Changes Coming to JetBlue Airways Corporation: But What Are They?

JetBlue Airways Corporation (JBLU -18.77%) reported record third quarter earnings last week, but investors were not impressed. While pre-tax income grew about 10% and JetBlue's margins widened slightly, most airlines posted much stronger earnings growth.

More importantly, JetBlue CFO Mark Powers announced on the company's earnings call that JetBlue now expects to miss its 7% return on invested capital target. This marks the second straight year that JetBlue will miss its ROIC target.

During the earnings call, JetBlue's management hinted that the company would be revealing new plans aimed to boost ROIC at its Investor Day event next month. What kinds of initiatives might JetBlue roll out to produce better results for shareholders going forward?

Fare families

There's one area where we can be sure that change is coming: baggage fees. Today, JetBlue and Southwest Airlines are the only major U.S. airlines to offer free checked baggage for all customers (one free bag on JetBlue, two free bags on Southwest).

Southwest has strong margins despite letting customers check bags for free (Photo: The Motley Fool)

Southwest's management has remained adamant that its "Bags Fly Free" initiative brings in more revenue (through higher market share) than bag fees would. JetBlue's management believes that amenities like generous legroom, a free checked bag, and free satellite TV help it earn a unit revenue premium over other carriers -- but only in some markets.

As a result, the company announced earlier this year that it plans to roll out "Fare Families" in mid-2015. The full details will probably come next month, but the basic idea is that JetBlue will offer multiple pricing tiers that would come with different bundles of amenities.

Given that the vast majority of JetBlue's competitors already charge for checking bags, it's virtually certain that the lowest Fare Family will not include a free bag. The extra revenue from bag fees should allow JetBlue to make a decent profit without raising base fares.

Bigger planes

Another initiative to boost JetBlue's profit margin and ROIC is the move to larger planes. Since JetBlue first took flight in 2000, the mainstay of its fleet has been the Airbus A320. Nearly a decade ago, it diversified its fleet with the Embraer E-190. JetBlue currently outfits these planes with 150 and 100 seats, respectively.

About a year ago, JetBlue began adding larger Airbus A321s to its fleet and revised its future fleet plans to heavily favor the A321. JetBlue is configuring most A321s with 190 seats. This arrangement will offer a double-digit unit cost reduction compared to the rest of JetBlue's fleet. A small subfleet of 11 A321s will be outfitted with 159 seats to offer "Mint" premium service on the high-yielding New York-Los Angeles and New York-San Francisco routes.

JetBlue's "Mint" premium service has quickly become successful (Photo: JetBlue Airways)

JetBlue is seeing early success from this initiative. September was the first month that it operated only Mint-configured aircraft on the New York-Los Angeles route, and thereby generated a significant year-over-year margin improvement. Due to strong demand for Mint flights, JetBlue is increasing some of the price tiers for lie-flat Mint seats.

JetBlue now plans for 73 of its 81 aircraft deliveries between 2014 and 2019 to be A321s. In the long run, this should boost its profit margin and ROIC. However, if it wants to have a more immediate impact, it could look to remove less efficient planes from its fleet in the next few years through sales, subleases, and/or lease returns.

Adding seats

Another possible avenue for JetBlue to boost its results is by adding rows to some of its planes in order to reduce unit costs. It's very unlikely that JetBlue will try to mimic ultra-low cost carriers with very tightly spaced rows -- doing so would destroy JetBlue's brand. However, it could add seats to its A320s while still offering better-than-average legroom.

Back in 2006-2007, JetBlue actually removed a row of seats from its A320s to reach the 150 seat configuration. FAA rules require at least one flight attendant for every 50 seats, so removing one row allowed JetBlue to drop from four flight attendants to just three. This savings more than offset the lost revenue. JetBlue has continually brought up this point when questioned about its seating density.

However, new "slim-line" seats allow airlines to put rows closer together without reducing legroom. JetBlue could potentially add two rows of seats to its A320s while only reducing seat pitch from 34" to 32", which would still be the most legroom in the industry. (Fellow discounter Southwest Airlines now has 31" of seat pitch in most rows.)

JetBlue could add 2 rows to its A320s while still providing plenty of legroom (Photo: JetBlue Airways)

Adding two rows would give JetBlue an extra 12 seats to sell. That should be enough revenue to offset the incremental cost of adding a flight attendant. Alternatively, JetBlue could reconfigure some of its A320s, while keeping some 150-seat A320s for use in markets where JetBlue's superior onboard product gets a significant revenue premium.

Other possibilities

Fare families, moving more decisively toward A321s, and adding rows to JetBlue's A320s are the most likely routes to margin and ROIC improvement at JetBlue. However, there are other possibilities.

For example, JetBlue is the only major U.S. airline with a no-overbooking policy. Overbooking allows airlines to capitalize on the probability that some passengers will cancel at the last minute or fail to show up.

JetBlue's management has vehemently opposed overbooking in the past, arguing that it's not customer-friendly. As a result, it's a long shot for JetBlue to change this policy. That said, through better data analysis techniques, airlines have reduced involuntary denied boardings to extremely low levels. Overbooking thus could generate a lot of incremental revenue without inconveniencing many customers.

JetBlue may also consider increasing other fees, particularly for flight changes. Today, JetBlue charges $75 for changes more than 60 days in advance and up to $150 for changes thereafter. That's less than most other U.S. airlines, though, creating another ancillary revenue opportunity.

A balancing act

JetBlue has built a stellar reputation over the past 15 years. Customer-friendly policies have helped it win 10 consecutive JD Power awards for customer satisfaction. On the flip side, it has lagged the rest of the industry in profitability and return on invested capital. Clearly, customers haven't been willing to pay enough of a premium for JetBlue's superior service.

That said, JetBlue's customer-friendly reputation is still one of its biggest assets. As a result, investors shouldn't expect to see JetBlue mimicking ultra-low cost carriers by squeezing passengers in like sardines or charging for carry-on bags and seat assignments. JetBlue's efforts to enhance its profit margin and ROIC are likely to be more incremental.

Two key initiatives already in the works are 1) introducing fare families, which will add a charge for the first checked bag at the lowest fare level; and 2) buying larger A321 aircraft, which are more efficient than JetBlue's other planes.

JetBlue may also add seats to some of its planes, change its overbooking policy, or tweak some of its existing fees. Whatever it changes, JetBlue should be careful not to alienate its loyal customer base. Keeping its core customers happy is just as essential to JetBlue's long-term success as any profit improvement initiative.