Lufthansa weighs future in Asia Part 2: Amassing scale for partnership/new airline will be critical

Part 1 of this report can be found here: Lufthansa's long-haul low-cost Asian operation. A range of partner options

Air France-KLM has a quiet but efficient partnership with the Jetstar Group, and Emirates is also set to tap into the Jetstar Group's network, especially in Asia, via its partnership with Jetstar owner Qantas. Jetstar is formally agnostic in its willingness to connect with full service airlines, but that position may evolve. SIA's Scoot has made clear it is open to partnerships while the AirAsia and Lion Air groups are more insular but would surely not overlook opportunities presented from one of the world's largest international airlines.

Low-cost long-haul has shown promise under eight hours

There is no shortage of expert opinion, based on operational logic and the scanty evidence of a handful of discontinued long-haul airlines. But Lufthansa's consideration of establishing a long-haul LCC should not be ruled out based on the failures of carriers like Viva Macau and Oasis Hong Kong. The collapses in those cases were unique: Viva lacked traffic rights it thought it could attain while Oasis was operationally profitable between Hong Kong and London at the time of its collapse, spurred by a shareholder disagreement about future funding.

The long-haul LCC approach does have its limits, however. On long-haul and ultra-long-haul services, those over about eight hours, fuel becomes such a high component of cost (upwards of 60% or 70%) that efficiency savings elsewhere (other input costs, high utilisation, density) become less significant and thus fares more comparable to legacy operators. Long-haul legacy airline services also tend to have very high load factors and dense configurations too. Also, the greater the distance, the greater number of one-stop alternatives.

AirAsia X in 2012 withdrew links from Kuala Lumpur to London and Paris, but it should be noted the carrier probably never entered those markets with its eyes on profitability on those routes alone. At the time of the London route's launch, AirAsia X was willing to only break even in exchange for the publicity and brand exposure it would receive. Nor should it be ignored than linking Kuala Lumpur with London was the original vision Tony Fernandes had for a low-cost airline before he was advised to concentrate on short-haul, which he did with AirAsia.

And as AirAsia gained success it irked Malaysia Airlines, so AirAsia X's London route also served as a form of competitive irritation - but this became unnecessary following the AirAsia-Malaysia Airlines cooperation (since cancelled), which came at a time of higher fuel prices and taxes increasing the losses on AirAsia X's European routes. AirAsia X's IPO prospectus shows the challenges the carrier faced on very long-haul flights to Europe and New Zealand, but also the potential on more medium/long-haul sectors to Australia and North Asia.

See related articles:

• AirAsia X IPO prospectus shows strength. AirAsia synergies help, also require definition
• AirAsia X route changes spotlight ownership complexity post MAS deal, but also growth opportunities

AirAsia X is considering a return to Europe with A350s, and Jetstar and Scoot are also waiting for next-generation aircraft to consider Europe, but even with the efficiency, they may prefer to concentrate on the larger and likely more profitable intra-Asia Pacific growth. Europe-Southeast Asia is a competitive market.

More importantly, there are now at least three active long-haul low-cost operations, each of them reportedly profitable: AirAsia X, Jetstar and Scoot (Cebu Pacific will also operate long-haul, along with its short-haul). All of them operate widebody aircraft on intra-Asian routes mostly between seven and eight and occasionally 10 hours. They have other common features too; they are not ultra-low cost, but are considerably lower cost than their competition; they have all hybridised, with some form of business class; each is, in one way or another connecting into other airlines' services over one or more hubs; and they apply LCC-type pricing offers. It is probably more accurate to classify them, if they must be classified, as simply a new, more efficient long-haul model. Thus they are (1) new; (2) more efficient and lower cost; (3) they target various yield sources; and (4) they have independent management. Two of them are subsidiaries of full service airlines - an advantage across a number of fronts - and AirAsia X is part of a wider group, linking into AirAsia's short-haul LCC operations.

New brand requires spooling-up but Germanwings does not offer a clean slate

A long-haul LCC for Lufthansa could be born out of a new brand (adding to an already large portfolio at the Lufthansa Group) or be expanded from Germanwings, the short-haul LCC Lufthansa is expanding as part of its own changes in the short-haul market. Germanwings, however, has some way to go as a brand and also already features some inefficiencies from its previous iterations and strategic approaches. A new brand would offer a clean slate from a cost perspective but also management, enabling a team to construct a long-haul LCC suitable for the purpose without being weighed by influences from Germanwings.

