For a company that's not making money, growing at a rapid pace is usually a bad idea, especially if that growth requires substantial capital investments. That was essentially the lesson learned by Virgin America -- the youngest passenger airline in the U.S. -- in the last few years. As a result, the company decided in late 2012 to reduce its growth rate and focus on profitability.
This new strategy has worked like a charm. Virgin America actually cut its capacity by 2.2% last year by dropping underperforming flights while adding more promising routes such as nonstop flights from San Francisco and Los Angeles to United Continental's (UAL 1.08%) stronghold in Newark. This led to a massive jump in Virgin America's operating margin.
Ending the rapid growth days
Between Q3 2010 and Q3 2012, Virgin America expanded its capacity by a stunning 73%. In November 2012, the carrier announced that this growth spurt had allowed it to reach sufficient scale. Accordingly, Virgin America decided to reduce its annual growth rate to the mid single-digit range (on average) by canceling and deferring numerous orders for Airbus aircraft.
Virgin America only took delivery of a single airplane last year, and its next delivery is not scheduled until the second half of 2015. In the meantime, Virgin America is fine-tuning its capacity by tweaking airplane utilization. By decreasing utilization last year, the carrier was able to reduce capacity despite having an extra plane in its fleet. This year, Virgin America is on pace to grow modestly despite not having additional aircraft.
Calling a halt to its rapid capacity growth drove a stunningly fast rise in Virgin America's profitability. In 2012, Virgin America posted an operating loss of $31.7 million, representing a -2.2% operating margin. By contrast, the company generated operating income of $80.9 million in 2013: good for a 5.7% operating margin.
This 790 basis point operating margin increase far outstripped improvements at Virgin America's larger competitors. United Continental improved its adjusted operating margin by less than 100 basis points last year: from 3.7% to 4.6%. Delta Air Lines (DAL 0.64%) performed better, boosting its adjusted operating margin by 290 basis points in 2013, from 7.2% to 10.1%.
Southwest Airlines (LUV 0.49%) posted a similar performance, raising its adjusted operating margin by about 300 basis points, from 4.7% to 7.7%. Even with the benefit of a bankruptcy restructuring, American Airlines (AAL 0.58%) only increased its adjusted operating margin from 3.7% to 8.1%: about 440 basis points.
Catching up to its rivals
While Virgin America leapfrogged United Continental in terms of margin performance last year, it still lags the other three major carriers. However, the company is likely to close much of that gap this year. Virgin America got off to a rough start in 2013, with a $15.0 million operating loss in Q1 -- although that was still a big improvement from the dreadful $48.6 million operating loss it posted in Q1 of 2012.
Virgin America may be on pace to post its first-ever Q1 operating profit this quarter. Through the end of February, traffic was up 7.7% on a 3.2% capacity increase, driving the carrier's load factor up from 73.4% to 76.6%. (However, the carrier does not report yields or unit revenue on a monthly basis.) March passenger demand may be weaker because of the shift of Easter into late April, but any weakness should be made up in April.
Looking ahead, Virgin America will benefit from its new slots at Washington's Reagan Airport and New York's LaGuardia Airport, particularly if it can also acquire gate space at Dallas Love Field.
All three airports would be good fits for Virgin America's business traveler-friendly service because they are close to their respective city centers. The carrier will be able to operate these new routes with capacity pulled from underperforming routes, such as San Jose-Los Angeles, where Virgin America is ending service in May after about a year.
Foolish bottom line
Not too long ago, many airline industry experts doubted Virgin America's long-term viability because of the company's history of losses. Those days seem to be gone for good after the company finally committed to a slower growth rate. This allowed it to generate a stunning 7.9 percentage point operating margin increase last year.
Virgin America is well-positioned to improve its operating margin once again this year. This puts it in a much stronger position to start growing faster again in the second half of 2015, when new A320s will be arriving. It will also smooth the way for a potential IPO as soon as this fall.