The Future of Discount Flying

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Delta could give away $8 billion of free tickets in Spirit's markets Spirit's revenue is $4.9 billion. And so that's a lot of cash the big airlines have to compete against the low-cost airlines. And so that was part of the gripe of the low-cost airlines, by the way, is it's unfair competition. That's just the way it works. That's, that's, that's the way the world rolls these days.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Daniel McKenzie. He's an airline analyst at Seaport Research, and he's going to tell us about Spirit Airlines, which is suddenly gone, and what it means for JetBlue and Frontier, which are still definitely here, and the rest of the group. He'll touch on fuel prices and what's next for discount flying, and whether and how investors should take a flyer on airline shares. I want you to picture a middle-class family that does almost nothing but drive.

They travel from New York City to Los Angeles and back each week.

Horrifying, I know. I think I might have something like a 10-hour drive coming up in the middle of summer. It's youth basketball-y in nature, and for reasons that are too complicated to get into, I don't think I can fly it. I think I'm gonna have to drive. And it's gonna take me the next couple of months to just get emotionally prepared. But anyhow, picture this family coast to coast and back each week. Its gasoline bill, instead of taking up a typical 5% of a family's budget, could come in over 30%. And that is what it's like to keep an airline fueled under normal circumstances. Now consider that the price of jet fuel has outpaced even gasoline this year. It has more than doubled, and Spirit Airlines, you've probably heard, recently succumbed. Remaining airlines are scrambling to raise prices. Measuring changes in airfare seems like a complicated business to me. There's so many moving parts, but the Bureau of Labor Statistics does it. That's the group that measures the nation's inflation. They say airline fares in U.S. cities are up 15% year to date. That number only goes through March. Kayak, the travel booking site, they have numbers that run through the end of April and they say that fares are up 26%. Whatever it is, they're up a lot and they could jump more if you haven't yet booked your summer flights. The strongest airlines, Delta, United, and some of the rest that are doing their best impressions of these two now, could actually benefit from present turmoil and generate healthy shareholder returns for years. Let me make some quick observations about US airlines now and about the ultra-low-cost carrier model. First of all, fuel did not kill Spirit on its own. There were accessories to the act. These included labor shortages, engine problems, and the rise of basic economy fares from big players. Spirit's market share had already fallen for years. It's now likely to benefit Frontier Group and JetBlue Airways. Both of these, if you look at consensus forecasts, are nonetheless expected to burn cash this year and next, as they have since the start of the COVID-19 pandemic in 2020. And both are really moving beyond their low-cost routes. Frontier is adding something called First seats. It's a roomier 2x2 configuration in the first two rows. Sounds a lot like first class. JetBlue already has a lie-flat layout called Mint on certain cross-country and transatlantic flights. On other flights, it's now going to add more traditional first class seating. The industry nickname for that is Junior Mint. This is where Delta leads— paid premium seats on domestic flights. That's one of the industry's 3 biggest moneymakers, and Delta's quickly expanding in the second one, international flying. And it cleans up in the third, which is loyalty revenue, including from credit cards and retail partners and lounge memberships. And that is high-margin, non-flying income. United is similar. It leads in international, and it's growing from a strong position in domestic premium and loyalty. And each of those two companies is projected to generate close to $2 billion in free cash this year. That's a fraction of what they're capable of, but it's pretty good for a terrible year. American Airlines is trying to catch up. It's adding new planes with lie-flat seats on select routes, and it's expanding its credit card partnership with Citigroup, but progress could be slow. And expensive, not least because there's a decade-long backlog for new aircraft and American's on-time service rate typically lags those of Delta and United. Travelers of means might like lying flat, but they love getting there on time. Southwest Airlines isn't going first class just yet, but it has left behind its all-inclusive low-cost model. Since last year, it's added baggage fees and it ended a half century of open seating. Now charges more for extra legroom and preferred locations. Southwest's fans are grumbling, but the extra income could turn its free cash flow positive for the first time in years. It'll be a close call now that fuel prices have spiked. Alaska Air Group. I know that