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Disruption in distribution in the travel industry – challenging the status quo

Airline Leader

By Martin Warner

"A disruptive innovation is an innovation that creates a new market and value network and eventually disrupts an existing market and value network, displacing established market leading firms, products and alliances." The term was defined and the phenomenon analysed by Harvard Business School Professor Clayton M. Christensen beginning in 1995. Since then, the term has become the standard euphemism for any supplier who has a desire to change the status quo to their sole advantage.

Summary
  • Lufthansa's Distribution Cost Charge (DCC) is seen as a disruptive innovation in the airline industry.
  • The DCC aims to displace established competitors, particularly Global Distribution Systems (GDSs) and travel management companies (TMCs).
  • Lufthansa's half-year results show a rise in passenger traffic but a decrease in load factor and yield, raising questions about the success of the DCC.
  • Other airlines and groups need to consider the impact and costs associated with implementing a similar model.
  • The current distribution model may need to change, but a collaborative and inclusive approach could be more effective than a confrontational one.
  • GDSs and intermediaries should rethink their economic model and value proposition to remain relevant in the industry's distribution chain.

An example of an action billed, as "disruption" is the Distribution Cost Charge (DCC) introduced by Lufthansa Group in late 2015. However, is this truly "disruption" in terms of the definition: that it should result in a process by which (1) a product or service takes root initially in simple applications at the bottom of a market and then (2) relentlessly moves up market, eventually displacing established competitors? This is certainly what Lufthansa Group would hope.

The question is, is it taking root and will it relentlessly move through the market to displace established competitors?

In this case it involves the displacement of historical partners, integrators and the deliverers of value, notably the GDSs, who facilitate intermediaries such as travel management companies (TMCs), who deliver a large proportion of the highest yielding business.

A bigger question should be: could the end objective of more efficient distribution that meets the expectations of the customer (leisure & business travellers, as well as corporates) have been achieved in a more collaborative, thoughtful fashion? Could a "win-win-win" scenario have been achieved for the supplier-intermediary-client value chain, rather than Lufthansa's confrontational approach? After all, these are not the only intermediaries in the complex financial and distribution system.

One way of judging the scope of Lufthansa's action in this context will be if others follow the Lufthansa Group model. This engages the need to explore the facts and myths of the choices airlines (and others) face today.

When Lufthansa Group published its half year results to 30-Jun-2016 on 02-Aug-2016, it made no specific mention of the impact of the DCC, but some elements must raise questions about the success or otherwise thus far.

While passenger traffic in the six months rose 0.7%, load factor fell by 1.4ptts and yield fell by 4.3%. For the same period, the cost for Computerised Distribution Systems rose by EUR64 million and Advertising & Sales costs rose by EUR34 million.

Management stated the group's share of Direct Distribution had risen, but supplied no hard facts to state by how much and what the net gain or loss from the initiative may have been. Nor was there any indication of the time needed for a positive ROI.

The questions therefore posed for other airlines and groups to consider include:

  • If Computerised Distribution Cost has risen, how much of this is associated with LH Group paying a higher segment fee (rack rate) to the GDS for the business that remains via GDS and has not (yet) transferred to Direct Distribution?
  • To what extent do these costs (and trailing depreciation) relate to the development of new and additional direct distribution alternatives for intermediaries to use?
  • In the increase in advertising and sales costs, how much of these relate to the increase necessary in communicating change, and persuading change to direct booking by corporates?

The data points strongly suggest that the group action may have been like taking a sledgehammer to crack a nut. A better outcome for all concerned might have been an inclusive dialogue and a longer signal to collaborate to change the distribution models in the travel industry.

The rancour that exists around a GDS sharing its revenue from airlines in forms of incentive to intermediaries is unrelenting and unproductive. Ignoring cost for a starting point, the GDS provides a remarkably efficient solution to intermediaries, and in certain high yielding sectors such as corporate travel is very cost efficient for suppliers. That the GDS continue to evolve their capability, embrace standards and add value by finding new solutions to present content in contemporary, user-friendly forms.

The advent of capability to present branded fares and ancillaries also helps airlines and aids intermediaries to deliver what results in improved supplier yields. All of this should be considered in the new reality of economics in distribution.

The current model may indeed need changing, and it is time to call a halt to the practice of intermediaries' fees to their clients being subsidised by the GDS revenues. The value proposition of intermediaries should stand alone, without the level of supply side subsidy that continues to exist today.

Every airline, and particularly groups that include low cost carriers, has a different mix of Direct Distribution, but there is evidence of a trend towards a longer term recognition of the current and future value of indirect distribution.

As recently as Sep-2016, US Airline Reporting Corporation (ARC) president Mike Premo stated that the intermediary share of bookings made at US points of sale had risen from 38% to 41%. Meanwhile, on the revenue side, 52% comes from indirect bookings, supporting the proposition that intermediaries deliver higher yield.

On 27-Sep-2016, in an interview with Peter Greenberg at the Association of Travel Agents (ASTA's) Global Convention, United SVP of Worldwide Sales Dave Hilfman recognised the importance and value of intermediary distribution to United, confirming intermediaries provided the majority of United's revenue - as well as its highest margins. He went on to say that consideration of paying commission on ancillary sales was a fair question for consideration, suggesting discussions with individual intermediaries.

Clearly in evaluating future disruption in distribution, airlines will continue to assess their own specific circumstances and business mix and make decisions each believes to be right for it at the time decisions are made. The point to consider is, if something is broken in the supply chain, solutions can be found segment-by-segment and step-by-step. A one-size-fits-all approach will not necessarily deliver the ultimate value that the disruptor is seeking to achieve.

As if to emphasise this point Amex Global Business Travel (GBT) in Aug-2016 sent a memo to clients advising that, effective 01-Sep-2016, it would begin to roll out a surcharge "to any transaction booked with a supplier that is booked outside a GDS; does not settle its accounts through industry standard methods; has limited or no participation in industry standard fare filing processes; or is designated as basic booking, low cost, specific or other similar designation." According to the Beat, the surcharge is designed to compensate Amex GBT for the additional cost of processing fees for corporate travellers.

Today's environment calls for strategic thinking and inclusive dialogue; otherwise, absent an alternative economic model, the industry is open for airlines to copy the Lufthansa DCC in full or in part. It is certainly time for GDSs and intermediaries to rethink their economic model and re-package their value proposition to suppliers and to clients/travellers if they are to remain relevant in the travel industry's distribution chain.

The end result might be a much less confrontational outcome that does not require extensive disruption, but which achieves successful solutions that deliver the best outcomes along what is a highly complex supply chain.