Low Cost Airlines - LCC Outlook: Who will be the winners and losers?


The mere prospect of diversity contrasts starkly with experience in the airline industry of the past few decades. One of our experts illustrated this by quoting from two airline executives: 'The current regulatory system does not allow winners to win and losers to lose.' And, 'the exit barriers in the global airline industry are higher than the entry barriers.'

With the advent of an array of new entrant airlines, each sharing a lower cost discipline, but all independent of "flag" carriage, the status quo is no longer. For the airline industry, the world has changed - and will continue to do so. Ideally this will lead to a financially healthier and more transparent environment. Constraints will always exist, but a system where rewards follow intelligent innovation and sound management has become a more realistic goal.

This extract is from the 'Great Expectations' section of CAPA's Global LCC Outlook report, available for free download at: centreforaviation.com/lcc/report

In the chapter, the report draws together the views of low cost airline CEOs from each region, together with those of industry experts, Professor Michael E. Levine, Dr Julius Maldutis, Professor Nawal Taneja and investor, Bill Franke of Indigo Partners. The chapter attempts to draw together the various threads, linking at the same time the views of airlines from each region. And, despite the varying levels of LCC development and the domestic/international differences, a perhaps surprising level of similarity of outlook emerges.

Schumpeter vs the airlines

It was, according to Joseph Schumpeter, entrepreneurial innovation that generates gales of "creative destruction" as innovations cause ageing inventories, ideas, technologies, skills, and equipment to become obsolete. He proposed that it is not "how capitalism administers existing structures, ... [but] how it creates and destroys them." This creative destruction, leads to continuous progress, thereby improving standards of living for everyone - and, by implication, securing the survival of a company, which goes through that process.

Much of the airline industry, especially the flag carriers, is longstanding and even geriatric. Many airlines still carry much of the baggage from their decades of existence. Of a relatively small industry, there are at least 10 major airlines that have existed for over 80 years, still in more or less the same form.

In most cases LCCs are not yet old enough to suffer corporate sclerosis, but this will occur progressively as airlines age and merge, or as they become more entrenched with unions.

Creative destruction is becoming increasingly a force to be sought out. Many full service airlines have dabbled at the edges of such a massive reinvention, but, in the absence of a tsunami of change, the inertial forces are such that total - rather than creative - destruction becomes more likely. This, despite the recidivism of many governments even today. There can hardly be a future in bailing out dinosaurs.

But in some ways we may be in the midst of that tsunami of change. The industry (or much of it) is suffering like never before. And the worst is probably yet to come. Having suffered the abrupt slump of the past 12 months, even if the slide has ended, prospects are that the industry will bump along the bottom for as much as another year. Applying the philosophy that this recession is "too good to miss", the opportunity for real adaptation by the weaker legacy airlines will never be greater.

Moving towards a New Normal

Professor Nawal Taneja sees this as the likely move to a "New Normal": "Composition, performance, and relative importance of economies, particularly of the US, will most likely see radically changes. Although the airline business has always been more exposed (than many other businesses) to the economic cycles, the current crisis is likely to have more severe impacts, such as considerably less financial leverage in the system. Moreover, even when the economies begin to show signs of a modest recovery, oil prices (that have a disproportional leverage on airlines) could go up again."

He sees a "post-crisis world" which is likely to be "fundamentally different". "Traditional airlines have obviously been trying, as best as they can, to deal with the current crisis, using their current business models and within the inherent constraints relating to the airline industry. However, airline leadership in the future will need to deal with a "new normal," that will be include the expansion of truly powerful low cost carriers (in regional and intercontinental markets) as well as people purchase behavior to "trade down."

…while airlines get bigger and older

But the search for a new normal will consequently be a dynamic one for all carriers, as legacy airlines increasingly respond to the low cost operators. And this challenge comes in two main forms: dealing with a larger sized operation and managing the results of ageing.

As the CEO of relatively young (long haul-low cost) AirAsia X, Azran Osman-Rani noted, "For AirAsia, the threats and challenges will primarily come from reaching a bigger size." From a tiny bankrupt shell in 2001, AirAsia will challenge to be the largest airline in Asia (by capacity) by 2013.

