An Economic Analysis of the Low-Cost Airline Industry

Occasional recessions, market crashes, and COVID-19 notwithstanding, there is little doubt that life has improved steadily in recent decades. Products and services that were once the province of the rich became widely available as living standards rose. No business better exemplified the democratization of services than the airline industry. Low-cost carriers (LCCs) were at the forefront of that movement. Here we will take a closer look at that segment of the industry.

The Changing Face of Air Travel

In the old days, flying was a luxury experience. Airlines primarily catered to the affluent and business travelers. Flyers were a pampered lot, plied with food and wine. In those days, flights were seldom full. One could stretch out on the adjacent empty seat and enjoy a nap in the hushed passenger cabin.

Air travel grew in popularity, with the industry offering more flights and lower fares after deregulation, As the passenger traffic swelled, air travel's cachet faded just as low-cost carriers arrived, pushing fares even lower. It now costs extra to secure more leg room or glass of wine in a business or first-class section of the cabin. All too often, air travelers have been forced to put up with long delays, overcrowded flights, lengthy security procedures and noisy cabins.

The Rise of Low-Cost Carriers

While many bemoaned the decline in quality, the number of complaints was not exceptionally high compared to the greater number of air travelers. That was because airfares dropped substantially after adjusting for inflation. Consumers have always known that you get what you pay for. Paying cheap fares for no-frills air travel was a bargain accepted by the majority of air travelers. Those who pined for the glamour days of flying always had the option of paying more for first class.

Deregulation

Pioneers including Southwest Airlines Co. (LUV) ushered in mass air travel in the U.S. during the 1970s. In that same decade, the deregulation of the U.S. airline industry accelerated the widespread use of low-cost carriers. The 1978 Airline Deregulation Act partly shifted control over air travel from the government to the private sector. That led to the termination of the once all-powerful Civil Aeronautics Board (CAB) in 1984.

The CAB previously had an iron grip on critical aspects of the U.S. airline industry. It controlled the pricing of airline services, agreements between carriers, and mergers within the industry. Airlines were only able to compete on tangible factors, such as food, service quality, and cabin crew. Their hands were tied concerning the most crucial consideration for most consumers—ticket price.

The Results of Deregulation

The liberalization of the airline industry yielded spectacular results. The number of U.S. air traveler enplanements soared from 205 million in 1975 to a record 927 million by 2019. Adjusting for inflation, the average price of a domestic round-trip ticket in the U.S. fell from $566.10 in 1990 to $367.34 in 2019. That's a decline of about 35%, but the drop mostly took place between 1990 and 2005. Airlines also went from filling about 54% of seats in 1975 to using 85% of their seating capacity in 2019.

Around the World

The low-cost carrier revolution spread worldwide between 1990 and 2020. The LCCs came to Europe in the 1990s and Asia in the 2000s. Flagship national airlines still exist in most countries. Italy even renationalized Alitalia during the coronavirus crisis. Low-cost carriers had been making progress for years. However, the extreme stress of dealing with the coronavirus put their survival at stake, especially in newer markets.

Why Low-Cost Carriers Soared

The success of low-cost carriers before 2020 can be attributed to many innovations and developments since the 1970s.

The Point-To-Point Model

Many large airlines were quick to adopt the hub-and-spoke model after deregulation. In that model, a major airport becomes the hub, and other destinations become the spoke. However, LCCs abandoned that system in favor of the point-to-point model.

The hub-and-spoke system allows airlines to consolidate their passengers at the hub and then fly on to their ultimate destinations (the spokes) in smaller aircraft. That boosts the percentage of seats filled, which helps to drive down fares. Furthermore, the hub-and-spoke system increases the number of possible destinations. However, it also has some drawbacks, such as the high costs required to maintain such a complex infrastructure. The hub-and-spoke system also imposes longer travel times on customers who must transit through the hubs. Finally, it is vulnerable to cascading flight delays caused by hub congestion.

The point-to-point system, on the other hand, connects each origin and destination via nonstop flights. That provides substantial cost savings by eliminating the intermediate stop at the hub, which gets rid of costs related to hub development. The point-to-point system also reduces total travel time and enables better aircraft utilization. Limited geographical reach is the major constraint of the point-to-point model. Unfortunately, direct flights are not economically viable for many city pairs.

Discount Pricing

The higher efficiency and better fleet utilization of LCCs, coupled with their reduced costs, enable them to offer significant airfare discounts. Ticket pricing is now the biggest competitive factor for airlines. Most consumers want to reach their destinations quickly and economically, and are willing to give up in-flight food and entertainment to save money. This drive for economy also extends to business travelers as companies increasingly clamp down on travel costs.

Technology Adoption

The widespread adoption of ticketless travel and Internet distribution has been a boon for LCCs. It decreases the need for complex and expensive ticketing systems used by legacy airlines to handle their complicated pricing structures. The emergence of the internet as the primary medium for booking tickets has dramatically increased the transparency of ticket pricing. That works in favor of the low-cost carriers because of their lower fares.