SIA's Scoot has had a strong brand launch, even if it understandably lags behind the mighty AirAsia brand. Jetstar's long-haul brand is the same while AirAsia X is so close - intentionally - to AirAsia that few passengers recognise the difference. Cebu Pacific's long-haul division will fall under the Cebu brand and AOC but with a different management team, the carrier believing the inherent difference in long-haul versus short-haul operations means it needs split management.

See related articles:

• Asian airlines watch Lufthansa's short-haul transformation, wanting change to their own services
• Cebu Pacific's new low-cost long-haul operation to initially focus on Middle East & regional routes

Lufthansa could look to Rouge or Jetstar long-haul - but this would limit potential

If Lufthansa were to establish its own long-haul LCC, there are broadly two streams to follow. The first is that from Jetstar (owned by Qantas) and forthcoming Rouge (Air Canada), and the second from AirAsia X (AirAsia Group) and Scoot (Singapore Airlines).

Whereas Jetstar and Rouge are considerable point-to-point carriers, AirAsia X and Scoot depend more on feed, AirAsia X from short-haul AirAsia subsidiaries and Scoot from Tiger Airways, SilkAir and Singapore Airlines. Scoot's long term success without feed would be nearly impossible. AirAsia X and Scoot benefit from local nuances in their point-to-point traffic: Malaysia Airlines has not fully exploited international markets, allowing AirAsia X to do so. Many of Scoot's routes are new to the Singapore Airlines Group, such as Dalian, Gold Coast, Shenyang and Tianjin, meaning that Scoot does not have to compete locally to those points. A long-haul LCC from Lufthansa will encounter fiercer competition.

See related articles:

• SIA's Scoot needs feed from Tiger Airways and smaller aircraft to achieve profitable growth
• Singapore Airlines interline boosts Scoot's prospects but growth & profits are still two years away

The Jetstar long-haul and Rouge models can be characterised as serving explicit markets at a lower cost base than the parent airline. These are typically very leisure-oriented markets. Jetstar long-haul links Australia to Hawaii, Southeast Asia and Japan. Rouge will initially link Canada to Caribbean destinations as well as European cities of Athens, Edinburgh and Venice. Jetstar and Rouge's markets are light on corporate and high-yielding traffic. Their lower cost base is more appealing, and a cabin configuration that is denser and without lie-flat seats more appropriate.

Critically, competition is light in some of the markets these carriers serve, largely due to Australia being an end-of-line destination and Canada not receiving the trans-Atlantic traffic its southern neighbour does. In most cases, Jetstar and Rouge are the only convenient options.

Jetstar long-haul and Rouge will depend on domestic feed for the long-haul sector, and the majority of passengers will be from the home market, typically going to the destination of the long-haul flight. Neither carrier places strong emphasis on connections from the long-haul point, with an exception to Jetstar's service to Singapore, the hub of its Asian short-haul operation Jetstar Asia and the base for three Jetstar-operated A330s, and services to Japan, which can now link to Jetstar Japan. Jetstar's Bangkok, Denpasar Bali and Honolulu (the latter, one of sometimes the most profitable route) services see passengers overwhelmingly end their journey at one of those cities.

The difference in strategy between Jetstar and AirAsia X/Scoot is apparent in fleet growth. Jetstar is targeting a modest long-haul fleet of just over a dozen 787s (which will replace its 10 A330s and then allow for limited growth) while AirAsia X has nine A330s with 18 on order, as well as 10 A350s on order. Scoot has 20 787s on order that will replace its four (soon five) 777-200s and allow for growth. (To put these figures in perspective, Singapore Airlines today operates 102 widebody aircraft.) It is notably however that Jetstar has the flexibility to ramp up on the back of Qantas Group orders for the 787, should Qantas later so elect.

See related article: AirAsia X, accelerating growth in response to Scoot, looks to capture Asian market once and for all

The disadvantage to the Rouge and Jetstar long-haul models for Lufthansa's purposes is the lack of focus on onward connections (with the exception of Jetstar's small long-haul operation at Singapore). India and Southeast Asia have scores of airports that are small enough that they lack intercontinental traffic but large enough that not insignificant passengers could be gained from a connecting service. Launching a new carrier to an Indian or Southeast Asian city without onward connecting options (as Norwegian will initially do with its 787s) could be possible and profitable but certainly a missed opportunity. So if Lufthansa goes down the path of having its own LCC, it would be wise to gather friends and make partners.

But first: is Lufthansa ready to de-emphasise premium traffic?

