive more traffic to its own website since late last year. This has included initiatives such as giving fewer frequent flier miles to customers who book through travel agencies, offering advance seat assignments only to customers booking on Frontier's website, and charging higher fees to customers booking through travel agencies. Frontier also stopped selling tickets through Expedia (NASDAQ: EXPE) earlier this year, after the two could not agree on the terms of a new distribution agreement.
Frontier's carry-on-bag fee – charged only for customers who book through a third-party channel – is thus a natural continuation of its recent moves to entice customers to use the Frontier website. Ever since online travel agencies like Expedia and Orbitz stopped charging booking fees for most flights, customers have had less incentive to book directly through the airlines. However, the commissions charged by these online travel agencies are significant, particularly given the low-margin nature of the airline business.
Frontier is therefore finding innovative ways to align customers' interests with its own. If customers absolutely want to use an online travel agency – for instance, because they can get a big hotel discount as part of a vacation package – then Frontier is willing to serve those customers. However, it will try to offset the added cost of travel agency commissions through higher fees for those customers, such as the carry-on baggage charge. Otherwise, Frontier is encouraging customers to book through the Frontier website, which is the lowest-cost method of selling tickets.
Foolish bottom line
For now, Frontier's carry-on-bag fee looks like the continuation of its recent strategy to entice customers to book through the carrier's website rather than third-party channels. (It is of course possible that Frontier will eventually extend the carry-on-bag fee to all passengers.) By exempting customers who book through Frontier's website, Frontier will avoid alienating loyal customers, while rewarding others for booking directly, rather than through travel agencies. It will be interesting to see how customers react to the changes, but Frontier's new carry-on-baggage policy seems like a very sensible strategic decision.
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