17-Apr-2014 5:00 PM

Canada Jetlines sees an opportunity from other airlines diving to the middle

Analysis

Canadian start-up carrier Canada Jetlines believes a "dive to the middle" by the country's two largest carriers Air Canada and WestJet has created an opportunity for the pure-play ultra low-cost business model to manifest itself in Canada as fares continue to climb.

The new carrier's thesis is it can stimulate traffic by offering lower fares to passengers that would otherwise travel by car and adopt the ultra low-cost carrier strategy of extreme unbundling - charging for nearly every aspect of travel outside of a seat. It is a strategy that has worked for Spirit Airlines in the larger US market.

It is not a certainty the ULCC model can be easily replicated in Canada; but if Canada Jetlines does ultimately become airborne perhaps the carrier to feel most of the heat is WestJet, an airline that is moving up market, but still has significant dependence on cost-conscious leisure travellers.

Summary

Canada Jetlines believes there is an opportunity for the ultra low-cost carrier (ULCC) business model in Canada as fares continue to rise.
The carrier plans to stimulate traffic by offering lower fares to passengers who would otherwise travel by car and adopt the strategy of extreme unbundling.
The "dive to the middle" strategy by Air Canada and WestJet, moving up-market and creating confusion among passengers, has created an opportunity for a pure low-cost carrier.
Canada Jetlines plans to launch operations with two Airbus narrowbodies and expand to 16 jets within 30 months.
WestJet, while moving up-market, still aims to retain its appeal with cost-conscious customers through its three-tier fare bundle offering.
The success of Canada Jetlines will depend on its ability to undercut current fares, gain necessary regulatory approvals, and stimulate traffic in a market with a smaller population base and a somewhat tenuous economy.

Canada Jetlines outlines its plans as WestJet and Air Canada undertake huge new projects

Plans by Canada Jetlines to develop and launch an ultra low-cost carrier in Canada first emerged in late 2013. Three Vancouver-based businessmen declared their intent to create a new airline based in the city and operate Airbus narrowbodies with low base fares. Passengers would pay for other services, which at one point included an onboard nanny.

See related report: Jetlines, Canada's new upstart, takes a huge bet that it can execute the ULCC model

In a briefing paper Jetlines listed five of Vancouver's top 10 domestic markets as potential destinations - Edmonton, Kamloops, Kelowna, Prince George and Winnipeg. The carrier anticipated launching operations with two Airbus narrowbodies and forecasted operating 16 jets by its 30th month of operations.

The "dive to the middle" by Air Canada and WestJet is creating customer confusion

As 2013 came to a close Canada Jetlines appointed former Frontier Airlines executive and native Canadian Jim Young as its president. He has also held positions at Canadian and Continental Airlines and payment processing firm GuestLogix in addition to helping found online travel site Orbitz.

Mr Young and the other members of Canada Jetlines' management team, which includes Jim Scott as chief executive officer, have concluded that Air Canada and WestJet are making a "dive to the middle", creating confusion among passengers, but an opportunity for a more pure low-cost carrier in the market place.

Referencing WestJet's strategy to move up-market Mr Young concluded during the recent CAPA Airlines in Transition conference in Dublin: "You have one carrier moving up the service curve, introducing a plus seat in an all-coach cabin...then we have another carrier introducing a fleet within a fleet, [referring to Air Canada rouge], a carrier within a carrier and densifying their aircraft and diving down to the middle".

The changing strategies by Air Canada and WestJet are "creating confusion in the market place and I think that confusion as well as the complexity that is created within the carriers themselves will yield probably not the same returns they were hoping they would get by doing those activities", said Mr Young.

WestJet's introduction of its premium economy offering, that included new fare bundles debuted in 2013 and the launch of its Encore regional subsidiary that operates Bombardier Q400s, did create some yield pressure for the carrier during 2013. Its yields for the year were essentially flat compared with 2012, and dropped 1% for the 9M ending in Sep-2013. WestJet's unit revenues fell 1.6% in CY2013.

See related reports:

Canada Jetlines plans to take customers from their cars to the skies

As the lines between Air Canada and WestJet's offerings become more blurred, Mr Young concluded that overall fares in the Canadian market place are not decreasing. The country's two largest carriers are either maintaining current fare levels or increasing their prices. "They're introducing cost-savings for themselves" and not passing them on to consumers, said Mr Young.

