04-Jan-2013 9:25 AM

LCCs in Japan welcomed with open arms, despite the many arguments against

Analysis

For years it was said that Japan, despite high air fares and inefficient incumbent airlines, would never be a breeding ground for low-cost carriers. Excuses were many - airport taxes were too high, there were no low-cost terminals - but the last resort claim for why LCCs would not work in Japan was that the Japanese people, used to pampering in their service-oriented society, would never accept the core principles of LCCs.

With breathtaking speed the Japanese government and companies broke down barriers to support LCCs, three of which launched in 2012. They could do everything but change public attitude about LCCs. Yet it turned out the Japanese public did not need the open-heart surgery many thought would be required. Japan's air market has been devolving on service, closing the gap between full-service incumbents and LCC start-ups. The LCCs are also not the bare-bones, service-adverse airlines many stereotyped.

This poses a challenge to how full-service carriers can maintain a yield premium, which received a bleak reminder with Skymark pulling off routes in response to LCCs entering. The Japanese experience also offers a lesson to other markets, like South Korea, Taiwan and Hong Kong, where some claim the population will not ever accept the concept of a LCC.

Japan domestic LCC seat capacity penetration: 2001-2012

Once a symbol of global wealth, Japan is more careful with spending

An economic powerhouse once nicknamed Japan Inc., the country that seemed to epitomise wealth and luxury in past decades is now on the wane as the economy slows and the population ages. LCCs are playing a role in what is hoped - and likely will be - a rejuvenation in air travel and the larger economy as lower fares at unprecedented levels generate more demand with all the spectacular triple-down affects to tourism and transportation sectors. Three LCCs launched in Japan in 2012: Jetstar Japan (Jul-2012), a joint-venture between Qantas' Jetstar unit and Japan Airlines; and two affiliated with All Nippon Airways, AirAsia Japan (Aug-2012, launched with Malaysia's AirAsia Group) and Peach (Mar-2012, launched with other non-airline investors). China's Spring Airlines intends to launch a Japanese subsidiary in late-2013.

But this theme of lower-cost options is present in other sectors. The most symbolic might be rice, not only because it is a staple dietary element but because of its production at home. That production, however, is significantly more expensive - upwards of 10 times - than alternatives from countries like Australia, China and the United States.

Buying foreign rice in Japan is gaining traction, but in small amounts: 10,000 tons were sold in 2011 compared to nine million tons of Japanese-grown rice, according to the New York Times. In a country whose default position has been protectionism, especially in politically sensitive areas like agriculture, this is still an important step.

On a much larger scale, discount chain Wal-Mart started expanding in Japan in 2012, the first time since 2008, and after years of mixed success. The message is Japanese consumers are changing, and lower-cost options, from rice to other goods to air travel is being welcomed. With air travel heavily commoditised and typically the first element of a trip the market looks to reduce expenses from, it is clear a lower-cost proposition for air travel is not a folly. In Europe the mantra of "fly cheap, stay chic" is finding ground around the world.

Japan's full-service airlines were not very full-service

The image naysayers had of LCCs was wrong on both ends. They imagined LCCs being too skimpy on service (more on that in the next section) and full-service carriers being too luxurious for travellers ever to walk away from. The truth is that Japan's full-service carriers on short-haul routes are not all that full-service. To be clear, on long-haul sectors they are full-service and their reputation of Japanese hospitality has helped them secure favourable corporate contracts, even though product development like lie-flat beds lagged behind other carriers around the world.

The short-haul market, comprising domestic Japan but also regional services to China, South Korea and Taiwan, is where LCCs will compete most with full-service incumbents. AirAsia Japan and Jetstar Japan are more aggressively and intentionally targeting the domestic market than Peach, which is focusing on international sectors. ANA has 87% of its seat capacity in the domestic market while JAL has 77%. Domestic flights are short, typically under two hours, and ANA and JAL offered a limited in-flight option confined to a few complimentary drinks like water, tea and coffee while other beverages - and all snack foods - were charged for. So with the LCCs all that was new in the in-flight service arena was charging for water, tea and coffee. In-flight entertainment was limited to nil. For regional Asian destinations, meal service can vary from a traditional hot meal to a cold bento box, reducing service gaps between FSCs and LCCs.