sounds niche to East Coast folks, but Alaska is suddenly a top 5 U.S. player after its 2024 buyout of Hawaiian Hawaiian Airlines. I should point out that number 5 is way, way smaller than numbers 1 through 4: American, Delta, United, and Southwest. The Hawaiian deal brings a key trans-Pacific hub and more long-haul flights with premium seats and airport lounges and a consolidated loyalty program. It moves Alaska from a cheap West Coast flyer to a more traditional carrier, if not quite a global one. The theme here, I suppose, is everyone is trying to look a little more like Delta and United. And it doesn't mean a permanent end to cheap flights, as we'll hear soon from Daniel at Seaport. But it does mean that the brashest experiments in cut-rate flying might subside, maybe for years, especially because there are shortages of pilots and airport slots and just about everything that these type of operations depend upon. It could turn airlines from an investment punchline to a good idea, at least some of them. It's arguably already happened for Delta and United. We'll come to that. This topic, what's next for cheap flights and airline shares, is the subject of a cover story I wrote this week in Barron's Magazine. Before we get to our guest, let me say a little more about one part of this, which is what exactly happened to Spirit. Suppose that I were an airline executive and I floated the idea of selling standing room flights. Imagine I said we should charge large passengers more and install coin-operated restrooms. You might call me insensitive, maybe even out of my mind, but there's an Irish airline executive named Michael Lewis who proposed just these things in the past. None of them were implemented, but the buzz they generated drew attention to his cause, and that might have been part of the point. In just over 30 years of running Ryanair, O'Leary transformed it from a small money-losing competitor to Aer Lingus to the largest airline in Europe by passenger count, and one whose profit margins dwarf those of flag carriers like Lufthansa and Air France-KLM. And Ryanair did this by posting extremely low base fares and charging for everything it can— checked bags, all but the smallest carry-ons, seat selection, and food and drinks. And today this type of airline is known as a ULCC, or ultra low cost carrier. To me, the words ultra and even low can be subjective. Airlines sometimes adjust their business models, and there could be disagreement over which are true ULCCs, but Not in Ryanair's case. Why can't this successful European airline model work in America? But hang on a second, because before transforming Ryanair, O'Leary made a careful study of Southwest and its no-frills, high-efficiency model that features a single aircraft type and point-to-point flying instead of hub and spoke. And quick plane turnarounds between flights. He then brought Southwest's model to Ireland in a much more extreme form, even a hard-edged one. Whereas Southwest took the ticker symbol LUV, L-U-V, and built a reputation for customer service with personality, Ryanair charged even for customer service calls and ticket printing. So I guess the question is, Why can't this American business model tweaked for Europe work in America? And the answer is, it did at first. Spirit was once a charter airline turned small scheduled carrier, and it took a private equity buyout and then transformed into a Ryanair-style ULCC and went public in 2011. It priced shares at $12 each. That was thanks in part to government COVID aid, but also to that post-pandemic revenge travel surge. Remember, we all left our bunkers filled with canned Spam and hoarded toilet paper and raced each other down to Orlando. But by then, major airlines having experimented with fun, cheap leisure brands— there was one from Delta called Song and from United called Ted— you might not remember. Those had been folded and by then these airlines had launched stripped-down basic economy fares. You've seen them, they're eye-catching for the price, but you don't get any bags or seat assignment. You have to stand on one leg while boarding and so on. Those fares were designed to compete with ULCCs and to fill planes with candidates for loyalty programs. That was one problem for Spirit. Another was that its labor costs jumped. Pilots, after many years of concessions, suddenly found themselves with bargaining power amid a pilot shortage. There were airport renovation projects that drove landing fees higher. Leisure travel became more price-sensitive as middle-class consumers got hit harder by inflation than wealthy ones. There was a Pratt Whitney engine problem that grounded 20% of Spirit's planes at one point, and it had a failed merger with Frontier and a disallowed buyout from JetBlue that distracted from operations. After two bankruptcies and a failed attempt to secure another government bailout, Spirit shut down. The biggest issue in hindsight might be that Spirit just couldn't get costs low enough. Airlines measure capacity using something called an available seat mile. That's one mile flown by one seat with or without buttocks.

