Air Canada brings depth to LCC plans

To say that the industry is curious about Air Canada’s plans to launch its third low-cost carrier attempt would be an understatement considering the questions from analysts to CEO Calin Rovinescu during its earnings call. But the protracted discussion did shed light on the company’s plans, what it will take to launch such a new entrant and whether labour will come on board.

While it has cut a tentative agreement with pilots, that may not stick as they push back on the LCC idea and Mr Rovinescu seemed sanguine at that. “One reason to start this carrier is to also bring in markets the mainline does not service,” he said, adding there are many markets the mainline carriers cannot now serve. “If labour doesn’t come through we have to develop another strategy to take advantage of those markets.”

The LCC would grow to a 50-aircraft fleet serving leisure markets in Europe and sun destinations, which means it will already break one of the cardinal rules of being an LCC – a two-aircraft-type fleet – as one analyst was quick to point out.

Mr Rovinescu was just as quick to acknowledge the dismal success rate for creating LCCs within mainline operations with Air Canada’s own efforts following in the destructive path of Delta’s Song and United’s Ted. He pointed to the success of Jetstar which will push Qantas into the future. But Qantas pilots are in revolt threatening industrial action.

CAPA analysis shows Air Canada has little choice

Analysis by CAPA clearly suggests that Air Canada has little future without a dramatic change in direction even saying that last year's meagre CAD107 million profit on CAD11 billion in revenues is as good as it is ever going to get for the carrier. Indeed, Mr Rovinescu acknowledged as much during the earnings call.

See related story: Air Canada’s low cost subsidiary runs into pilot turbulence

Plans for the LCC captivated analysts who kept peppering executives with questions.

“We believe such an evolution is a necessary ingredient for sustaining growth,” Mr Rovinescu said in his remarks, adding the combination of lower costs with leveraging the Air Canada identity would make a significant difference in the LCC’s potential success. “We have a tremendous franchise and we are not able to be as competitive as we’d like to be. For the longer haul, we’ll need a widebody so we’ll have a two-aircraft fleet. In order for this to go forward, and this is how the management and board think of it, we need a sustainable LCC. Creating a new business with a fundamentally different cost structure should mean a profitable, high volume operation for the next decade and beyond in markets where we cannot now serve profitably.”

While cautioning investors these were by no means route announcements, he mentioned Amsterdam, Dublin, Nice, Manchester, Lisbon and Casablanca, saying they would be complemented by numerous sun destinations.

In an effort to assuage pilot concerns, he indicated the new LCC would create more jobs and provide more a more robust salary and progression opportunities for the 462 pilots that are projected to be on board by 2015. Mr Rovinescu also expects three times that amount for flight attendants in addition to jobs at airports and for maintenance employees.

But he emphasised the company would not go ahead with its LCC plans unless the new company can, over the long term, avoid the cost creep that doomed similar legacy attempts in the past.

“I’m convinced it can be a key driver in our kit for achieving our ultimate goal of long-term profitability,” he concluded. “The whole concept is that it would require low cap ex, low operating costs and low upfront investment. The labour costs are one component of the overall costs and we are committed to getting CASM to a very competitive level.”

Applying the logic is easier said than done

That is a tall order considering the just reported WestJet results. Its strong results – net income of CAD48.2 million, up CAD46 million from the year-earlier quarter – came with a 3.3% drop in CASM ex fuel and profit sharing at 8.91 cents. CASM grew 4.5% to 13.24 cents, largely on fuel. Total CASM ex fuel and profit sharing is expect to rise by double digits this year, however. WestJet’s increases came on a 24.7% increase in total revenue to CAD772.4 million and an 11.3% increase in ASMs to 5.2 billion.

Air Canada’s domestic RASM was up 9%, underperforming the 12.2% increase posted by its LCC competitor. Chief Commercial Office Ben Smith countered that the company was pleased with its RASM progress, noting that the carriers are very different in that Air Canada has far more connecting traffic. In addition, Mr Smith pointed out that the increase in its Toronto-Asia capacity changed the passenger mix on its transcontinental routes.

