What's Driving JetBlue's Profits?

By Markets Fool.com

For 2014, JetBlue Airways reported a record profit of $401 million, or $232 million excluding the sale of the airline's LiveTV unit, but the sources behind this record profit have implications for the entire airline industry. I'll take a look at how JetBlue posted this profit and how other airlines are also posting record profits.

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Record year
Last year saw Delta Air Lines , United Continental Holdings , American Airlines Group , and Southwest Airlines all post record profits, in large part because of a combination of rising demand, higher fares, and gains in ancillary revenue.

JetBlue's 10-K notes that 92% of its 2014 revenue was "passenger revenue." You may think that all of an airline's revenue would come from "passengers," but the airline prefers to break it down further and needs to find a way to account for revenue not directly attributable to passengers.

Besides the base fares themselves, there are other items included here as well. JetBlue includes some of its ancillary revenue here, such as the $200 million collected from Even More Space seats, the airline's larger economy-seat offering.

In the 10-K, JetBlue discusses the balancing act it undergoes in pricing fares:

Our objective is to optimize our fare mix to increase our overall average fare while continuing to provide our customers with competitive fares.

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Source: JetBlue.

For those who don't speak airline, JetBlue tries to increase average fares while keeping those fares competitive with those of its rival airlines. In 2014, the airline was largely successful in doing so, increasing its average fare 2.1% from $163.19 to $166.57 and increasing revenue passenger miles from 35.8 million in 2013 to 37.8 million in 2014.

Revenue from the Even More Space seats was also impressive, seeing 16% growth from 2013 to 2014. The strategy of offering larger economy-class seats for an extra price has taken hold across the airline industry, with all the majors climbing onboard and even many of the newer entrants taking them on.

Unfortunately, JetBlue's competitors don't break out revenue growth from upgraded economy offerings like JetBlue does. However, Delta Air Lines appears positive on its upgraded economy seats citing them as a key factor behind an increase in passenger revenue during 2014. Delta is also voicing its bullishness for tiered classes of seating by launching a plan to have five classes of fares in an initiative to generate more revenue per passenger.

Other major carriers are also going forward with this approach with Economy Plus seating at United and Main Cabin Extra at American Airlines; however, Southwest Airlines is notably absent from the trend and it will be interesting to see if it moves in this direction in the future. Nonetheless, while major carriers are not disclosing their upgraded economy revenue growth like JetBlue, they are voting with their wallets to continue or even expand the programs.

Going forward, this should be an area to watch, to see whether this type of growth can continue and what other new seat offerings airlines roll out to capture the market.

Other revenue
Among the other items included in "other revenue" are cargo operations, charter operations, onboard product sales, and reservation change fees. These all represent potential areas for future growth, but they comprised a mere 8% of JetBlue's 2014 revenue. Below are the five largest U.S. airlines with JetBlue ranking second-to-last in "other revenue" as a percentage of operating revenue.

Airline Other Revenue Percent of Operating Revenue*
Delta Air Lines 13.3%
United Continental Holdings 13.2%
American Airlines Group 13%
JetBlue Airways 8%
Southwest Airlines 5.1%

source: Company 10-Ks

*Other Revenue combines the Other Revenue and Cargo Revenue at each airline to better compare to JetBlue's Other Revenue measurement which includes both types of revenue.

There's reason to expect that this number could change, though. "Other revenue" includes fees from checked bags, and JetBlue plans to roll out a fee on first checked bags. Since both JetBlue and Southwest lack the first checked bag fee for now, that could explain much of the difference in percent of operating revenue coming from other revenue.

Source: JetBlue.

The checked bag fee is part of the JetBlue's new tiered pricing structure and will only affect passengers buying the fares in the lowest tier. Since these fares are the cheapest, many passengers are likely to go this route anyway and pay for the checked bag. By making first checked bags no longer free with the lowest fare, investors should expect the "other revenue" category to show growth from this factor alone.

Expenses
No income-statement analysis is complete without a discussion of major expenses. At JetBlue, as with most airlines, labor is one of the largest expenses, costing JetBlue $1.3 billion in 2014, or 24.4% of total operating expenses.

But while labor costs are fairly stable because of existing contracts, fuel prices aren't. Jet fuel prices are highly correlated with oil prices, and oil prices rise or fall based on a plethora of factors. In 2014, aircraft fuel and related taxes made up the largest single operating expense, costing JetBlue $1.9 billion, or 36% of operating expenses, an amount in line with broader industry levels.

JetBlue noted in its most recent 10-K form that it consumed 639 million gallons of jet fuel in 2014. With this amount of fuel consumption, it's easy to see how small swings in the price-per-gallon of jet fuel can mean a big impact to JetBlue's bottom line. Excluding the effects of hedging, JetBlue would see a $6.39 million pre-tax change in profit for every cent-per-gallon move in jet fuel prices.

But JetBlue does hedge 15%-20% of its fuel consumption to smooth out oil price volatility. Despite this, the hedges do not fully protect the airline from fuel price movements since only part of the consumption is hedged and the hedges only extend a year into the future. With fuel being such a major expense, investors should keep an eye on fuel prices as they have the potential to significantly alter the bottom line.

Other costs at JetBlue totaled $2.1 billion and are summarized in the table below.

Expense Cost
Landing fees and rents $321 million
Depreciation and amortization $320 million
Aircraft rent $124 million
Sales and marketing $231 million
Maintenance, materials, and repairs $418 million
Other operating expenses $682 million

source: JetBlue 10-K

When taken together, these expenses are significant but are essential to running an airline. Of course these costs are at a lower scale compared to the major carriers since JetBlue is significantly smaller by both fleet size and market share. But even when this is taken into account, as a percent of revenue, none of JetBlue's other expenses appear to be too far out of the ordinary for an airline.

As JetBlue continues to expand, investors should expect many categories of expenses to grow as more flights are operated and more aircraft are used. However, this should also generate more revenue for the airline and if management can execute, it could result in higher earnings.

The bottom line
The vast majority of JetBlue's revenue comes from fares and products closely associated with fares such as Even More Space seats which are posting impressive revenue growth. But as the airline rolls out its new baggage-fee policy, look for growth in the "other revenue" category as more bag fees are collected and the possibility of closing the gap with the major legacy carriers. On the expense side, the biggest factor for investors to watch for right now is fuel. As JetBlue's single largest expense, fuel prices can have major effects on the airline's bottom line.

Overall, JetBlue's income and expenses are similar to those of many other airlines but investors should keep an eye on new products and fees from JetBlue on the revenue side and movements in fuel prices on the expense side.

The article What's Driving JetBlue's Profits? originally appeared on Fool.com.

Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines,. Alexander MacLennan has the following options: long January 2017 $25 calls on American Airlines Group and long January 2016 $60 calls on American Airlines Group. 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.