Privately held Virgin America has been ridiculed by many in the airline industry for its long streak of unprofitability. In its first five years after starting service in 2007, the company lost money every year and posted just one profitable quarter.
The main cause of Virgin America's recurring losses was its rapid expansion. However, last fall, it decided to change course by radically scaling back its growth plans. The company reduced its Airbus A320 order by 20 jets, and also deferred its A320 NEO order to begin in 2020 rather than 2016.
This strategy has been incredibly successful so far. The company reported its second-ever quarterly profit in Q2 of this year, improving net income by more than $40 million year over year. The company is likely to report Q3 earnings later this month, and all signs point to a similarly dramatic improvement in profit.
Refocusing the network
In 2013, Virgin America has taken a breather from growth, but it has still made significant schedule changes. Most notably, it secured its first slots at Newark Airport as part of the AMR (NASDAQOTH: AAMRQ) bankruptcy proceeding. This allowed it to start service from San Francisco and Los Angeles (Virgin America's two largest operational bases) to Newark, with three daily round-trips on each route.
Prior to Virgin America's entry, United Continental (NYSE:UAL) nearly monopolized the route to Los Angeles (with the exception of one daily flight on American), and United had a full monopoly on nonstop service from Newark to San Francisco. With only one serious competitor, Virgin America was able to quickly reach profitability on both routes despite a fare war instigated by United.
Virgin America also added a few other routes this year, including flights from Los Angeles to San Jose and Las Vegas, as well as a flight from San Francisco to Austin and a seasonal flight from San Francisco to Anchorage. The company also moved all of its Portland service to San Francisco, rather than also flying nonstop between Los Angeles and Portland.
All of Virgin America's new services in 2013 were accomplished through schedule reductions on other routes. Through the end of Q3, Virgin America's year-to-date capacity was actually down 2.5%.
Big unit revenue gains
Virgin America's newfound capacity discipline has led to big gains in unit revenue, as expected. The company's Q2 profit was driven by a 7.8% increase in unit revenue, and it achieved similarly strong unit revenue growth in Q3. Unit revenue grew 6.5%-7.5% in July, 8%-9% in August, and 11% in September. This implies an 8%-9% gain for the full quarter.
Virgin America's strong Q2 performance led to an 860-basis-point improvement in operating margin, from -1.2% to 7.4%. It is likely to post a similarly strong improvement in Q3, but it is starting from a much better base: In Q3 2012, its operating margin was 4.3%. Its Q3 operating margin is therefore likely to fall in the 12%-13% range.
For comparison purposes, this would be nearly double the 7% operating margin posted by United and better than Southwest Airlines' 10% operating margin, though still short of Delta Air Lines' 16% operating margin. (All of these figures exclude special items and integration costs.)
In other words, Virgin America has quickly gone from perennially unprofitable to middle of the pack within a profitable airline industry. That's just one year into its "growth slowdown" phase, and the company is likely to make further gains next year as its newer routes continue to mature.
Next step: IPO?
In one year, Virgin America has undergone an incredible transformation. At this time last year, it was a textbook example of everything Warren Buffett hates about the airline industry: rapidly growing, capital intensive, and unprofitable. Today -- assuming that Virgin's Q3 profit is as strong as I am projecting -- it is a solidly profitable, free cash flow-generating business.
Virgin America's rapid move to profitability sets the stage for a potential IPO in 2014. The IPO market has been very hot this year, and now that Virgin America has established that its business model is profitable, its owners have little reason to keep waiting. Airline investors should keep Virgin America on their radar screens as a potential investment opportunity, as it has a strong brand and good long-term-growth prospects.
Adam Levine-Weinberg is short shares of United Continental Holdings. 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.