A lounge culture in Japan has not taken hold the way it has in other markets. With Japan's clockwork public transport and efficient airport experience, passengers do not need to leave much padding before their flights: they know exactly what time a train will get them to the airport just in time to breeze through check-in and security.

It is not unheard of for a gate area population to swell mere minutes before boarding commences. At the same time, the Japanese carriers have not offered expansive lounge perks, reducing incentives to arrive early. (The lack of plush lounges in service-oriented Japan can surprise international travellers.) This further reduces the premium associated with full-service carriers, allowing Japanese LCCs to greater rival FSCs, offering service only slightly, not seismically, less but for a fraction of the price.

For more information, download CAPA's comprehensive North Asia LCC and New Age Airlines 2012 report.

LCC start-ups tactically created service and experience to rival incumbents

Some in the industry call for the abolition of labels like "full-service" and "low-cost", arguing it is difficult to place airlines in one of two buckets since they vary so widely. That variance is true in Japan, and is another element that was missed by naysayers who took a stereotypical image of Japanese people, used to heated train seats and expansive toilets, suddenly being on a Ryanair-like operation where seats do not recline and window shades are absent. The Japanese LCCs - indeed, most across Asia-Pacific - are a far cry from peers elsewhere in the world, a mixture of diligent planning as well as the airlines having considerable experience, allowing a strong launch in Japan from day one rather than experiment in the market. AirAsia Japan and Jetstar Japan had the backing of their parent pan-Asian LCC groups while Peach during its launch phase was managed by Mango Aviation Partners.

Japan remains one of the most tech-savvy societies in the world, and the experience AirAsia and Jetstar had with check-in kiosks, online check-in and mobile check-in made the check-in experience similar to ANA and JAL. Winding check-in queues would not have been received well. The two also had extensive experience in making their websites their primary booking source, whereas website bookings are a minority for ANA and JAL. Consequently AirAsia and Jetstar have gotten their websites to be highly effective in meeting customer satisfaction but also generating revenue opportunities that keep base fares low. ANA and JAL are clear legacy operations, and their websites are notoriously complex to use with a myriad of fares but also different booking options for domestic versus international itineraries. Anecdotal evidence from the Japanese market indicates some passengers prefer to use the websites of LCCs than FSCs. Peach, not having an airline pedigree, has lagged behind AirAsia Japan and Jetstar Japan in technology.

On-board investments are also paying off. Jetstar Japan uses slimline seats that are not only thin but have moved the seatback pocket to the top of the seatback, freeing up precious inches of legroom and doing away with the stigma of LCCs not having much legroom as they cram seats in to reach the maximum certification (180 in an A320). Lack of legroom is not a new concept to Japan: ANA and JAL have domestic configurations of widebody aircraft that squeeze in extra seats; for a while they both operated the most densely-configured 747 aircraft. With the FSCs diminishing their full-service proposition and LCCs taking initiatives like slimline seats (which can pay off in fuel savings), the difference between the two is not as stark as it may seem at first glance.

Japan domestic seat capacity by carrier: 31-Dec-2012 to 06-Jan-2013

Pressure mounts: Skymark pulls off LCC routes as LCCs eye more growth

As differences between FSCs and LCCs shrink, there is a threat to the yield premium FSCs garner. A quieter worry is to carriers that, to use one term, are caught in the middle: not low-cost but not full-service, thus unable to win on price or superior service. Skymark, Japan's third largest carrier by some distance, fits in this camp. Its costs are lower than ANA and JAL but not at the level of AirAsia Japan and Jetstar Japan (Peach has higher costs than those two). Its service is simple but does not offer the expansive network of ANA or JAL, let alone the critical frequent flyer programme or expansive network to facilitate connections and greater traffic.

For now, Skymark is entirely a domestic carrier but this will change, including with the arrival of A380s that will initially operate services to New York JFK. That long-haul offering however faces the same short-haul challenge of not being a network carrier, unless Skymark forges partnerships. The trans-Pacific market has been cleaned up by alliances, and it is only Delta without a deep partner, although it may be looking to work more closely with Korean Air.

