I had the pleasure of chatting with Virgin America (NASDAQ:VA) CEO David Cush and CFO Peter Hunt last week on the occasion of Virgin America's IPO. One of the most interesting comments that Cush made was in response to a question about Virgin America's ability to keep its costs low going forward:
... So I think one of the big things investors worry about with young airlines is that as they get older, there's just inevitable cost creep. What do you think are the biggest potential challenges you might face in the next few years with cost inflation, and what are the kind of levers that you can pull to offset that?
... I think the key thing in terms of our cost structure is our simple production model. As long as we don't deviate from that, we can control our costs long-term, and I think where other carriers have gotten in trouble is they deviate from it.
Cush's comment appears to be a dig at JetBlue Airways (NASDAQ:JBLU). In its early years, JetBlue was one of the low-cost leaders in the U.S. airline industry. However, by getting away from the simple strategy of its first few years, it has encountered severe cost pressure that has cut into its profit margins.
JetBlue's big mistake
JetBlue's troubles can be traced to its decision to become the launch customer for Embraer's 100-seat E-190 aircraft. JetBlue ordered the E-190 in June, 2003 in order to serve mid-sized markets, and began its first flights with the E-190 in November, 2005.
As a smaller aircraft, the E-190 was certain to have higher unit costs than the A320s that represent the majority of JetBlue's fleet. However, the E-190s have also had much higher than expected maintenance costs. Moreover, adding a second aircraft type increased JetBlue's operational complexity.
The introduction of the E-190 therefore began a sharp escalation in JetBlue's unit costs. In 2005, JetBlue's non-fuel cost per available seat mile was $0.0492. By contrast, through the first three quarters of 2014, JetBlue's non-fuel cost per available seat mile was $0.0759.
Thus, JetBlue's non-fuel unit costs have risen by 54% since 2005, a 5% compound annual growth rate. JetBlue's fuel efficiency has also declined over that period. In 2005, it averaged 78.2 available seat miles (or ASMs) per gallon. Year-to-date, JetBlue has only averaged 70.4 ASMs per gallon. This 10% reduction in fuel efficiency has been particularly painful because fuel prices have risen significantly in the last decade.
Learning from a competitor's mistakes
JetBlue has tried to address its cost creep with a fleet restructuring plan announced in late 2013. The carrier deferred all further E-190 orders until 2020 and thereafter, while increasing its orders for the significantly larger and more fuel-efficient Airbus A321. Even with this move, JetBlue may be unable to do better than keeping non-fuel unit costs flat for the next few years.
Virgin America CEO David Cush wants to avoid this problem in the first place. Today, Virgin America operates 43 Airbus A320s and 10 A319s. These planes are part of the same aircraft family, meaning that they have more or less the same components and can be flown by the same crews.
While Virgin America might at some point add the A321 -- a larger model from the same A320 aircraft family -- to its fleet, it's not going to deviate from its single fleet-type strategy.
Virgin America CFO Peter Hunt also pointed to the company's use of outsourcing as another way that Virgin America avoids complexity and keeps its costs down. Virgin America has $1.48 billion of revenue over the last four quarters and about 2,800 employees. That's about $528,000 in revenue per employee.
By contrast, JetBlue has revenue of $5.74 billion over the last four quarters, and 13,225 employees. This works out to around $434,000 in revenue per employee. JetBlue should have economies of scale from being nearly four times the size of Virgin America, but instead Virgin America is more efficient in its usage of full-time labor.
A story to watch
Virgin America and JetBlue are outliers in the low-cost carrier space. Unlike most of their peers, they strive to create a premium on-board experience, and they don't pack passengers in like sardines.
JetBlue is working hard to halt or even reverse its recent cost inflation trend in order to boost its margins. Meanwhile, Virgin America will need to proactively manage its costs in order to avoid the rapid cost inflation that JetBlue and many other airlines have faced in recent years. For both airlines, containing costs will be critical for delivering strong returns for investors.