The latest data available from the Canadian Government show that average domestic fares in Canada increased 0.8% year-on-year in 2012, with Saskatoon and Edmonton showing the largest increases of 6.3% and 4.6%, respectively. Mr Young estimated that presently fares within Canada are more than CAD62 cents per mile, and Canada Jetlines plans to "come in under that, take customers out of the cars and grow the market".

Average domestic airfares in Canada: CY2011 and CY2012

WestJet still maintains it is Canada's low-fare airline

Interestingly, WestJet is attempting to still retain its appeal with cost-conscious customers that would otherwise travel by car with its three-tier fare bundle offering that features Econo, Flex and Plus. The Econo option in theory offers passengers a low base fare and then add-ons for an extra fee. The higher-fare buckets target business passengers willing to pay more for flexibility including itinerary changes and extra legroom.

WestJet's three fare bundle offerings: Econo, Flex and Plus

See related report: WestJet continues its hybrid evolution, watching costs as it weighs a potential widebody operation

Obviously WestJet feels that it has the cost-conscious segment of the Canadian market place amply covered, and that, "they [Canada Jetlines] clearly see an opportunity I don't," WestJet CEO Gregg Saretsky recently told Canadian news outlet The Financial Post. "We are Canada's low fare airline and we're going to compete vigorously as we always have."

The WestJet pledging robust competition against Canada Jetlines is different from the carrier that embarked on a business model transition into a hybrid carrier a few years ago. While its unit costs excluding fuel and profit sharing fell 0.7% year-on-year in 2013, WestJet has warned that its unit costs during 2014 are forecast to increase 1.5% to 2.5% year-on-year, and it is unlikely that the carrier can achieve unit costs excluding fuel of CAD8.29 cents. WestJet attained those cost levels in 2008 just as it was creating new initiatives to attract a higher share of corporate travellers and contemplating entering the regional market place.

WestJet's unit cost performance: 2007 to 2013

Over the long term WestJet believes its change in business strategy to attract more high-yielding revenue will pay off, and ultimately it will strike the right equilibrium between cost and revenue. That would be challenging under the best of circumstances, but with an upstart that can charge lower fares nibbling at its leisure passenger base, WestJet has an added challenge in executing its business transformation. Air Canada will also feel some pressure from Canada Jetlines, but with a broader international network and arguably still a higher level of corporate traffic, Air Canada may be a bit more shielded from Canada Jetlines' encroachment.

Can an ULCC flourish in Canada's high-cost environment?

Air Canada and WestJet frequently note that their unit costs are inherently higher than US airlines given the cost of doing business in Canada stemming from certain government policies. WestJet recently estimated that it cost an extra cent per ASM to operate in Canada compared to the US.

See related report: WestJet attains investment-grade as it faces near-term cost creep

Queried by CAPA if an ULCC could flourish in Canada under those circumstances, Mr Young said the various taxes and fees such as Nav Canada charges are baked into its costs estimates, which could get as low as CAD6 cents by the carrier's fourth year of operations.

A major advantage cited by Mr Young is Canada Jetlines' ability to start with a clean-sheet design, which will ultimately be a factor in its ability to undercut current fares in the market. Previously the company has estimated fares 25% to 40% lower than Air Canada and WestJet on transborder international flights and service in large markets. In secondary markets, its fares could be 60% lower.

Canada Jetlines estimated fares on select routes from Vancouver

Until an official launch, Canada Jetlines remains a threat in words only

At the moment Canada Jetlines is only a threat on paper. Mr Young anticipates a late 2014 or early 2015 launch as the airline works to gain all the necessary regulatory approvals for launch.

The Canadian market place seems like a good fit for an ultra low-cost carrier given its duopoly status - Air Canada and WestJet combined represent roughly 80% of the seats on offer in the domestic market place.

Canadian domestic capacity by carrier (% of seats): 14-Apr-2014 to 20-Apr-2014

While it seems Canada is ripe for an opportunistic low-cost carrier, the country's population of 36 million inhabitants is projected to remain essentially flat during the next few years. Canada's smaller population base (the US has a population of approximately 319 million) could result in fewer stimulation opportunities than in other regions of the world. The Canadian economy is also somewhat tenuous, which could affect the spend of the consumers Canada Jetlines is targeting.

All of those factors combined with the threat of much larger competitors willing to flex their competitive muscle create interesting dynamics for Canada Jetlines. If it officially launches operations, its strategy of capitalising on traffic stimulation to create a new-breed ULCC in the Canadian market place will be put to the test. For Canada Jetlines to achieve success, the country's residents not only have to get out of their cars, but pull out their wallets too.