http://www.businessweek.com/bwdaily/dnflash/content/aug2009/db20090814_542215.htm

News Analysis

Frontier Win Surprises Even Republic's CEO


In the end, the auction for Frontier Airlines was not strictly a matter of money. Frontier and Southwest Airlines' (LUV) pilots unions quickly determined this week that melding seniority lists would prove difficult, at best. Southwest officials saw the potential for long-term rancor in their labor force, thanks to a messy integration of some Frontier employees who would be dispirited by the disappearance of their airline and the wave of pink slips that would have accompanied it. The cultural risk to Southwest, the airlines' executives decided, would likely not be worth the reward of marginally better financial performance from the Denver market.

The outcome also surprised Republic Airways (RJET) CEO Bryan Bedford, whose company won the auction for Frontier after Southwest declined to amend a term in its bid that said its pilots would need to reach a deal with Frontier pilots before any sale could close. In an interview on Aug. 14, Bedford said he thought that, strategically, Southwest had firmly decided it needed Frontier. "Honestly, I thought the value of Frontier in the hands of Southwest was more important to them than the value of Frontier in our hands," said Bedford. "I really viewed this as a David-Goliath sort of struggle." Republic sweetened its initial $108.8 million offer by agreeing to cancel a $150 million secured claim in Frontier's bankruptcy, thereby giving unsecured creditors a higher collection on their claims. The deal is expected to close on Sept. 17.

"We knew if it was going to come down purely to money, they were going to prevail—and our conciliation prize was going to be a nice big check," Bedford said, referring to the $150 million. Southwest officials declined to comment Friday.

Southwest Pilots to Blame? Dan McKenzie, an analyst with Next Generation Equity Research, says Southwest's pilots "essentially pulled the rug out from underneath [Southwest] management" and will limit the airline's strategic flexibility in the future. In a note Friday to clients, McKenzie said he expects Southwest to continue optimizing other parts of its network as a way to subsidize losses in Denver, where it has become the third-largest player in three years behind United and Frontier.

Indianapolis-based Republic already operates 1,200 flights per day for seven U.S. airlines, including American (AMR), Continental (CAL), Delta (DAL), and United (UAUA). In less than a month, the company has begun to rapidly transform itself from a fee-for-service airline, which flies connecting traffic to the majors' hubs, into a mainline competitor in its own right. On July 31, Republic completed its acquisition of Milwaukee-based Midwest Air Group from TPG Capital; Midwest now operates as a wholly owned subsidiary. Frontier will add another 51 long-range domestic planes to Republic, its biggest expansion to date. Republic shares jumped 10% Friday, to 6.60.

Republic is trying to diversify its revenue streams, anticipating a day when the industry consolidates further and legacy airlines reduce their focus on large hubs. Doing so would mean less flying work for regional airlines such as Republic, Mesa (MESA), and SkyWest (SKYW). "There's not a lot of organic growth in the fixed-fee contract flying business," Bedford said. He added: "I hope these transactions don't negatively affect these relationships in the long term." However, it's possible that many legacy carriers will increasingly view Republic as an avaricious competitor, and they could retaliate against a tiny airline that doesn't have very deep pockets.

Tough to Boost Fares Frontier CEO Sean Menke will be asked to stay on and run the airline, Bedford said. Some of Frontier's Airbus 319s will migrate to Milwaukee for new nonstop flights to the West Coast. Republic also is likely to seek cost "synergies" for its expanded fleet, in terms of maintenance and other aircraft operations.

To date, Midwest has flown only Boeing 717s, which do not have cross-country range. Vaughn Cordle, an airline analyst and former pilot, said in a note Friday that Republic's small market capitalization—$227 million, vs. Southwest's $6.7 billion—"suggests that Republic will want to move aggressively to displace as many Airbuses as fast as practical to lower its average costs."

And while Frontier workers and Denver-area passengers stand to benefit with the continued competitive status quo, Menke conceded on a conference call with reporters Friday that the auction outcome—leaving Southwest as a competitor rather than owner of Frontier—"makes it tough" for airlines to boost fares and achieve profitability in Denver. "I'm not going to beat around the bush on that one. That's why we've been focused on the cost structure." It is also likely that United gains some financial breathing room in Denver by not having Southwest assume a larger presence overnight.

Indeed, Bedford said that United was the first of several airlines to send him congratulatory notes. "We think we bought a tremendous asset at a bargain-basement price," he said.
Bachman is an associate editor for Businessweek.com.

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