Who Needs Airline Seat Pockets?

It's the $64 million question: How much is a window blind worth?

Tuesday, I looked at just what makes JetBlue (NASDAQ:JBLU) tick from a business-model perspective. Today, we'll look at the financials and try to determine what makes its better-established brethren tick.

Ryanair (NASDAQ:RYAAY) is the 800-pound gorilla in the European market, with net profit margins at more than 20%, and is rapidly growing, with earnings up 18% so far this year. Given that most U.S. carriers would love to simply have the earnings to go into a P/E, Ryanair is the class of the airline industry, period. Because it has succeeded where so many have tried and failed, a relevant question is, how the heck is it doing it?

Answer: Outsourcing everything not nailed down, the luck of the Irish, and giving away free tickets in exchange for the opportunity to sell you lottery tickets while you're flying. I should clarify: It did outsource quite a few things nailed down -- by ordering a fleet of Boeing aircraft without "luxuries" such as reclining seats, Velcro headrests, window blinds, and seat pockets. Sound a bit crazy? You bet! The numbers:

**RYAAY available seat mile figures, stage length, aircraft utilization, and related operational metrics come from data in the Form 20-F filed with the Securities and Exchange Commission and released March 2005 and revenue/cost figures are for the trailing 12 months. The load factor is based on the most recently ended fiscal year.

Revenue per available seat mile (RASM) equals operating revenue per available seat mile; cost per seat mile (CASM) equals operating costs per available seat mile, and stage length equals the average length of a flight.

As far as clear differences between the business models, a few things stand out: Ryanair has outsourced much of its labor costs (think ticketing agents in airports, etc.) to third-party companies, and because of luck, has a 9.9% tax rate per the Irish government. The outsourcing contributes to its incredibly low number of 29 employees per aircraft, versus JetBlue's 95 and Southwest's (NYSE:LUV) 75.

Another number that stands out is Ryanair's aircraft utilization, which is much lower than JetBlue's because of Ryanair's shorter stage lengths, which means more time on the ground picking up new passengers. It would be very interesting to see if revenue per available seat mile begins to increase (and how much Ryanair can push it up) as gambling is introduced; the more people on a plane and gambling, presumably the more money the airline makes.

Keep in mind that the Irish tax rate of 9.9% offers another 20 points of margin advantage over JetBlue that drops straight to the bottom line. While JetBlue's low revenue per available seat mile is cause for concern, keep in mind that its costs, or cost per available seat mile, has been driven by fuel so far. Until recently, the RASM/CASM spread was enough to keep the passengers flying and the company profitable.

Losing your shirt over the Alps
Gambling is a key area for growth at Ryanair. The company derives about 13% to 14% of revenues from services such as in-flight lotteries and luggage fees, and this enables it to offer about 25% of its flights for free. Ryanair CEO Michael O'Leary has mentioned that by introducing gambling games like poker and blackjack on the company's website and on flights, it would like to eventually offer 50% to 100% of its flights for free. The company is placing a considerable bet that passengers want to be entertained. If the move is not successful, would the airline be able to raise its prices or find new services, or both, to keep customers flying? In a hugely competitive atmosphere where ticket prices may be irrationally low, it could quickly spell disaster for the airline.

However, Ryanair's experimentation means that JetBlue would do well to consider additional revenue opportunities outside of the now fairly standard airline add-ons, such as vacation getaways and the American Express-branded credit card. By focusing on adding high-margin service extras such as a wine sommelier (which JetBlue recently did), not only does JetBlue raise profit margins, but it also extends and strengthens its competitive advantage. While prices can be duplicated easily, offering unique services can be extremely difficult to copy. Unfortunately, these services cost money to launch and involve a certain degree of experimentation and risk-taking, and with JetBlue forecast to have losses for the foreseeable future, its experiment budget might just be tapped out.

Good, bad, and ugly: This is just ugly
JetBlue recently reported a full-year loss for 2005 of $20.3 million, and forecast more of the same for 2006. This was primarily driven by fuel costs that were up 50% year over year. Given the company's highly leveraged balance sheet -- almost $3 billion in debt -- this presents a challenging operating environment. The end result of these losses is that CEO David Neeleman needs to find a way to raise revenues or lower costs. Neeleman has few structural costs to cut at his company, so he is focusing on raising prices by $5 to $10 a ticket.

When we consider that the airline business is quite cyclical, does this mean it is time to buy? After all, investors often get outstanding returns from buying cyclical stocks when earnings are in the proverbial trough. In this case, though, this analyst advises caution. Fuel costs are causing an industrywide problem, but with JetBlue, we have several operational challenges that are only now rearing their heads as the airline ages.

• The introduction of the Embraer 190: JetBlue plans to double the size of its fleet in the next few years, while at the same time being a launch customer for the plane. The company initially is targeting the business traveler on smaller, regional routes, blurring the distinction between a traditional airline carrier and a regional one. Operational costs are expected to increase about a penny per available seat mile on these new routes; however, the company expects this to be offset by higher fares that would still be substantially cheaper than "high cost" regional competitors. (Sound familiar?) The tremendous opportunity here lies in being able to better match expected demand with plane size, and expanding into another profitable stronghold of legacy carriers. But it's not known whether JetBlue can actually execute the ambitious plan and find profitable routes.
  
  
• Maintenance: As its airplanes come off their initial five-year warranty periods and start to show their age, increased repair costs will hit the company where it counts -- on the bottom line.
  
  
• Employee satisfaction: With employees being compensated rather heavily with stock options and profit-sharing and the stock in the doldrums, how will this affect customer satisfaction, hiring, and employee retention? Recently, JetBlue's on-time performance fell to last place in the industry, and little tricks like extending the flight length to compensate for unhappy employees are not a particularly effective long-term Band-Aid.

Can JetBlue actually survive its grandiose plans? Based on firm orders, the company is growing like gangbusters and plans to expand its capacity 250% in the next five years, compared with Southwest's measly 25%. Neeleman seems to be betting that in a U.S. market beset by overcapacity, the company can continue to fill its flights, and presumably steal passengers from other carriers to do so. The crux of the issue can be summarized simply: Is the JetBlue flight experience that much better than the rest of the industry, and will that be enough to drive demand on these proposed new routes?

For these reasons, it is difficult to see a positive catalyst for JetBlue in the future, and investors should be wary. However, if JetBlue can make its way through the industry's current fog, the stock might become a darling of the sector again. That's a tall order for any company, let alone one with expectations as high as JetBlue's.

Fool contributor Stephen Ellis owns shares of JetBlue, a Motley Fool Stock Advisor pick. He can be reached at [email protected] and appreciates feedback. The Motley Fool has a high-flying disclosure policy.