Fleet Uniformity

A significant benefit of the point-to-point model is that LCCs can use a single fleet type. They frequently do not have much variability in passenger demand between the major city pairs that they serve. Traditional carriers often need larger planes to carry passengers between hubs, and smaller ones for flights to the spokes. The fleet uniformity of low-cost carriers leads to lower training and maintenance costs.

Motivated Staff

Several LCCs prided themselves on the high motivation levels of their employees. They motivated employees with competitive compensation, incentives like profit-sharing, and a strong corporate brand identity. Additionally, most LCCs tend to fly shorter routes. That means employees might only be away from home for a few hours, as opposed to a couple of days or longer for long-haul flights. More time at home can also be good for morale.

Pandemic Symptoms

Fewer Flyers

The COVID-19 pandemic dramatically cut demand for air travel. According to Airlines for America, the number of commercial flights globally declined about 75% between March and May in 2020. At the same time, U.S. passenger airlines reduced flights by 74% domestically and 93% internationally. Even worse, the number of passengers on a typical domestic flight fell from a range of 85 to 100 to just 10. However, the average number of passengers rebounded to around 30 by the middle of May. It was clear airlines could not long operate under those conditions.

The Bailout

In March 2020 the airline industry secured nearly $60 billion in U.S. government funding under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, saving the industry from bankruptcy. However, there were strings attached that have significant consequences for potential investors. The airlines had to agree to forego layoffs, stock buybacks, and dividend payments. The dire situation for airline earnings was already highly unfavorable to buybacks and dividends, so those restrictions mattered little. The prohibition of layoffs, on the other hand, limited the companies; flexibility in adapting to a dramatically different business environment. Nonetheless, the aid represented a significant win for the airlines and their employees.

Buffett Departs

Legendary investor Warren Buffett sold in 2020 all the airline stocks owned by his company Berkshire Hathaway Inc. (BRK.A). Berkshire Hathaway's holdings were in the larger airlines, including a substantial stake in the large low-cost carrier Southwest. Buffett's company paid $7 billion to $8 billion for its stakes in the airlines, but they were worth closer to $4 billion when sold amid the COVID-19 pandemic, marking a rare loss for Buffett and his firm. "I don't know that three, four years from now people will fly as many passenger miles as they did last year," Buffett said. "You've got too many planes."

Startup Success Stories?

The economic environment after the pandemic could be extremely favorable to new entrants in the low-cost carrier space. Fear of the virus is likely to decline dramatically under most scenarios, unleashing repressed demand. The industry's contraction during the pandemic promises to leave many older planes on the market, along with additional gates and take-off slots at some airports. That, in turn, could lower startup costs for new low-cost carriers. New LCCs would also be free of the massive debt and restrictive agreements with governments weighing down the incumbent carriers.

The Biggest LCCs in the U.S.

While startups seem likely to emerge in the future, large established low-cost carriers are not going away. The top U.S. low-cost carriers are listed below.

Southwest Airlines Co.

Dallas-based Southwest Airlines (LUV) began operations in 1971. It became the largest U.S. carrier in terms of originating domestic passengers boarded and also operated the world's largest fleet of Boeing aircraft. Southwest had a 17.7% share of the domestic U.S. air travel market in the 12 months through October 2021, just behind American's 18.5%. As of Feb. 8, 2022, Southwest had a market capitalization of $27.2 billion.

JetBlue Airways Corp.

JetBlue (JBLU) launched in 2000 and grew to become one of the largest U.S. passenger carriers by focusing on some of the top U.S. travel markets. JetBlue differentiated itself by offering the most legroom in coach class, as well as free TV and broadband Internet service on its flights. JetBlue had a 5.3% share of domestic U.S. air travel in the 12 months through October 2021. The company had a market capitalization of $4.9 billion as of Feb 8, 2022.

Spirit Airlines, Inc.

Spirit (SAVE) has operations in the U.S., Latin America, and the Caribbean. The airline's strategy is to offer an unbundled, stripped-down "Bare Fare" and charge customers for options like baggage, seat assignments, and refreshments. Spirit launched its initial public offering in May 2011 and had a market capitalization of $2.8 billion as of Feb. 8, 2022. Spirit matched JetBlue with a 5.3% share of the domestic U.S. air travel in the year through October 2021. On Feb. 7, 2022, Spirit Airlines and Frontier Airlines parent Frontier Group Holdings, Inc. (ULCC) announced the two companies planned to merge in a deal valued at $6.6 billion. The combined airline would be the fifth-largest in the U.S.

Allegiant Travel Co.

Allegiant Travel (ALGT) is the parent company of Allegiant Air, which was founded in 1997. Allegiant focuses on the U.S. domestic market, flying passengers from small and mid-sized cities to top holiday destinations like Las Vegas and Honolulu. Allegiant Travel had a market capitalization of $3.2 billion as of Feb. 8, 2022.

The Bottom Line

Whether one calls them low-cost carriers or LCCs, budget airline stocks are risky investments. However, high risks sometimes give investors high returns. While the stocks have already rallied impressively from their 2020 lows, the rebound in air travel as the COVID-19 pandemic subsides may drive additional gains for the shares of low-cost carriers.