Lufthansa could follow the above approach and create a unit or subsidiary for specific markets, such as in India and Southeast Asia, that are not profitable on Lufthansa mainline. Lufthansa presumably would have considered changes it could make within its existing operation, such as a more efficient fleet (the carrier has a high number of A340s and 747-400s), higher seating density and stripping out unnecessary (and weighty) galleys and in-flight entertainment. Lufthansa may fear that embarking on those latter measures would compromise the Lufthansa brand and so marketing the services as a new carrier or unit does not give passengers the expectation of Lufthansa's normal service.

A long-haul LCC would mean that Lufthansa would need to be prepared to de-emphasise premium traffic. Indeed, the problem on some Indian and Southeast Asian services is that its premium traffic, in volume or yield, is too light. While long-haul LCCs can incorporate premium products, this is no substitute for a full-service carrier's premium cabin.

If Lufthansa sees viability in full service but on a lower cost base, there are examples of half-way approaches. Air France has a sub-fleet of 777-300ERs that serve long-haul leisure routes around the Indian and Pacific Oceans. They have a lighter premium cabin and seat 10 abreast in economy compared to the nine on the rest of its 777 fleet (Emirates and Etihad already seat 10 abreast on their workhorse 777s). Air Canada will have a small number of high-density 777-300ERs that have fewer premium seats and a tighter economy cabin; the new denser configuration will seat a staggering 109 additional passengers on the same floorspace.

Air Canada saw that the markets for the new denser 777 could not be served sustainably by its existing operation but were also not (yet, at least) suitable to be handed over to Rouge.

India and Southeast Asia are distinct markets and may require individual solutions

Lufthansa's concern is loss-making services in India and Southeast Asia. It is tempting, and geographically accurate, to group these as "Asia", but they are distinct markets. They will likely require their own individual partnership solution. Two caveats: tying up with the AirAsia Group, which is planning an Indian subsidiary, could cover Lufthansa in India and Southeast Asia. A deeper partnership with Turkish Airlines or a Middle East network carrier could cover Lufthansa in both regions, but on some metrics not as adequately.

Lufthansa may feel inferior at Emirates' dozen-odd destinations in India and Southeast Asia, but a local carrier in each market has wider reach. India's leading LCC, IndiGo (another possible candidate for partnership), serves 28 Indian cities while AirAsia serves 85 cities around Asia Pacific. With size comes scale in the form of additional passengers from existing destinations and passengers from destinations Lufthansa did not previously have convenient access to.

South Asia accounts for about 2% of Lufthansa's international northern summer seat capacity while Southeast Asia is even less, so these markets are important but not Lufthansa's lifeblood. They will however, be the source of much future potential growth.

Lufthansa international seat capacity by region: 24-Jun-2013 to 30-Jun-2013

Source: CAPA - Centre for Aviation & Innovata

India has limited connecting opportunities to Southeast Asia. Tiger Airways links Singapore with Indian cities, and AirAsia will grow its India-Southeast Asia network following the launch of its Indian subsidiary. Jetstar has shied away, seeing the market as presently too competitive for services from Singapore or its own subsidiary in India (Jetstar has a sizeable interline agreement with Jet Airways).

Indian carriers have concentrated on the domestic market (in the case of the LCCs, because government regulation required several years of domestic service before going international); regional flights around Asia are limited and in some cases are growing, including from SpiceJet, which recently opened a Delhi-Guangzhou service. But there have been also many recent examples of LCCs pulling out of India-Southeast Asia routes, including AirAsia and IndiGo, as well as Tiger and Jetstar Asia. India is a severely choppy market, despite its potential.

Growth is also dependent on air services agreements, and the ASEAN region currently enjoys a more liberal stance than nations have with India, and is lining up for the phase-in of an open skies agreement in 2015.

20 largest carriers ranked on international seat capacity to Southeast Asia: 24-Jun-2013 to 30-Jun-2013

Rank	Airline		Total Seats
1	SQ	Singapore Airlines	458,684
2	TG	Thai Airways	393,036
3	MH	Malaysia Airlines	262,788
4	AK	AirAsia	245,880
5	CX	Cathay Pacific	166,741
6	VN	Vietnam Airlines	148,790
7	EK	Emirates	136,868
8	PR	Philippine Airlines	114,802
9	TR	Tiger Airways	114,120
10	QZ	Indonesia AirAsia	104,400
11	GA	Garuda Indonesia	103,144
12	MI	SilkAir	96,336
13	FD	Thai AirAsia	93,960
14	3K	Jetstar Asia	81,880
15	CI	China Airlines	78,846
16	MU	China Eastern Airlines	78,694
17	QR	Qatar Airways	78,175
18	5J	Cebu Pacific Air	75,260
19	KE	Korean Air	72,868
20	D7	AirAsia X	67,408