"Our operating model and management style will have to evolve accordingly. Growth breeds complexity. Survival and continued success will hinge on our ability to change and adapt. Creatively destroy anything that holds back growth - without emotional attachment and organisational resistance, and reinvent ourselves while keeping the core AirAsia brand and consumer proposition alive and fresh. We have to be smarter at deploying and managing a much bigger sized aircraft fleet. We need to completely remodel the way we manage airport terminal operations, and we have to look at acquiring new customers - especially ones that are less price-sensitive and place more importance on the service experience."

And, for example, the granddaddy of all of the LCC models, Southwest Airlines, employs pilots who now enjoy relatively luxurious conditions. The carrier's pilots' union recently imposed significant restrictions on cross-border/international cooperation by the airline and, along with their counterparts in Frontier Airlines, were largely responsible for preventing a takeover of the bankrupt Frontier.

Jim Parker, of Raymond James, told us he believed this to be one of the biggest problems ahead for the sector: "Labor costs are expected to be the most challenging issue for LCC's in the US as pilots demand to be paid the same rates as Southwest - whose pilots are the highest paid in the industry."

Southwest's recent attempted takeover of Frontier is itself a sign of the way the airline has changed tack as it became the biggest domestic carrier in the US.

Evolving - or preserving - the LCC model?

This all sets the scene for a continuing and increasingly chaotic process of adjustment, not just for legacy carriers, but right across the industry, with each airline having to confront its own issues, peculiar to its region and home market. And, it is not surprising therefore that there are clear divisions between CEOs and experts on where the dry ground lies.

With this in mind, the first question we asked our CEOs, investors and experts was how they saw the LCC (and the overall airline) model evolving over the next three years.

This delivered a marked difference of opinion between those who see the low cost model(s) as an unforgiving constant, up against the proponents of adaptation into evolving environments. On balance however, the numbers are heavily with those who see evolution as inevitable - and often desirable.

The "real LCCs" and the others

The divide essentially follows the lines of a difference in philosophy which we identified in the body of this report: (1) the "pure" low cost model - which is a tiny minority of low cost airlines operating today; and (2) those which come off a low cost base but are modifying their model to embrace frills of one or more kinds.

The number of airlines which wholly complies with the classic low cost airline profile - independent, short haul, "domestic", single aircraft type, aggressive cost control, very low fares and no connectivity, includes Ryanair, the Indigo Partners' stable (Spirit, Tiger, Mandala, Wizz Air and, most recently, Avianova), AirAsia, Air Arabia, Allegiant, and India's Indigo, GoAir and SpiceJet. There will be other claimants; these are the (nearly) uncontroversial ones. The Philippines' Cebu Pacific is also cutting edge for example, but operates two aircraft types.

(1) In support of preserving the basic model

Bill Franke, of Indigo Partners, investors in several low cost airlines from Asia to Europe and the US, sits squarely in the former group: "A lot of airlines claim they fly the LCC model. Most, in fact, do not. I think it is important that the true LCC stay the course and works to gain market share until it hits market equilibrium with legacy and other full service carriers. By "staying the course" I do not mean letting increments of full service creep into the model: interlining; longer haul flying; bigger aircraft; on-board amenities; lounges and so forth have killed a number of low cost airlines who now have to rely on shifting service, experimentation with the product and other efforts to improve their top lines, having lost their cost advantage."

At Ryanair, there is little argument. The biggest airline in Europe is of one mind with Mr Franke (one reason we have suggested a friendly future between Ryanair and Wizz Air, one of Indigo Partners' investments).

For Michael Cawley, Deputy CEO and COO of Ryanair, there is no question of where the airline is - and always will be. "The lowest cost airline in the market."

So long as that is the case, Ryanair remains untouchable. Ryanair's "competitive advantage in the European market is massive and growing". Mr Cawley believes that, right across Europe the potential remains enormous - once you drop the fares. "In the US, with a population half the size of Europe, their passenger market is vastly bigger". This is indeed a telling statistic: in 2008, intra-European passenger numbers were 356 million; 741 million US domestic passengers were uplifted during the same year.