In the short-haul arena, Skymark has shown some initiatives to claw back and compete against LCCs, but the carrier has flagged that on directly overlapping routes, it cannot stand up. The concern for Skymark is that the new LCCs are already showing dominance despite their small size. They will grow rapidly, and their affects will be felt more, not just by Skymark but also ANA and JAL - and indeed, Japan's larger transport and tourism industry.

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Skymark says it will likely withdraw from the Osaka Kansai-Sapporo and Osaka Kansai-Okinawa Naha routes due to low load factors (the tentative nature of the announcement could suggest the carrier is willing to negotiate; there are low-cost terminals with lower fees being used by Peach and AirAsia Japan that are not available to Skymark). Skymark entered both routes in Mar-2012 to compete with Peach, which operates on those sectors. In Jan-2013 Peach offers five daily Kansai-Sapporo return services on A320s while Skymark offers only three on 737s. Between Kansai and Okinawa, Peach has double daily services and Skymark three. There was a sudden glut of capacity, and it appears the victor was Peach, which has lower costs and received tremendous media attention during its launch.

Despite the short nine month history of LCCs with formidable cost bases in Japan, this is not the first example of incumbent carriers losing ground to LCCs. ANA and JAL have pulled off routes largely as a result of LCCs.

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Cannibalisation will continue as the LCCs grow. Peach will open its second base at Okinawa in Mar-2013 while AirAsia Japan has confirmed its second base will be at Nagoya from Mar-2013.

Jetstar Japan has already flagged its second base will be at Osaka Kansai, the home of Peach. In addition to new bases, new routes will be launched from existing hubs: Peach intends to launch Kansa-Busan service in Sep-2013, complementing its existing Korean service between Kansai and Seoul Incheon. Peach has also secured approval for services to Beijing and Shanghai that, due to slot limitations, will most likely operate at midnight hours, also improving aircraft utilisation.

Tokyo Narita system seat capacity by carrier: 31-Dec-2012 to 06-Jan-2013

AirAsia Japan's first route from its Nagoya base will reportedly be to Fukuoka from Mar-2013, with a formal announcement and sale commencement by the end of Jan-2013. Afterwards AirAsia Japan will consider adding services from Nagoya to Okinawa and Sapporo as well international services to South Korea, where it serves Busan and Seoul Incheon from Tokyo Narita.

Osaka Kansai system seat capacity by carrier: 31-Dec-2012 to 06-Jan-2013

Jetstar Japan was bullish in operating a second base early on, a plan that fell through when the carrier failed to adhere to its internal maintenance procedures (although its actions did comply with the minimum required by Japan's regulator). As a result, Jetstar Japan and the regulator mutually agreed (a process that avoids the carrier from embarrassingly receiving an official sanction in safety-obsessed Japan) to postpone expansion. Jetstar Japan's second base at Osaka Kansai, which was due to formally open from Oct-2012 has been postponed to Mar-2013 at the earliest while international operations due to commence around Mar-2013 have been postponed until after Jun-2013.

Load factors for three LCCs were strong over the peak summer season but have dipped in quieter months. AirAsia Japan's load factors have failed to meet performance goals. In Dec-2012 the carrier reported an average load factor of 65.4% since launching operations in Aug-2012. The carrier reported load factor of 84.4% during its first month of operation in Aug-2012, falling to 68.3% in Sep-2012, 56.9% in Oct-2012 and 55.9% in Nov-2012, levels more commonly seen at ANA and JAL, where 60-70% domestic load factors are common.

One cost advantage Japanese LCCs can have over FSC competitors is higher load factors, driving unit costs down. Jetstar Japan reported an average load factor of 64.9% in Nov-2012, a dip from its 85.5% load factor in Jul-2012, 85.6% in Aug-2012 and 76.7% in Sep-2012. The dips are worrying, indicating that the LCCs face a challenge in changing Japan's approach to holidaying, which is traditionally heavily centred on the summer season. Short trips and weekend getaways at other periods of the year are not mainstream, a result of the lack of affordable air fares.