Source: CAPA - Centre for Aviation & Innovata

20 largest carriers ranked on intra-Southeast Asia system seat capacity: 24-Jun-2013 to 30-Jun-2013

Rank	Airline		Total Seats
1	JT	Lion Air	851,317
2	AK	AirAsia	466,920
3	GA	Garuda Indonesia	427,654
4	MH	Malaysia Airlines	333,236
5	5J	Cebu Pacific Air	291,959
6	VN	Vietnam Airlines	280,172
7	TG	Thai Airways	236,136
8	SJ	Sriwijaya Air	207,396
9	FD	Thai AirAsia	177,840
10	QZ	Indonesia AirAsia	176,040
11	QG	Citilink	135,864
12	IW	Wings Air	125,898
13	DD	Nok Air	124,866
14	2P	PAL Express	113,536
15	SQ	Singapore Airlines	111,720
16	PG	Bangkok Airways	104,580
17	PR	Philippine Airlines	104,280
18	MI	SilkAir	70,316
19	TR	Tiger Airways	67,680
20	MZ	Merpati Nusantara Airlines	67,536

Source: CAPA - Centre for Aviation & Innovata

Aircraft range also becomes an issue. Narrowbodies are the workhorse of LCCs, and the region's LCCs tend to prefer to operate them on flights under 3,000km. From New Delhi such a range is not sufficient to reach Indonesia, Malaysia and Singapore, amongst other regions. (IndiGo tried Delhi-Singapore despite it being a very long route for a short-haul LCC but recently dropped it.)

A base at Kolkata in far eastern India starts to bring these regions into focus but is not necessarily the best hub from an Indian perspective. Nor is it convenient for Indian connections from Europe given the backtracking involved, meaning Lufthansa could not simply (too simply) put capacity into one city and have it connect across India and Southeast Asia.

Even where range is in focus, demand for Southeast Asian cities is not necessarily there. And if demand is present, it may be at limited frequencies whereas intra-Southeast Asia demand (from a Southeast Asia hub) is larger and frequencies higher, giving more connecting opportunities to Lufthansa in terms of flights as well as a cheap connecting seat on any one of a day's services to bring down the total trip cost.

3,000km range from Chennai, Kolkata and New Delhi

Source: Greater Circle Mapper

Extending the range to 3,600km, about the length of SpiceJet's Delhi-Guangzhou service, operated by 737-900ERs with longer range than the more common 737-800s and A320s, still presents range limitations in addition to demand and frequency. Indeed, SpiceJet's Delhi-Guangzhou service is offered less than daily.

3,600km range from Chennai, Kolkata and New Delhi

Source: Greater Circle Mapper

So Lufthansa would need a partnership solution for each market unless it can find a suitable way of covering both - but without compromising both. The Indian market could change for Lufthansa once an Indian carrier - most likely Jet Airways - joins Lufthansa in the Star Alliance.

Within the alliance framework, there could be opportunity to grow closer to SilkAir, the regional subsidiary of Singapore Airlines which so far has been reluctant to join Star. Lufthansa already interlines with SilkAir, which has recently been the most profitable carrier in the SIA portfolio and does not have cheap fares. SIA is pragmatically expanding its partnerships, in volume and depth, but Lufthansa may simply seek to leapfrog these models and go in search of a new age carrier.

See related articles:

• Singapore Airlines looks to ride out the storm as profits continue to slide
• Singapore Airlines Group aims to improve long-term outlook following its biggest ever strategy shift
• Singapore Airlines regional unit SilkAir poised for rapid growth after quietly emerging as SIA's gem

Asia's LCCs offer partnership options

Partnerships and connections with LCCs have sprouted up as strategy evolves and carriers realise there are opportunities for modest cost growth in exchange for larger yield growth, and also partnerships becoming physically possible. Navitaire, which most LCCs rely on, supports partnerships although in some cases LCCs have switched to legacy suppliers to pursue more robust partnership options. Airports (with airline nudging) are also starting to accommodate LCC transfer traffic.

