Fee Spirit

How would Spirit Airlines president and CEO Ben Baldanza ideally price airline tickets? “I’d love to have a world someday where you [the passenger] pay for your [share of] fuel and everything else is an option,” he said, explaining that US airline passengers now generally pay about one-third of their total cost for fuel, one-third for the base ticket price and one-third for ancillary charges.

“I’m not going to be [Ryanair CEO] Michael O’Leary and say, ‘We can get that [core] fare down to zero.’ But we can lower that further by making it more and more optional,” he said, adding that everything other than fuel being optional “is probably not realistic. But right now, two-thirds is the [non-optional] and one-third is optional. If we can switch that ratio, I think that would be great for consumers.”

Such nontraditional thinking has guided Ft. Lauderdale, Fla.-based Spirit since 2006, when Baldanza, who had held senior positions at US Airways and Grupo TACA, took over as CEO. Spirit in 2007 became the first US airline to begin unbundling fares to offer á la carte pricing, imposing fees for nearly all services including checked baggage, following in the footsteps of European carriers Flybe, Ryanair, Aer Lingus and Norwegian.

“Basically, we made the decision back in 2006 that we were going to compete for customers on the basis of price and price alone,” Baldanza said. “Once we made that decision, it became a little bit easier to do things. If we want to have the lowest price, why would we put fewer seats on the plane? And then we said, ‘Why would we charge people for things that they may not want or need?’ So this led to a process where we looked at all parts of the airline product, both traditional and what we offered, and said, ‘Where are the points where we can separate this out from the base fare, charge an incremental fee to those people who want it and lower the fare for those who don’t?’ And that’s what we’ve done.”

Spirit—which began life in 1980 as Detroit-based Charter One—has gained a reputation in recent years, fairly or not, for “nickel and diming” passengers, but Baldanza strongly insisted that the airline’s customers are the biggest beneficiaries of its “ultra-low cost” business model.

“In 2006, we competed as a traditional airline,” he said. “The average fare we charged customers was $104 and the extras that we sold—change fees, excess baggage weight fees, liquor on board,things that airlines were [traditionally] charging for—amounted to about $5 [per passenger on average]. So the total price was $109 in 2006 for Spirit.

“Now fast forward to 2010. For that year, the amount we collected from extra fees went from $5 to $35, but at the same time the average ticket price on Spirit went from $104 down to $77, meaning that the total price customers pay—ticket plus all the extras—was $112 in 2010, up from $109 five years ago. So in that five-year period, despite much higher labor costs, much higher fuel costs and higher regulatory compliance costs, our total [average] cost paid by customers only went up $3. In that same period, Southwest’s [average] fare went up 30%. JetBlue’s went up over 20%. What we’ve done is give the customers the power to save money . . . It’s great for Southwest to say, ‘Bags fly free,’ but if you’re not checking bags, you should ask yourself, ‘Why am I paying for them?’ [as part of the base ticket price].”

In addition to keeping fares low, the business model has also led to consistent profitability, aggressive capacity expansion and the launch this year of an initial public offering.

Spirit operates a fleet of 26 Airbus A319s (configured for 145 seats), seven A320s (178 seats) and two A321s (218 seats), all powered by International Aero Engines V2500s. Daily it operates 175 flights to over 45 destinations, about half in the US and half in the Caribbean and Latin America.

It has 33 A320s on order for delivery by 2015, including two this year and seven in 2012. “We believe we can maintain profitability at a high margin level as we’ve done for the last four years while growing the airline 15%-20% by capacity annually,” Baldanza said, emphasizing that the carrier won’t grow just for the sake of getting bigger.

“We’ll make sure that those [new] airplanes are deployed in the most profitable way possible,” he said. “You know, we have very high financial targets for every route flown by every airplane. We’re not interested in an airline where half the airplanes in the network subsidize the other half. We’re interested in having every airplane we fly, every route we fly, contribute positively to the company.”

Sparking Controversy

Spirit has been pushing the ancillary revenue envelope since 2007, both in terms of á la carte pricing and finding other ways to generate additional revenue, such as advertising in aircraft interiors. In March 2007, it became the first US carrier to impose checked baggage fees, charging $5 (a small fee relative to current-day norms) for each of the first two bags for online check-in and $10 for airport check-in. Nearly every US airline eventually followed; checked bag fees are now a standard revenue generator for the industry. According to US Dept. of Transportation data, US airlines collected $784 million from baggage fees in the 2011 first quarter.

But Baldanza realized by early 2010 that the checked bag fees had created an imbalance, driving passengers to carry too many bags aboard. “We had very serious aircraft delays that were very much tied to too much carry-on baggage,” he explained. “In part, we and others perpetuated that by charging for checked bags and not charging for carry-on bags. People who were acting rationally started to carry more onboard. And it’s burying your head in the sand to say, ‘That’s not a problem.’ So we made a proposal that we thought was a fair one, a reasonable one, saving people money.”

The “reasonable” proposal, made by the carrier in April 2010, was to impose a $45 fee on carry-on bags stored in overhead bins starting in August 2010. A political firestorm ensued. US Transportation Secretary Ray LaHood called Spirit’s carry-on bag fee “outrageous” and “ridiculous,” adding that it showed the airline doesn’t “care about their customers.” Some lawmakers threatened legislation to outlaw the fees. Under pressure, a number of major US airlines publicly committed to not charging for carry-on bags.