Yield figures for 3Q2012 released by Japan's MLIT show the new LCCs have yields half that of FSCs. Cost bases are not disclosed, but once the carriers spool up they are understood to have cost bases more than 50% less of FSCs.

Passenger yield per RPK: JPY18.3 (USD 23.3 cents), -1.6%;

Japan Airlines: JPY18.9 (USD 24.0 cents), -0.5%;
All Nippon Airways: JPY19.0 (USD 24.2 cents), -1.0%;
Japan TransOcean Air: JPY17.6 (USD 22.4 cents), +6.7%;
Skymark: JPY13.5 (USD 17.2 cents), -4.9%;
Air Do: JPY19.0 (USD 24.2 cents), -2.6%;
Solaseed: JPY14.5 (USD 18.4 cents), -11.0%;
StarFlyer: JPY17.9 (USD 22.8 cents), stable;
Peach: JPY9.7 (USD 12.3 cents);
Jetstar Japan: JPY7.9 (USD 10.1 cents);
AirAsia Japan: JPY8.0 (USD 10.2 cents);

In dual-brand strategies, gap between brands is key - and this should worry Japanese incumbents

The changing equation in Japan is not favourable to full-service carriers. ANA and JAL have pursued dual-brand strategies. This was a rightful decision: the country's air travel network needs new growth channels and if they did not partner in establishing LCCs, someone else would have. The challenge is how to protect your existing business. Unfortunately examples are few and not encouraging for Japan. Australia, home to the most famous dual brand combination of Jetstar and Qantas, has a corporate market where high yield premiums are afforded to Qantas for plush lounges, business class service and even hot meals and complimentary alcohol on flights barely an hour in duration. That culture is not existent in Japan, reducing opportunities for ANA and JAL to move up-market, although they have tried with new domestic seats and small perks like better coffee.

One big asset going for FSCs is that they are using Tokyo's more convenient downtown airport, Haneda, whereas LCCs are operating at further afield Narita. But Haneda's slots are tightly controlled and only gradually expanded. In Dec-2012 the MLIT dispersed a total of 25 slots, a small amount but a grouping followed by the media for many months. ANA received eight, JAL three, Starflyer five, Skymark four, Solaseed three and Air DO two. A much larger expansion is planned sometime around 2015, but the scale of that offering could see the new LCCs request slots, although they have not made public comments about that.

Adding to woes, the new Japanese LCCs launched more strongly than naysayers expected. Extensive media coverage educated the public not simply about the LCCs' existence but also fine nuances, such as how to use their new terminal facilities: magazines ran features with maps sporting photos illustrating every step of the way. In advance of the launch, local newspapers reviewed the buy-on-board food and its prices. This coverage - all for essentially zero cost - reduced surprises amongst the Japanese consumers once expected never to be receptive to LCCs.

The LCCs are narrowing the service gap with FSCs yet at a fraction of FSC prices. The gap between carrier types is small and closing in. A successful dual-brand strategy will be harder to achieve if the two have more in common than they do differences.

South Korea, Taiwan and Hong Kong watching developments

The rise of LCCs is a global story, and likewise their effects tend to play out similarly across markets, even if inertia prompts various excuses from naysayers that LCCs will not work. A needy market was a failed excuse used in Japan but still circulates heavily in South Korea and Taiwan, and to a lesser extent in Hong Kong, markets that have yet to gain a large LCC footing.

In South Korea, a revitalised Jeju Air sees that with changing competition, especially comparatively cut-throat LCCs from Japan, South Korea's quasi-LCCs cannot stand still. But the carrier, like others, is caught in not wanting to make changes ahead of what it judges is the market's readiness - or willingness.

Japan has become a testbed for the region, and its LCC experience is already spilling over to neighbours, trying to process the transformation and extrapolate it to their own business before competitors do. There are many people, inside and outside the industry, who are surprised. Once the often sleepy airport and tourism bodies catch on - and it won't be long - they will only add fuel to the fire.