On Oct. 1, Republic Airways (NASDAQOTH:RJETQ) announced that it had reached a tentative agreement to sell its Frontier Airlines subsidiary to private equity firm Indigo Partners. However, observers couldn't be sure that the sale would actually go through, as the agreement was contingent on reaching new agreements with disgruntled labor groups.
This week, Republic and Indigo finally cleared the last major hurdles standing in the way of the sale. Within a month or so, Indigo Partners -- led by Chairman William Franke -- will have the opportunity to start remaking Frontier in the image of Spirit Airlines (NASDAQ:SAVE). As Frontier becomes a full-fledged ultra-low cost carrier, customers should expect lower prices, but higher fees and more cramped seating in the future.
A new project
Under Franke's leadership, Indigo Partners has invested in a variety of airlines across the world, with a focus on the ultra-low cost carrier model. Indigo was one of the major investors in Spirit Airlines at the time of its IPO in 2011, and was the driving force behind Spirit's move to the ULCC model. Indigo only exited the Spirit investment this year when a bigger opportunity came along: Frontier.
Whereas Spirit's strong record of profitability since its IPO has driven its market cap to more than $3 billion, Indigo was able to snap up Frontier for around $145 million, including assumed debt. That's a pretty impressive discount, considering that Frontier is fairly comparable in size to Spirit.
The discrepancy in valuation is almost entirely the result of Frontier's higher cost structure. In 2012, Spirit had a cost per available seat-mile, or unit cost, of $0.1009, while Frontier's unit cost was $0.1179. Spirit's cost advantage more than made up for Frontier's slightly higher unit revenue, and allowed Spirit to earn 7 times as much pre-tax profit as Frontier, with less revenue!
To fix these cost issues, I expect Frontier to shift its fleet decisively toward larger aircraft like the Airbus A320 and A321, rather than the A319 that currently makes up around two-thirds of Frontier's fleet. Frontier is also likely to squeeze extra rows of seats onto its airplanes to reduce unit costs: Spirit's planes tend to have one to two extra rows of seating compared to the same model at Frontier.
Frontier also has room to improve its unit costs by boosting fleet utilization. Last year, Spirit's planes were flying for an average of 12.9 hours per day, while Frontier's planes flew just 11.0 hours per day. Airplanes are expensive assets, and spreading those fixed costs over more flights is crucial for cutting costs.
Spirit has also pioneered the concept of incentivizing "low cost" behavior among passengers through its fee structure. Spirit's carry-on bag fee incentivizes more passengers to check bags, which reduces boarding and deplaning times, which is a major factor enabling its exceptionally high aircraft utilization. Frontier currently has a complicated fee structure where it has a carry-on bag charge, but it is waived for customers who book directly through Frontier's website. I wouldn't be surprised to see Frontier start charging all passengers for carry-on bags soon.
A new era of growth
Republic Airways executives are clearly relieved to have Frontier leaving the fold. CEO Bryan Bedford stated on the company's earnings call that he believes the separation is the best thing for both companies. Indigo has expertise in the ULCC segment that should allow it to succeed in making Frontier's cost structure competitive.
Moreover, Indigo has the resources to finance a return to growth at Frontier (which can also help reduce unit costs). Frontier has an order for 80 next-generation Airbus aircraft on the books, which allows for significant growth starting in a few years.
Once Indigo gets Frontier's cost structure in reasonable shape, the company is likely to start adding routes at a breakneck pace, just as Spirit has done in recent years. This will bring cheap airline service to numerous routes where it does not exist today. Thus, in addition to being good for Republic and Indigo, the Frontier sale should ultimately be good for the flying public.
Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. 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 don't 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.