Southwest Airlines' Missed Opportunity: Frontier Goes to Republic

Includes: LUV, RJETQ, UAUA
by: Vaughn Cordle, CFA

Southwest Airlines (NYSE:LUV) CEO Kelly washed his hands of the seniority issue by allowing the pilots union (SWAPA) to decide how Frontier pilots (FAPA) are integrated. Naturally, SWAPA decided to protect the junior pilots, which resulted in Republic (RJET) winning the bid for Frontier.

The junior SWAPA pilots may have been protected, but that security came at a very high price. The opportunity cost for Southwest shareholders is likely in the $1.3 - $1.5 billion ($1.6 - $2 per share) range based on our recent valuation of the acquisition.

In this case, Southwest’s shareholders have been trumped by a powerful pilot’s union. Even the Southwest employees – especially the pilots – are hurt by this as the largest shareholder, and they now must accept lower growth prospects.

This missed opportunity results forces Southwest to continue offering below-cost fares in the Denver market and a share price that falls back to a pre-Frontier bid value.

Without an acquisition, Southwest has no choice but to compete on price and depend on a war of attrition for its growth. United (UAUA) benefits in the longer term because a Republic-owned Frontier will be a much weaker competitor, with both a higher cost structure and lower sustainable growth.

However, having three big competitors in Denver instead of two will certainly result in lower average fares, and Frontier will likely be the loser in such a war of attrition.

Southwest's current share price of $9.24 is too high given any reasonable estimate of 2010's earnings, which now appear to be in the .35 per share range. It is likely that the share price will fall towards ~ $7 now that the Frontier acquisition has failed, which represents a 25% hit.

SWAPA is a political entity, and its primary objective is to the protect the interests of its members. The pilots recently rejected a new contract with the company, which suggests that SWAPA's negotiating leverage, as it pertained to the Frontier bid, was enhanced significantly.

Republic will likely replace a significant number of Frontier's aircraft with new regional jets - E190s are the likely choice - to lower costs. For example, the maintenance costs on the E190s will be a fraction of those spent on Frontier's current Airbus fleet because of the maintenance-cost holiday of new aircraft.

Pilot block hour crew costs are 58% lower at Republic ($100 per capita) versus Frontier ($170) and this suggests that Republic will want to reap the benefits of operating its own lower-cost crews. It’s interesting to note that Frontier's crew costs are 59% ($170 vs. $290) of those paid by Southwest, so perhaps they can accept the current labor costs for a period of time, or on some percentage of the capacity. Frontier's stage-length adjusted seat mile costs are slightly higher (2%) than Southwest's, but 48% lower than high-cost United.

Republic is a tiny bird with a $200 million market cap versus Southwest's $6.2 million. This weak financial leverage and growth capacity suggests that Republic will want to move aggressively to displace as many Airbuses as fast as practical to lower its average costs. In fact, it’s the only way Republic-owned Frontier can win a war of attrition with Southwest and United out of Denver.

Eventually, Southwest must raise fares if it is to earn its cost of capital and boost the sagging share price. Based on our recent analysis, an approximate 5% average fare hike would result in a $1 per share earnings in 2010. The current consensus is $ .35.

However, we would not expect this to happen before a new pilots' agreement has been concluded. After all, why produce higher earnings when negotiating with labor. The below-cost pricing to buy market share in Denver has thus served two purposes: Southwest has grown market share in Denver from zero in 2005 to 17.5% by the first half of 2009, and the reduced earnings has likely shaped labors' views in terms of how much the company can afford to pay.

Bottom Line: Economics are significantly improved if Republic displaces a significant percentage of Frontier's current capacity with its own crews and aircraft.

In our view, it's hard to make the case that a stand-alone Republic-owned Frontier (and Republic-owned Midwest) can survive over the longer term. Even if Republic displaces aircraft/crews to lower costs, its balance sheet and size may simply be too small to win a prolonged fare war in Denver and Milwaukee (Midwest).

It's interesting to note that US Airways has indicated a desire to sell 25 Embraer 190s to raise cash. These aircraft could be purchased to replace some of Frontier's 10 A318s and 38 A319s. There doesn't appear to be anything that prevents Republic from doing at Frontier what they've done at Midwest, which is to displace B717 crews and aircraft with lower seat mile costs - 40% lower - regional jets and crews. Lowering costs significantly is likely the only way Republic survives as a standalone airline.

Disclosure: no positions