With Baldanza holding firm, Spirit started imposing the carry-on fees as planned and they have now been in place for more than a year. The initial controversy has faded away. “The response to that announcement last April was certainly greater than we expected it would be in terms of the emotion that issue brought out,” he said. “The fact that we lowered our fares at the same time, just as we’ve done with other charges, seemed to get washed out a bit.”

How has it worked in practice? “It’s a wonderful, wonderful system and I think customers appreciate it and really like it now,” Baldanza said. “It’s very easy to board the airplane. You get off very quickly. There are fewer bags onboard. Anyone who carries a bag boards the airplane first and they always find space right above their seat for the bag. So there’s not the angst you see on every other airline, where you see customers searching for a place to put their bags or the flight attendant says, ‘Sorry, sir, I’ve got to check that.’ That just never happens on Spirit anymore.

“We saw a 6-8 minute [improvement in] boarding time for airplanes as a result of this. Some of that we’re able to pull out of the schedule. Some of that just gives us a little more time to recover in the day.”

LaHood and Congress backed off from imposing a regulatory edict once a number of other airlines had pledged to not start charging for carry-on bags, believing that would put enough of a check on the renegade Florida airline. But that was a misunderstanding of Spirit and its operating philosophy, Baldanza said.

“One of the things that the politicians [assumed] was that if the whole industry doesn’t match, [Spirit] wouldn’t be able to do it,” he explained. “They didn’t realize that we don’t make decisions based on what our competitors do … If everyone matches us or no one matches us, it’s not going to affect what we do . . . We lowered our checked baggage charge to encourage [passengers] to check, and we felt very strongly about it. The political pressure didn’t change our view because we believe we’re doing the right thing for consumers . . . In hindsight it’s proven to be a really, really good idea. There are absolutely expenses related to carry-on baggage and so if you factor that into the [base ticket] price, the price therefore has to be higher. Or you separate it out.”

Earning Money

Baldanza can counter critics by pointing to the bottom line. Spirit earned net income of $24.8 million for the first half of 2011, significantly widened from a $1.2 million profit in the 2010 first half, which was negatively affected by a five-day pilots’ strike that eventually led to new collective bargaining agreement for flight deck crew. First-half 2011 operating revenue surged 40.7% year-over-year to $508.6 million as “non-ticket” revenue leaped 78.2% to $174.9 million. In fact, Spirit generated more revenue during the six months than in the entire year 2005, when its revenue totaled $484.4 million.

After posting losses of $76 million and $80.7 million in 2005 and 2006, respectively, it turned the corner on profitability, earning $1.4 million in 2007 and $33.3 million in 2008—a year in which few other US airlines were in the black. Earnings totaled $83.7 million in 2009, representing a net after-tax margin of 12%. Net profit slipped to $72.5 million in 2010 owing in part to the pilots’ strike. Nevertheless, Spirit stayed profitable all the way through the turbulent 2007-2010 period.

First-half 2011 capacity increased 24.2% to 4.63 billion ASMs while traffic heightened 31.7% to 3.93 billion RPMs. Load factor—on aircraft with high seat numbers (Spirit’s A320 has 28 more seats than a JetBlue Airways A320)—was 85%, up 4.9 points year-over-year.

The cost picture is impressive. First-half CASM including fuel did increase 7.2% to 9.66 cents, but CASM excluding fuel lowered 6.6% to a mere 5.54 cents (Spirit’s CASM ex-fuel in 2005 was 6.66 cents).

“We maintain a robust view of the company even in a high fuel cost environment,” Baldanza said. “We have a natural hedge in the business in the fact that we’re a more efficient operator of our equipment than all of our competitors … What that means is our fares don’t have to go up as much as the rest of the industry when fuel prices increase … In general, we’re raising more money when fuel costs are lower than higher, of course. But on a relative basis, as fuel prices increase we’re going to do better than the other guy because we don’t need as much of an increase in our ticket prices to cover our costs.”

IPO Launch

It is that kind of push Baldanza is now making to investors following a slightly disappointing IPO. In late May it launched the IPO and began trading on NASDAQ under the “SAVE” symbol, but the public offering price of $12 per share of common stock was well below the $14-$16 planned. It consisted of 15.6 million shares, 22% fewer than the 20 million it said it was offering in early May.

The carrier raised $187 million from the IPO. It had offered guidance of raising $276.3 million in net proceeds in early May and last year predicted the IPO would net $300 million.

Baldanza said the IPO’s lower-than-expected pricing is more representative of the overall economic environment than Spirit’s financial prospects. “I think the IPO went quite well given the fact that there’s investor reluctance to invest in an airline in a high fuel price environment,” he commented. “The fact that we were able to float the IPO during a high fuel price environment showed that many investors thought our business model is more resilient than others.”

The numbers back up Spirit’s contention that, from a business standpoint, it is outperforming the rest of the US industry, according to US Air Transport Assn. chief economist John Heimlich. He pointed out that the 13 publicly traded US passenger airlines incurred a combined $290 million net loss in the first half of 2011. Six of the 13 were profitable for the year’s first six months, with three carriers—Allegiant Air, Alaska Airlines and Spirit—operating with 5% or better profit margins.

“These guys are doing something very rare in this business, which is returning the cost of capital,” Heimlich said. Even other US LCCs considered successful, Southwest Airlines and JetBlue Airways, had operating margins of just 1%-2% in the first half of 2011.

Speaking of Spirit, Heimlich said, “Whatever people say about them, they’ve obviously got a loyal clientele that allowed them to go public.”