It is hard to argue with the fact of Ryanair's successful formula and the carrier's juggernaut-like expansion. In fact it is almost intimidating to see the profile that Ryanair has taken, seeing almost boundless expansion - provided the airline maintains a brutal control on costs.

This is where Ryanair's vociferous attacks on high government taxes on aviation in the UK and Ireland make a lot of sense, as fares reduce and those taxes constitute a growing part of a disincentive to travel.

David Cush, CEO of Virgin America, sounds a broadly similar note on staying low cost: "More than ever, the low cost provider will win. The differences on the revenue side between the legacy carriers and the low cost carriers are diminishing." Clearly, cost is king in this world.

But in Virgin America's case there is a twist: "LCCs are upgrading their distribution capabilities, including participation levels in GDSs, travel agency sales, and corporate contracts, and corporate buyers are increasingly abandoning contract buying for transactional buying"-basically, buying the least expensive ticket in each transaction rather than bundling purchasing with a single airline in an attempt to maximize total savings.

One inference that can be drawn from this - and from the recent behaviour of Southwest Airlines - is that opportunities for low cost expansion in the US market have actually hit a wall, as it becomes saturated with the low cost competition from other low cost airlines, as well as low prices from the higher cost full service airlines. This appears pretty clearly not to be the case in Europe - or elsewhere for that matter.

Adel Ali, CEO of a startlingly successful LCC based in the Emirate of Sharjah in the UAE, Air Arabia, is somewhat more cost-driven and probably fits squarely into the basic model category (even though the airline does operate some atypical very long hauls). To extend its reach, Air Arabia once attempted a takeover of an airline on the Indian subcontinent - which operated briefly but didn't work out - and has recently established cross-border joint ventures in Morocco and Egypt. Each were adaptations to get around international regulatory constraints. They are variations on the basics, but do not influence the low cost obsession.

Indeed, Tony Fernandes, mercurial CEO of the AirAsia Group in Malaysia, argues that the establishment of cross border low cost subsidiaries, even if they involve more complexity, gives the airline "more options for choosing lower cost alternatives", as different markets have varying cost bases. This means that "we can position our activities like aircraft maintenance, crew training and recruitment generally in the markets where the quality is high but the costs are lower."

Adel Ali believes that the "low cost travel market segment is set to grow in the Middle East. Air Arabia introduced this model to the region five years ago and since then air travel has shifted to something better. Customers now have the choice to select what is best for them and the travel trend is moving towards value for money air travel." This is not as obvious a development as elsewhere. The force of belief that the "wealthy" Middle East would not support no-frills, low cost products was nearly overpowering. Until a couple of years ago, Dubai Airport for example would not admit LCCs. But the model persists and flourishes - sufficiently effectively that it eventually pushed Emirates Airline's parent to establish its own Dubai-based low cost subsidiary, flydubai.

And the world's lowest cost airline, AirAsia X (with a non-fuel CASK[1] of US 1.5 cents, or 2.5 cents with fuel) understandably sees cost as dramatically the highest priority. Says Azran, "Airlines have to keep examining the entire operating model and value chain and keep finding new ways to take cost out. Nothing should be left unchecked. Even a successful premium carrier like Singapore Airlines thrives because they are the lowest unit cost operator in their category. Yields will keep shrinking in real terms, and comparative lower costs will be absolutely essential to survive."

And he adds one thing that a much longer-established airline like Ryanair is now pretty well able to assume in most of its markets: "Size of fleet, breadth and depth of route network, market share on individual city-pair routes, and extent of brand reach, will become even more critical going forward." But here the differences start to emerge: "Models will keep evolving as LCCs acquire more scale and grab a bigger share of overall commercial aviation." There is another underlying vision here. Of perhaps something that looks like a full service operation stripped of costs and the more complex activities that involves.

Download the full Global LCC Outlook report at: centreforaviation.com/lcc/report

Comment at our blog: https://centreforaviation.com/lcc/blog

[1] CASK - cost per available seat kilometre. Azran candidly offers too that his revenue per ASK is currently 2.7cents. A thin margin, but, unlike the full service airlines, above the cost of provision.

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