Keep unit revenues high and unit costs low—even if that means no flat-bed seats.
Virgin America VIRGIN AMERICA INC VA -0.5592% made its public trading debut last Friday. Its first few days as a public company have been incredibly successful — at least from the perspective of early investors. The Virgin America IPO priced at $23 (above the midpoint of the projected $21-$24 range). In its first three days of trading, the stock soared more than 60% to close at $37.05 on Tuesday.
On the day of Virgin America’s IPO, I spoke with CEO David Cush and CFO Peter Hunt about the company’s strategy for growth and margin expansion. Here’s how Virgin America plans to take the U.S. airline industry by storm.
High unit revenue and low costs
To hear Cush talk about it, Virgin America’s formula for long-term success is extremely simple: keep unit revenues high and unit costs low.
Well, I think the key thing is understanding our model. Our model is we do have a premium product, we do generate a revenue premium to most of the industry, but we do it with a low-cost model.
So we have a very pure low-cost model. We are single fleet type; we are point-to-point. That was really the original playbook for the low-cost model. So: high revenue, low cost, and I think we’re seeing it on the bottom line now that the network has matured.
–Virgin America CEO David Cush
Of course, having high revenues and low costs is what every CEO wants. Virgin America is making progress toward this goal. In the 2 years leading up to Virgin America’s IPO, the company dramatically boosted its profitability.
Through the first 9 months of 2014, the company reported operating income of $86.3 million, representing an operating margin of 7.7%. By contrast, in the first 9 months of 2012, Virgin America posted an operating loss of $36.8 million for a -3.7% operating margin.
That said, among the top 10 U.S. airlines, Virgin America had the second lowest operating margin (excluding special items) for the 12-month period ending in September. Virgin America has solid margin growth momentum, but it still has plenty of work to do.
Plans to earn a revenue premium
Let’s take a look at the revenue side first. Virgin America plans to boost its unit revenue by continuing to offer a superior on-board product, including leather seats, a first-class section on every flight, Wi-Fi on every plane, mood lighting, etc.
In addition, Virgin America will focus its growth on high traffic routes in its top markets. “We’re not a big connect-the-dot carrier,” says Cush. “We like to focus on where we’re strong.” This really means San Francisco and Los Angeles: more than 95% of its capacity touches one of these two cities.
In other words, the seasonal routes from New York to Fort Lauderdale and from Boston to Las Vegas that Virgin America announced last month will be the exception, not the rule.
Virgin America has strong roots in San Francisco and Los Angeles. Moreover, these are two of the top business markets in the U.S. Both factors make it easier to attract corporate travel accounts there. On average, corporate travelers pay 50% more than other customers for Virgin America tickets. Thus, the carrier has a strong incentive to expand in those two cities.
The one promising market that Virgin America sees aside from San Francisco and Los Angeles is Dallas. Earlier this year, Virgin America snagged two gates at Love Field, a small airport that is much closer to downtown Dallas than the significantly larger Dallas-Fort Worth International Airport.
Love Field is a unique expansion opportunity. Nearly all of its gates are controlled by Southwest Airlines, a carrier that doesn’t offer many of Virgin America’s amenities (like first-class seats and personal TVs). As a result, Virgin America thinks it can attract corporate travelers who want those amenities but also value Love Field’s convenience.
Virgin America began flying from Love Field a month before the IPO. According to Cush, financial results for its flights to San Francisco and Los Angeles (which had previously used DFW) have been better at Love Field from day one.
Virgin America’s has also seen plenty of demand in its new markets from Dallas: New York City and Washington, D.C. This should lead to excellent financial results once these routes have a few years to mature, due to the capacity-constrained nature of all 3 airports.
Cost containment plans
Virgin America also has to keep its costs in line to produce outsize profits. Like most young carriers, Virgin America currently benefits from comparatively low labor costs. Its young fleet is also easy to maintain. However, as the company’s workforce and fleet age, both will be sources of cost pressure. (Unionization of its workers is another potential cost driver.)
Another challenge Virgin America faces is its refusal to mimic competitors by cramming rows closer together to fit more passengers on each plane. How can Virgin America mitigate or offset these cost headwinds?
One thing that both CEO David Cush and CFO Peter Hunt emphasized in our conversation was Virgin America’s “simple production model.” By maintaining a single fleet type and outsourcing more tasks than other airlines, Virgin America avoids complexity and keeps costs down.
Virgin America’s IPO will improve the company’s access to capital, according to CFO Peter Hunt. This will allow it to reduce its aircraft financing costs. For example, rather than leasing planes, it could take advantage of the low interest rate environment to issue cheap debt and buy the planes outright.
Virgin America also keeps costs down by not using flat-bed seats in first class on the lucrative transcontinental routes from JFK Airport in New York City to San Francisco and Los Angeles, where it deploys a lot of its capacity. This puts it at odds with the other 4 carriers serving those routes.
Flat-bed seats are an “overrated feature unless you’re on a red-eye,” David Cush recently told Bloomberg. Most transcontinental flights are not red-eyes. Virgin America doesn’t operate any red-eye flights going westbound, and it operates one daily red-eye on each of the San Francisco-JFK and Los Angeles-JFK routes.
Flat-bed seats take up lots of space, increasing unit costs. Most of Virgin America’s planes are A320s configured with 146 or 149 seats. By contrast, American Airlines recently began flying the A321 on its transcontinental routes. The A321 is a bigger airplane, yet American Airlines has configured these planes with just 102 seats (of which 30 are flat-bed seats).
Thus, for transcontinental flights, Virgin America operates with a denser configuration than its competitors (which is the reverse of the situation on most of its routes). If Cush is right and very few people care about having a flat-bed seat for their transcontinental flights, Virgin America will be able to generate plenty of revenue on those flights while having the lowest unit costs.
Time to get to work
Virgin America has plenty of work to do if it is to earn a revenue premium to the U.S. airline industry while maintaining low unit costs. In some areas, it has clear plans. Its recent buildup at Dallas Love Field should boost unit revenue. Virgin America’s IPO should reduce aircraft financing costs.
However, there are some big open questions. Is Virgin America right that flat-bed first-class seats aren’t necessary on transcontinental flights? Can Virgin America avoid the cost creep that has hurt various other low-cost carriers as they have aged? Only time will tell.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.