Or is it a buttocks?

No, it's just buttocks. You have a buttock, you put two of them together, it's buttocks. The pluralization on that one always briefly confuses me. Anyhow, Ryanair's cost per available seat mile, or CASM, has historically been about 6 cents including fuel, and that's among the lowest globally. Spirit got down to 11 cents and struggled to stay there after COVID. And some of the differences between the two seem unavoidable. Ryanair flies shorter flights among different countries, allowing it to pack seats tighter and source labor where it is relatively cheap. It also uses more small airports which offer low fees and marketing support to lure traffic, and those airports can turn planes around quickly. I don't know if you can do the same thing quite as well in the U.S. Beyond Frontier, there are a bunch of smaller companies trying: Sun Country Airlines and Allegiant Travel Company, which are publicly traded, and Avelo, which is private. There's a group that represents them called the Association of Value Airlines, launched last year. It recently petitioned the government for a $2.5 billion pool that these carriers can tap to, quote, keep airfares affordable. TD Securities wrote in an investor note this past week, we expect Delta, United, and American to continue outperforming the ULCCs given many of the advantages are structural. It went on, capacity cuts by the ULCCs should result in a more rational domestic pricing environment, which in turn should help buoy full-service margins. By rational, it means we're all going to be paying more. And by margins, it means that airlines can profit. To learn more about all of this, I reached out to Daniel McKenzie. He's an airline analyst at Seaport Research. Let's hear part of our conversation now.

This to me feels like—

maybe I'm overstating things—

it feels like a farewell to cheap flights, meaning we have this thriving business in Europe, Ryanair, with the, this ultra low cost carrier model. And Spirit was the company that, that, that brought that to, uh, to America, the, the extreme version of it anyhow. And so you could buy these very cheap flights and you'd pay extra for, for anything else you wanted. And we have other companies that do that, but they're not making money now. And, and Spirit has now closed. And every airline that I can see seems to be doing their best Delta or United impression, in part. Like, maybe it's, maybe it's adding a little more premium or adding some, some more fees, what have you. So now, is that an overstatement? Is this— do you think that the industry in the U.S. is shifting toward, you know, a goodbye to the— eventually to these ultra-low initial fares?

Spirit absolutely had an impact on fares in the markets where it traveled, but profitable industry supply will find its way back into those— into those markets. And so I think what some in the media may have forgotten is that we still have Frontier Airlines. And I'll give you an example. Frontier, you know, so Spirit at Fort Lauderdale was, you know, call it 26%, 27% of the competition, or market share was 21.9%, 22% when it exited. But as it exited, I've seen Allegiant Air grow 27% year over year at Fort Lauderdale. I'm seeing Frontier Airlines grow 217%, doubling its size, seeing JetBlue grow 43% in the second quarter. And so it's really this sharp escalation in capacity in the second quarter here. United's growing 12%, American's growing 14% at Fort Lauderdale. So overall industry supply is down 15% at Fort Lauderdale. So yes, you're going to probably see— I would expect to see anyways— a bump up in fares in May and June. And I can tell you when I look at industry fare data, it takes a step up in the month of June. So leisure fare is up, call it mid-single digits in May, and when I look at June I'm seeing fares and talking leisure fares, that's back of the economy and that's Spirit's flying, yeah, kind of up in the 15% to 20% range. A lot of that is being driven by a number of initiatives, but the other thing to remember is that as the industry adds back the supply, it's increasing the volume and it is a price times volume game in the airline industry. And as that volume continues to backfill Spirit's lost flying, you're going to see those ticket prices come back down. The other thing that's going on just in terms of pricing is you've got oil prices that have doubled for the second quarter. So the industry had passed along half a dozen fare increases. And so the industry is really struggling, really grappling with a lot of things. So seeing some of these fare increases that I'm seeing in June is really just the industry trying to take back their income statement. That's it.