It must also be noted that WestJet’s performance bettered Southwest – with a 54.6% drop in net income – and JetBlue which posted a rather anaemic USD4 million rise in net income. Perhaps, rather than Qantas and Jetstar, Air Canada’s best role model would be Alaska Air Group whose net income rose from USD5.3 million to USD74.2 million as the result of a multi-year transformation programme that Air Canada is only now commencing.

Unknown whether past is prologue

A decade ago, Air Canada launched Tango, but without a separate operating certificate. Mr Rovinescu noted the different booking rules at Tango as well as different product and distribution model.

“It worked well and Tango ended up morphing into a new fare category,” he said. “It was one of the more successful experiments. We then tried Zip, an LCC with a separate operating certificate, in domestic operations which did not last that long because it didn’t have the size or scale that produced the benefits needed. Let me be clear. We are only going to do this if we are convinced it will have staying power. This one will start with scale. Secondly, while there will be different work rules for the two aircraft types – one narrowbody and one widebody – the work rules and scale would be absolutely competitive with LCCs.”

He also pointed to a different distribution methodology designed for leisure. There would also be a different configuration in the number of seats serving markets that require a higher density.

“In order for this to work, we need sufficient scale and work rules that are not capable of bouncing back to the mainline structure,” he said. “Unless we have that we won’t proceed with it.” 

Mr Rovinescu said the LCC is the only way for the carrier to grow until the delayed delivery of  its 37-aircraft B787 order. Despite his emphasis on staying power it seemed as if he were talking about the LCC as a stop-gap measure until the B787s arrive.

“When you look at the collective opportunity for growth over the next several years until the 787s are delivered at the end of 2013 and the beginning of 2014, we will have many years of virtually no growth,” he told analysts, acknowledging the B787 schedule did influence the company’s decision to launch an LCC. “We said we would not bring aircraft into the fleet unless there was a compelling business case to do so. The only way to do that, until we have some of the 787s, is to bridge the gap.”

Analysts worried that the launch of an LCC would derail the company’s efforts at culture change but Mr Rovinescu reported the continued high level of employee engagement and the progress made in getting them to share the vision.

When asked about the timeframe for the new entrant, he indicated he wanted it sooner rather than later and suggested it would be within the next year. “We view the establishment of an LCC as akin to an investment in the market and we know it is going to take a period of time to produce a return,” he said. “Why now? Because it takes time to start. We are in negotiations with our pilot group and working on the distribution method and, as a result, it will start slowly, not with 50 planes overnight. Our expectations on cap ex is that it will not be huge nor will debt be a material burden. We get the distraction factor but the reason we are doing it is because it fits squarely in our four-point plan to reduce costs and become profitable.”

One of the major concerns was the potential to cannibalise mainline yields as happened in its previous attempts at starting an LCC when the loss of high yields negated the benefit of an LCC.

“At that time, we knew someone was going to cannibalise yields and that led to the evolution of Tango which operated on trunk routes and we did that with eyes wide open,” said Mr Rovinescu. “We are now targetting some markets which I would characterise as largely leisure, with point-to-point attractions that don’t attract business travellers or corporate accounts. We’re talking about places like that. We’ll have a different product so there will be a major differentiation from the mainline product. We learned a lot from our previous experience in the last decade.”

Chief Commercial Officer Ben Smith noted that a big part of Tango was the distribution and the fare structure with one-way fares. “The new LCC concept is going to markets that the current mainline is not optimally set up to service; where we can’t make it work with the mainline,” he said.

While it will be interesting to watch, the track record does not bode well. Even so, Air Canada is facing the same problem faced by its US counterparts, little growth on the domestic front and increasing competition on the international front. In the US, legacies are clearly focussing on international but they are also talking about growth not in terms of markets but in terms of revenues.

This earnings season they have clearly signalled no matter how efficient they get or no matter how much they narrow the cost gap with LCCs, the gold at the end of the rainbow lies in ancillary revenues and turning traditional distribution models on their head. Air Canada’s development of a new cost category – distribution and sales costs – signals it is also aware of the antiquated distribution model can not be sustained if legacies are to excel. With a CAD24 million or 17% jump in such costs, it too is clearly hoping for relief and the ability to tap the gold mine that is ancillary revenues.

It will be interesting to see whether these changing dynamics, if they do happen, will have a similar impact as creating an LCC subsidiary.

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