Looking at the airline industry, it can be split into two categories – legacy carriers vs. ultra-low-cost-carriers (ULCCs). Today, we will be focusing on the ULCC category. Over the past few years, we have seen ULCC such as Ryanair and Easyjet changing the airline scene within Europe.

By Follash (Own work) [Public domain], via Wikimedia Commons
By Follash (Own work) [Public domain], via Wikimedia Commons

Business Model

Such low-cost carriers follows a simple business model of offering unbundled services to reduce base airfares as much as possible. All its other services, like checked bags, carry-on bags, food and drinks, and boarding passes, are charged separately. ULCCs believes that passengers should pay only for the services they use and shouldn’t subsidize other passengers’ services. Such airlines also believes that its lower fares will stimulate air travel demand by attracting travelers who would have otherwise rented cars, carpooled, or traveled by train and bus. They rely on higher passenger volume to grow its revenues, which also brings in more revenue from ancillary services.

Managing Costs

The way such budget airlines are able to offer such cheap airfares is by managing their costs efficiently. Some of the techniques such airlines uses to cut costs are as follows.

  1. High Daily Aircraft Utilization. Aircraft utilization is one of the important measures of operational efficiency that low-cost airlines count on to lower unit costs. Higher utilization should result in lower fixed costs per unit, as the costs spread across more air trips and passengers, resulting in lower costs per available seat mile. Point-to-point carriers have better aircraft utilization rates, resulting in lower operating costs compared to hub-and-spoke carriers for two reasons. Firstly, their shorter trips enable a higher number of trips in a given period. Secondly, their turn-times are shorter than hub-and-spoke carriers. Turn time is the time taken to unload an airplane and prepare it for the next departure. Higher turn-times allow passengers to arrive from different feeder airlines.
  2. High Seat Density Configuration. Some ULCCs like Spirit Airlines uses a strategy to increase the seat density in its planes. This should result in increased available seat miles without increasing any fixed costs. The company’s A319 planes have 145 seats, compared to 128 seats available for the same plane on United Airlines and American Airlines (AAL). Similarly, the company’s A320s accommodate 178 seats compared to 150 seats on JetBlue Airlines (JBLU) and United Airlines. Spirit’s A321s have 218 seats compared to 181 seats on American Airlines and 190 on JetBlue Airlines.
  3. Efficiency. ULCCs uses planes with a similar cockpit and operational mechanism, which helps the airline manage its pilots more effectively. Even the passenger cabins are similar in these planes, making the cabin crew interchangeable in different planes and avoiding the cost of training crew members for different type of planes. Costs are also reduced in training the supporting ground crew, which simplifies extra parts inventory management.

Being able to minimise their cost, this would translate to a lower breakeven cost per passenger, translating to more competitive prices.

Valuation Metrics

While we can discuss about the business of a company all day long, ultimately, it boils down to valuations. The interesting thing about the airline industry is that traditional valuation metrics would not be as appropriate when valuing companies within this industry. In our opinion, for airline companies, EV/EBITDAR (Enterprise Value to Earnings Before Interest, Tax, Depreciation, Amortization and Rent) is a better valuation metric than to other ratios like P/E, EV/EBIT or EV/EBITDA. This is because of the following reasons.

  1. Airline companies generally have high debt levels. Price multiples do not consider debt, whereas Enterprise Value multiples do.
  2. Airline companies may have high leases, as aircraft can either be purchased or be leased and multiples would vary accordingly. Hence, EV/EBITDAR would be able to capture and compare companies with different lease and ownership structures.