WHINE AND CHEEZ
by


jetBlue vs Delta : The Battle of Hartsfield


On October 23, jetBlue announced that they would discontinue service to rival Delta Air Lines' principal hub city of Atlanta. This came on the heels of Delta's strong competitive response of increasing services and slashing fares on routes serviced by jetBlue.

jetBlue is a poster child for my theory which states that "Without a complete overhaul of operating costs every decade, an airline cannot remain competitive in a deregulated environment."

Historically, this has proven to be very accurate. The first round of industry deaths was seen in the early 80s with consolidation being the fate of those unable to control operational costs, with a few shutdowns (Braniff). A decade later saw a spate of bankruptcies, some resulting in liquidation (Eastern, PanAm) and others in restructuring (Continental, TWA). This time round, the ranks are being thinned again with TWA already biting the dust, USAirways going through Chapter 11 and with the jury out on United.

How do the survivors keep themselves viable? Their methodology varies. In the first round, some sought to survive by acquisition, seeking instead to increase revenue rather than cut costs. PanAm acquired National, TWA acquired Ozark, Northwest acquired Republic and Texas Air acquired pretty much everyone else. Others went the way of labor concessions, which took the form of B-scales at American, "Blue Skies" at United and the infamous Lorenzo bankruptcy at Continental. American's B-scales were the only truly long-term solution to the problem, which bought them an additional generation of savings and allowed them to consolidate their strong position. Similarly, Continental's abrogation of labor contracts achieved the same end, but killed the golden goose while doing it. In the second round, some achieved their targets by acquisition again (Delta acquiring Europe, AA acquiring LatAm), with United using ESOP as a means towards their target for that generation. Continental used bankruptcy yet again, as did TWA. Throughout this, USAir continued to acquire many small carriers and built themselves up into the major carrier than they became. Northwest played conservatively and chose to avoid major capital expenditures while increasing revenue streams through the introduction of the first comprehensive marketing alliance. Fleet renewal programs at most of the carriers also slashed direct operating costs.

In their own way, each of these carriers thus were able to overhaul operational expenditure every decade. Usually, this was done at the expense of the labor groups, but occasionally at the expense of creditors or other airlines.

Unfortunately, with maturity comes seniority, and seniority brings with it the related pitfalls of higher labor costs and less efficient workrules. A new entrant, by definition, does not have any of this baggage. Additionally, a well-funded new entrant has the advantage of choosing the most beneficial markets for infrastructure investment and vendors for capital acquisition, benefits that existing operators utilized generations earlier and are now irrevocably tied into, despite possible changes in the operating environment. In the short term, provided sufficient capital exists, and provided the appropriate markets are targeted, it is very easy for a new entrant to be succesful, often to the detriment of the incumbent who is handicapped by pre-existing baggage outlined above. However, as new entrants themselves consolidate and become incumbents, the next generation of operational streamlining comes knocking and the cycle continues.

jetBlue is perceived as being succesful today because they enjoy a CASM advantage over the major carriers that is largely due to (a) their younger and hence more efficient fleet and (b) a workforce with less seniority. Both of those are advantages that come about because of their relatively miniscule size in comparison to Delta. There is absolutely no way that jetBlue could be the size of Delta and offer a similar product at their cost structure. It simply is not possible. To illustrate just how vast the difference between them is take a look at their 2002 numbers. jetBlue offered 8.24 billion ASMs while Delta offered 141.72 billion ASMs making them approximately 17 times larger.

I decided to go through jetBlue's results and see what the true reasons for their pulling out of Atlanta might be. My data consists of filings between Q1'02 (the first quarter that JBLU filed a 10-Q) and Q2'03 (the latest 10-Q available).

Over that period, we have seen jetBlue decrease their CASM by 11% which is very impressive. However, in that same period, we have seen RASM drop by 9% and yields by a distrubing 15%. Still, those numbers aren't particularly bad.

The most interesting part here is the proportion of unit costs that are composed of (a) wage expenses and (b) maintenance expenses. Wages as a proportion of unit costs increased 12% over this period. While this in itself does not appear troubling, it should be noted that fuel prices over the same period increased 27% and the fuel component of unit costs increased 38%. Hence, adjusting for fuel costs, we find that the wage component has actually increased 18% which is on the high side.

More troubling is the maintenance component of costs which, as the fleet ages, has increased an absolutely STAGGERING 58% over that period when adjusted for fuel costs and a still staggering 49% unadjusted.

An even more troubling sign is the projected aircraft rent costs as a proportion of unit costs for the next 3 years. When jetBlue first set up, they negotiated sweetheart backloaded deals from the leasing companies that allowed them to pay a pittance on the leases to begin with but ballooning to higher rates from 2004 onwards. In fact, as per jetBlue's own filings, their per-Airbus aircraft lease rates are expected to increase by an unbelievable 56% between Q2'03 and Q1'05. This does not even begin to factor in the acquisition and integration costs for their new Embraer fleet.

What is my opinion? Well, their preliminary CASM for Q3'03 was unbelievably below 6c. That is the most impressive CASM performance I have seen in a very long time from any carrier. However, whether this low CASM is sustainable in view of the above trends I have detailed remains to be seen. Historic data from other carriers, including no-frills carriers, leads me to believe that they cant. I project their CASM increasing to around the 7c mark by Q1'05 as a result.

However, the current RASM is in the low 7c range on an 87% load factor. The RASM has fallen 9% over the period under consideration, while the yield has fallen 15% over the same period (partly offset by the increased load factor). This leads me to believe that when load factors stabilize in the low 80% range, the RASM will also plateau in the sub-7c range, creating an unsustainable revenue model.

I think this exposes the chink in jetBlue's armor that can be exploited by the competition and was very succesfully exploited by Delta. With Delta having access to essentially infinite incremental capacity both through their larger fleet as well as their infrastructure available at destination airports (remember LGB is severely slot constrained), jetBlue realized that the only way they could grow market share in Atlanta would be by selling at a further deflated yield and higher load factor which would become unsustainable beyond the next year. There is no way that I could see for them to avoid that. Hence, they decided to cut their losses and pull out of Atlanta.

 



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