The market share that Spirit gives up, does that go chiefly to Frontier and JetBlue? And is it, um, is it enough? These are companies that, to my eye, it looks like they've burned cash since the pandemic. Is, is this enough to really, um, to move the needle for them or maybe even restore them to generating positive free cash?

Yeah, so those are the two airlines that are probably the most controversial in my space. You've got 29% short interest in, in Frontier. You've got 22% short interest in JetBlue, that's all. And part of that short interest in JetBlue just ties to a convert deal. And there's some mechanics, there's sort of technical mechanics that govern that short interest for that particular name. But these are controversial names, controversial stocks for the reasons you just listed. JetBlue has added $9 billion, over $9 billion in gross debt since the outbreak of the pandemic in 2020. And it's not gotten back to profitability. And so I am the only buy on this name. And I just conceded, things have to work in my favor for this buy to work. But I'm forecasting JetBlue generates $500 million in free cash flow in 2027, gets to a profit of $0.70 in '27. Street's modeling a loss of $0.50. Part of that '27 EPS for me is fuel prices that come back and normalize. And part of it is this revenue shift from Spirit. And so when you ask if this revenue comes cheaply, it does, but I can tell you this industry is brutally competitive. I don't mean to give the impression that this is not a competitive industry. It's brutally competitive. And so in terms of JetBlue, things have to go right. And at least from my perspective, what I was telling my sales force this morning is it just Based on what we're seeing in the media with respect to the Iran war, it just sort of seems like we're getting kind of closer to the end of some of this macro volatility than we are towards the beginning. And so to the extent that we have visibility and a line of sight on Iran war eventually subsiding here, going away, that's when I would expect my thesis to come and resonate a little bit more strongly with investors.

Thank you, Daniel.

We'll be back with more of my conversation. The fasten seatbelt light is off. Go ahead and stretch your legs during this quick break.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data. —so you have the right ingredients to help you shine. Morningstar—where data speaks.

Welcome back. You might have heard airlines referred to as cash incinerators or fixed-cost disasters with wings. If you want to make a small fortune in airlines, you might have heard someone say at one point, start with a large one. The industry has long been a Wall Street punchline, and deservedly so. Just count the bankruptcy filings: United in 2002, Delta 2005, American 2011, US Airways twice before merging into American. No wonder Warren Buffett famously expounded on a capital preservation plan involving time travel, murder, and one of the Wright brothers. This year the group is understandably trailing behind the S&P 500 index, but over the past 3 years Delta and United have nonetheless made 123% apiece versus 85% for the index. Is that a fluke or is it a sign of where things are headed after fuel costs subside? Maybe the latter. Delta traded recently at 13.6 times this year's humbled earnings forecast, and it has a credible path to doubling earnings per share over the next 3 years. The same goes for United at 10.9 times earnings and Southwest at 16.6 times earnings. The rest, you definitely have to be bolder to take a chance on. Daniel at Seaport has thoughts on that. Let's get back to my conversation with him now.

You're buy-rated on JetBlue and your forecasts for next year, for 2027, are above— it sounds like, you know, a fair bit above the Street. So that's an interesting view. What are your other buy ratings across airlines?

So I have buy ratings on most of the airlines: American, Alaska, Delta, United, Allegiant, even Southwest, Frontier, Airbus here is my only neutral-rated stock. And, you know, but what I've argued, you know, I just tell investors, look, I hate these stocks near term. We have to have line of sight, a credible, not a social media post, a credible line of sight to the war in Iran ending. So hate these stocks near term, love these stocks over the coming year. I was telling my sales force this morning that in my opinion, airline stocks are investible, especially Delta, Southwest, both investment-grade rated. And when I look at American, it's a large beneficiary, the largest beneficiary on an absolute dollar basis, just because it overlaps 61% of Spirit's routes from Spirit exiting. And then JetBlue, Frontier, large relative winners.

