WestJet’s cost pressures mount as 2Q profits surge

2 August, 2012

Canadian low-cost star WestJet delivered a 66% rise year-on-year in 2Q2012 profits to CAD42.5 million (USD42.2 million) as strong demand helped lift the carrier’s revenues by 9% to CAD809 million (USD804 million). But despite showing confidence that positive revenue trends will continue, WestJet has further revised its full-year 2012 unit cost guidance upwards driven by hiring staff to accommodate its winter schedule, shorter stage-lengths and a slight capacity reduction stemming from an aircraft reconfiguration project to install a premium economy section on its fleet of 100 Boeing 737s.

Similar to its US codeshare partner Delta, WestJet believes the costs it is incurring from certain investments in the short term will produce favourable margin expansion over the long term, particularly the addition of eights seats on its 17 737-800s as part of the reconfiguration project scheduled to begin in Aug-2012. The carrier is also increasing its technology spend to improve its product merchandising. But those investments along with other cost pressures has resulted in WestJet issuing its second revision to unit costs guidance excluding fuel for the full year to 3%-3.5% from 1.5% to 2.5%.

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The carrier is declining to comment on how much of the rise in unit costs is attributable to one-off expenses such as maintenance and seasonal hiring, and if the cost pressure would carry over into 2013. WestJet has seen increasing pressure on its maintenance cost line, and expects that to continue as it accelerates some heavy maintenance checks to coincide with the reconfiguration project.

WestJet unit cost breakdown: 2Q2012 vs 2Q2011 and 1H2012 vs 1H2011

Carrier CEO Gregg Saretsky remarked a lot of the spend WestJet is undertaking is “margin expansionary” and noted the carrier was careful with its premium economy project not to reduce seat count on its aircraft. The carrier is adding eight seats on its 17 Boeing 737-800s currently configured with 166 seats, and retaining current configurations of 119-seats on its 737-600s and 136-seats on the 737-700s, which comprise the bulk of the carrier’s fleet.

WestJet selected financial statistics: 2Q2012 vs 2Q211 and 1H2012 vs 1H2011

Robust demand drives strong yield and unit revenue growth

WestJet grew yields by 1.5% during 2Q2012 and improved its unit revenues by 6%. Mr Saretsky told analysts that unit revenue improvement during 3Q2012 should be moderately stronger than 1H2012 as load factors and yields continue to remain strong. During the six months ending 30-Jun-2012 WestJet’s yields grew 3.2% and unit revenues increased at a 6% clip.The carrier’s load factor in 2Q2012 increased 3.5ppt to 82% and grew 2ppt during 1H2012 to 80%.

Carrier CFO Vito Culmone concluded that overall capacity in the Canadian domestic market should be flat year-over-year in 3Q2012 while transborder and capacity into the Caribbean is rising slightly. Mr Culmone stated WestJet was “part of driving that industry view” of increasing capacity to those regions. WestJet has recently launched service from Toronto to New York LaGuardia, flights from Calgary and Vancouver to Chicago O’Hare and new service from Toronto to Kingston, Jamaica.

Mr Saretsky remarked that WestJet is pleased with the performance of the carrier’s eight daily flights launched in Jun-2012 in the key business market of Toronto-New York, and the results from its codeshare agreement with Delta covering 16 of the carrier’s routes from LaGuardia.

During 2Q2012 about 39% of WestJet’s capacity was allocated to transborder and other international destinations, up 2pp from the year prior. The percentage of capacity allocated to domestic operations dropped from 63% to 61%.

Breakdown of WestJet's capacity allocation to domestic and international markets: 2Q2012 vs 2Q2011

As it makes further inroads into transborder and Caribbean markets WestJet expects full year 2012 domestic capacity to be flat to down 1% and and overall supply to grow between 3.5% to 4.5%.

The airline has also recently firmed up its winter schedule and plans new flights from Toronto to Antigua, Barbuda, Curacao and Liberia, Cost Rica. WestJet also plans new service from Calgary to Manzanillo, Mexico in 2013.

Hitting ROIC targets

WestJet has set a goal of trailing 12-month return on invested capital (ROIC) of 12%, and during 2Q2012 the carrier drew closer to that target with an ROIC of 11.4%. Mr Saretsky stated WestJet should reach its ROIC targets earlier than expected and predicted the airline would reach the 12% goal in 3Q2012. However, he cautioned the carrier needs to ensure the 12% target is maintained for a sustained period of time.

WestJet’s ROIC targets mirror those of Alaska Air Group, which has consistently been a top performer in that particular financial metric. At the end 2Q2012 Alaska had a trailing 12-month ROIC of 12.3%, and company management has concluded that it is likely the company would exceed its 10% ROIC goal in 2012, the third consecutive year it has surpassed those targets. Low cost leader Southwest Airlines recorded a 12-month trailing ROIC of 8% as of 30-Jun-2012, and has said it would restrict its growth until the company reaches its target of 15% return on invested capital.

See related article: Southwest remains cautious as it records strong 2Q2012 earnings

First in the Canadian market with a premium economy

WestJet’s decision to quickly move forward to complete reconfigurations on its 737s to feature four rows of premium economy with a 36in pitch by year-end could increase competitive pressure on rival Air Canada.

Canada’s largest carrier Air Canada a few weeks ago indicated it was studying a premium economy offering, and WestJet’s quick timeframe to bring its extra legroom to market could accelerate Air Canada’s evaluations. Mr Saretsky stated that WestJet could offer premium economy fares roughly 50% lower than Air Canada’s prices for business class on domestic flights. WestJet during the last few years has been working to increase its mix of business travellers and last year began penetrating the highly-contested “eastern triangle” in Canada with flights from Toronto to Ottawa and Montreal.

Mr Culomone remarked that WestJet’s passenger mix was “moving in a healthy direction” as it gains traction among corporate travellers.

WestJet declined to offer a cost estimate for the retrofit if its 737 fleet (which will reach 100 by year-end 2012) with the premium economy product. But the expense joins start-up costs WestJet is facing as it works to launch its new regional subsidiary in 2013. The carrier is taking delivery of four 70-plus seat Bombardier Q400s in 2013 for operation on new, smaller regional routes. The carrier has placed a firm order for 20 of the larger turboprops.

In addition to cost pressure associated with its expansion, Mr Saretsky also admits that as the 16-year old company continues to mature and more employees reach the top of their respective pay scales, there is inflationary pressure in WestJet’s business that it is “working hard to offset”.

Only time will tell if WestJet’s two major undertakings – its new regional subsidiary and the premium economy project – will produce the margin expansion the carrier is hoping for. But it will quickly become apparent if the carrier does not achieve success in combating persistent cost increases.

Background information

WestJet total revenue and net earnings: 2Q2012 vs 2Q2011 and 1H2012 vs 1H2011