In the first part of this series, we discussed how Spirit Airlines (NASDAQ:SAVE) is taking the idea of a discount airline to the next level. In creating the ultra-discount category, Spirit is trying to break into the air travel market like discount carriers Southwest Airlines and WestJet Airlines did in their respective markets of the U.S. and Canada. With big growth plans from Spirit, should major full-service carriers be worried?
Due to the highly commoditized nature of the airline industry, capacity has become a four-letter word. Airline investors will recall years past where airlines waged market share wars through price cuts and capacity increases led to financial issues at all major carriers.
The modern bull thesis for airline investing rests on the idea that the reduced number of competitors and better management of capacity will allow airlines to raise fares enough to ensure their financial viability and generate a profit for investors.
In the last few years, we have seen airline profits rise and the number of legacy carriers fall from six to four (and possibly to three if the latest airline merger is approved). It seems trends are working in the legacy carriers' favor. But does Spirit Airlines pose a threat to this stability?
Travelers frequently see airline seats as a commodity, where a low price trumps all. If a traveler finds a $200 ticket and a $250 one, the natural tendency among travelers without any carrier allegiance is to opt for the lower price. Spirit Airlines is hoping to capitalize on this thinking in undercutting current airfares while passengers believe all seats are the same.
You get what you pay for
Airline margins are known as some of the thinnest in existence so if Spirit is going to sell tickets at a significant discount, it has to find ways to cut costs. Southwest was able to lower prices by using less popular airports (where fees are lower) and WestJet was able to pay its employees less than legacy giant Air Canada.
But as an ultra discounter, Spirit needs additional cost cuts. Packing seats tightly into planes ensures more passengers per plane and therefore lower costs per passenger. However, not all of the ultra discounting must be made up for with cost cuts. Spirit is also famous for fees that include everything from printed boarding pass fees, to fees for basic snacks, to the infamous carry-on bag fees that can run up to $100 for passengers who do not pay ahead of time. Not too surprisingly, Consumer Reports ranked Spirit as the worst airline in its 2013 review of airlines.
De-commoditizing airline seats
Airlines are now working hard to differentiate their seats from those of their competitors. American Airlines, a subsidiary of AMR (NASDAQOTH:AAMRQ), made big news when it unveiled its new Boeing 777-300ER. Being the first U.S.-based airline to fly the plane, American went all out creating first class seats (or should I say suites) with electronically controlled visors, swivel seats, and even an ottoman for guests.
Meanwhile, Delta Air Lines (NYSE:DAL) is joining the trend of flatbed seating in planes, creating seats that all have direct aisle access and a personal entertainment system. American Airlines seems to be getting more attention than Delta or most other carriers for its redesigned aircraft interiors, with this likely being due to American's companywide rebranding effort as it tries to emerge from bankruptcy and merge with US Airways.
In comparison to these seats offered by American and Delta, Spirit's seats appear tiny by comparison. That's because even when they're compared to American and Delta's ordinary economy seats, Spirit's offer the least seat pitch (distance between a point on one seat to an identical point on the seat in front, also known as knee-crunch) coming in at a mere 28 inches on some flights compared to the industry norm of 31 to 32 inches.
In the process of shrinking this seat pitch, Spirit creates a new cheaper airline product. Indeed, some Spirit officials say that the airline is targeting people who would otherwise not fly at all. In this way, Spirit is not just taking from the air travel market -- it's expanding it.
Different products for different customers
Spirit's move into the airline industry highlights an industrywide effort to de-commoditize air travel offerings. If carriers can offer their own more unique products, it could help to build customer loyalty in a way a highly commoditized industry never could. In regards to Spirit, the ultra discounter may steal away some of the lowest-paying passengers but many of these people would not have been able to buy an airline ticket without Spirit. And based on Spirit's ultra-discount model, I do not see the carrier posing any reasonable threat to take the high-priced business travel that drives the profits of legacy carriers.
Overall, I remain bullish on legacy carriers while seeing Spirit as a new type of airline worthy of investment consideration as it tries to expand the U.S. air travel market.
2 airlines shaking up the industry
Alexander MacLennan owns shares of Air Canada, AMR, Delta Air Lines, and Gol Linhas. He is also long the following options: $22 January 2015 Delta calls, $25 January 2015 Delta calls, $30 January 2015 Delta calls, $17 January 2015 US Airways calls. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.