Tell me a little more about the structural change. What do airline stocks look like from here? I started saying that, you know, a couple of these companies like, like maybe Delta, for example, starts to look to me— I saw a consensus forecast for this year for generating free cash of $2 billion, and that's down by half or more from what the forecast once was. But it's pretty darn good for a terrible year. And that to me starts to look like a blue-chip airline. And then I said, wait a second, blue-chip airline. Those are not three words that I'm used to putting together. What is this new thing called a blue-chip airline? Is it— are we entering a period where airlines can go from, you know, let's face it, at one point investment punchlines, a Warren Buffett favorite punchline, to being things that can reliably be counted on to generate investor returns for the long term? Or is that a leap too far?

No, I would argue Delta is an accelerating return of capital story on free cash flow before the Iran war. It's an accelerating return of capital or return of cash story after the Iran War. It is one airline where I left my full-year outlook unchanged, $5.25 this year. And yeah, I'm actually at $2.9 billion in free cash flow this year for Delta. I'm at an 8% operating margin, which is a healthy, respectable margin in this kind of environment. And what makes Delta What makes Southwest, United, and American different than, say, 10 years ago is a consolidation. And the reason why consolidation— the reason the industry is structurally different today is because you have a more efficient allocation of supply. And greater efficiency at the industry level results in greater economics at the industry level. So efficiency and economics are two things that go hand in hand. And in the case of In the case of Delta, the other thing that's really unique about it is just the loyalty programs have grown so exponentially over the past decade, contributing roughly $8 billion a year in cash for Delta. That's $8 billion you didn't have. Delta could give away $8 billion of free tickets in Spirit's markets. Spirit's revenue is $4.9 billion. So that's a lot of cash the big airlines have to compete against the low-cost airlines. So that was part of the gripe of the low-cost airlines, by the way, is it's unfair competition. That's just the way it works. That's, that's, that's the way the world rolls these days.

If I asked you for your favorite one or two of these names right now, and bearing in mind that, of course, like any analyst, you have to take into consideration not just how well the company is doing, but what's the price and what's the, you know, what's the potential for investor returns.

What would you say are your one or two favorite names in the group right now?

I actually would take a portfolio approach, and I love Delta. It's probably the more expensive of the stocks. It's higher quality, as you, as you, you know, pointed out, trading at 8.8 times my 27 EPS. It's trading at 5.6 times enterprise value EBITDA. But if I want to swing for the fence— and by the way, United is trading at 6.7 times. And this is a stock that I've argued at $98.50 is ultimately worth $150 on earnings of $15 a share normalized at some point. In the case of American, it's one of the cheapest. If you're OK with a little bit more volatility, it's This is an airline that's got a lot more debt. It's a far more controversial name trading at 4 times my 27 EPS. So it's trading at half the valuation of Delta today, 5 times enterprise VAT EBITDA. So its screens are a little bit richer than that. And if you have to go down to a small-cap airline, the stock that is really high quality on the other side of this at $40.34 is Alaska Airlines. It's a $4.6 billion market cap. It's a little bit smaller, but it's trading at 4.5 times my 27 EPS. The challenge for Alaska is just that it's exposed to West Coast oil. And that West Coast oil is held hostage by the supply disruption in Asia. So oil coming in from Singapore. So Alaska's paying 50 cents or more a gallon for jet fuel versus all the competitors. Yet it has to price at the same— so same price, same ticket prices as the rest industry, but paying $0.50 more a gallon. And until oil price, till that supply chain normalizes, yeah, Alaska is going to be probably trade poorly here in the near term. Love it one year out.

Let me just circle back to something we started on, and that is the future of the ULCC, which is— which stands in the industry for ultra low cost carrier. And I'm sometimes a little bit uncertain about which airline is which because ultra is subjective and low is even subjective.

I know that Ryanair is one.

I know that Spirit was one. And I'm pretty sure that Frontier still is one, not least because it uses ULCC as its ticker symbol, which makes it easy. But businesses looking at the experience of Spirit, are they going to be less likely to want to go as bare bones? In other words, is there something about that that says that that didn't quite work out? I noticed that Frontier is adding some, some premium service levels. Is it going to move at some point out of ULCC into just LCC or something like that? What's the future of the ULCC model in America?

Yeah, that's a great question. You're going to still see— there's still going to be a ULCC presence, uh, as it stands today from where I sit. It's just not going to be as big not as fast a growing a segment as it once was. So instead of growing at 15% a year, it probably grows much, much slower at 10%, and it's off of a lower base given the exit of Spirit Airlines. But keep in mind, you don't have to have— and this is maybe a misnomer— you don't have to have a ULCC to have a low fare. All you need to have is 3 to 5 airlines sitting on top of each other in a market that they all love and they all want to own. And I'll give you an example. New York Metro to Miami Metro. And, you know, you've got, you know, 5 major competitors in there. You've got JetBlue, you've got American, you got United, you've got Delta. You did have Spirit. But, you know, those are markets when you've got 3 to 5 airlines going at it, you're still going to find those low fares offered by ULCCs. You may not find as many in volume as you saw before.

This was most interesting for me, most helpful.

Is there anything I've neglected to ask you on this subject of where things stand for the airline industry, where we're headed, that you think is important for investors to know, or you think we have the basics covered here?

You know what, the one thing we haven't talked about is merchandising. And the airlines are getting really, really sophisticated. And from their perspective, the data centers can't be built fast enough. And so what's happened is that any point in time you've got 20 million fare changes a day, you've got millions of data points, you've got millions, billions of people shopping, and the airlines need these data centers to tie all of this data together in an accurate, uniform way to present as an offer to customers. And so one thing that is another misnomer, by the way, airlines can't price based on you, your cookies. They just don't have the technology to do that One, two, it's illegal. They're not going to do that, but they do price based on the broader demand trends.

You mean I don't have to go to an internet cafe and wear a bag over my head before searching for flight prices? That's good to know. All right.

Continue. You're in the clear. You're in the clear. But the punchline is, as the airline brings together, as the industry brings together these disparate data points to become more sophisticated in the pricing, it's worth more revenue. It's, you know, I've quantified it at 20% revenue upside. So 20% revenue just from being smarter in how you look at the data, how you look at demand, how you forecast demand. The way that you're seeing that is in the form of bundles. And, you know, you may want to be able to change your ticket that day and they'll throw that into the bundle and and charge you a premium for that. And it's just being able to offer what the customers want, being a little bit more sophisticated on your product offer, that allows them to capture more revenue.

Super helpful, Daniel. Thanks so much. It was great speaking with you.

It's a pleasure, Jack.

You have a great day. I definitely see what Daniel means by the bundles, and it's not just airlines. My kids bought my wife a high-end juicer for Mother's Day. And by my kids, I mean me. And by high-end juicer, I mean a preposterously overpriced machine for turning preposterously overpriced produce into liquid. And at checkout, there was an $8 option for box protection. Anybody know what box protection means? Like, if you want to return it but you tore into the box too eagerly because you were really excited about juicing, then they'll cover the box fees. I don't know, I skipped it. We're living dangerously. Thank you all for listening. If you have a question you'd like played and answered on the podcast, you can send it in. It could be on a future episode. Just use the voice memo app and send it to jack.hough— that's H-O-U-G-H— at barons.com. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, you can write us a review. Remember, we don't charge for box protection like some of those other podcasts. See you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data. So you have the right ingredients to help you shine. Morningstar, where data speaks.