AirAsia, Jetstar and Tiger offer connections amongst their individual AOCs as well as to other AOCs within their family (Thai AirAsia to AirAsia X, Jetstar to Jetstar Japan as well as Tiger to Scoot). Externally, and to full-service carriers, they vary. AirAsia has not embarked on this path the way Jetstar and Scoot have. Scoot sells SilkAir and Singapore Airlines interlines (and Scoot passengers on SIA/SilkAir receive standard service on those flights) but the two do not sell on Scoot, fearing a passenger will expect full-service SIA/SilkAir offerings and instead be on low-cost Scoot. The issue here is not the connection between the carriers but rather lack of communication. SIA feels it can deliver what would enable it to sufficiently differentiate the products to passengers.

A number of other airlines do not have that problem - or perhaps are not as worried about a backlash as SIA. Jetstar has codeshares with American Airlines, Japan Airlines and Qantas. JAL places its code on domestic Jetstar Japan services and only sells them when an international ticket is being purchased, the rationale being that Jetstar Japan opens more connecting opportunities. Jetstar Japan also has more domestic services than JAL at Tokyo Narita and Osaka Kansai airports where most of JAL's international flights are from. Without the Jetstar Japan codeshare, passengers would likely have to switch airports.

The Jetstar Group also has 25 interline partners, including with Air France-KLM, Lufthansa and Jet Airways, which sell Jetstar services (but Jetstar does not sell on them). Jetstar has rather easily gotten past the full-service versus LCC product alignment challenge by offering Jet Airways passengers free checked luggage and, for long-haul flights, complimentary meals, drinks and amenity kits. JAL passengers on Jetstar Japan codeshares receive complimentary checked luggage (and can have lounge access if they qualify under JAL rules) but pay for all other extras; this is becoming the basic formula. The alignment is not perfect, but by managing expectations potential issues can be averted. The short-haul nature of most of these connections means any lack of alignment and/or communication is not critical as the flight is relatively short.

Emirates and Qantas have flagged that their partnership will encompass Jetstar's various hubs, but the mechanics of the partnership - relatively straightforward once the two sit down together - have yet to be worked out.

Most other LCCs in the region do not offer connections, internally or externally. Peach for one is steadfast about not having connections, but for the other carriers the lack of connections or partnerships is less an opposition than it is not yet seeing the market or having the resources to implement it.

See related articles:

• Japan Airlines and Jetstar Japan embrace LCC hybridity, codesharing - and reap rewards
• SIA's Scoot needs feed from Tiger Airways and smaller aircraft to achieve profitable growth
• Singapore Airlines interline boosts Scoot's prospects but growth & profits are still two years away
• Low-cost airline Peach boldly pursues Japan-Southeast Asia one-stop market using new Okinawa base
• Jet Airways-Jetstar interline positions carriers for growth in India, Southeast Asia and Australasia

Lufthansa feed would make many airlines envious, but integrating it would be challenging

If Lufthansa pursues its own new operation, it will need to consider how to integrate feed. Feed from short-haul LCC Germanwings would be relatively straightforward as Germanwings is already an LCC (the Scoot-Tiger partnership is a model here) but working with full-service Lufthansa feed would be another matter. Ignoring it would limit the new operation's growth, especially if it is to take over services from Lufthansa. SIA has ignored selling Scoot flights (while Scoot can sell onto SIA's) - perhaps unwisely, and not forever - but SIA may see it has little to lose since Scoot is not being handed SIA routes. (Scoot has the flexibility to launch routes alongside SIA and has done so in some cases such as Sydney. It also has the option of picking up routes SIA drops but so far has elected not to.)

Again, communication and the managing of expectations is key. This is new territory for Lufthansa, although it has exhibited some skills at allowing its other brands, like SWISS, considerable autonomy. But there are many nuances, with leverage confined to its website and distribution channels Lufthansa has control over. For the GDS, a Lufthansa codeshare on a new LCC service may not be effectively communicated. Forgoing the codeshare could limit sales opportunities.

Catching up in India/Southeast Asia could put Lufthansa at forefront in North Asia

Lufthansa's dilemma is substantial but options numerous and conceptually easy to understand - if difficult to agree on and implement. If Lufthansa can work out a successful solution, far easier said than done, it has the opportunity to position itself in Southeast Asia above rivals who face the same problems to varying degrees as Lufthansa but are holding back on acting.

Lufthansa's reactive experience in Southeast Asia could later provide it with the opportunity to be more proactive in North Asia. North Asia is less affected by Middle East network carriers as diverting through their hubs from Europe on the way to North Asia adds journey time, but there is still some dilution of Lufthansa's German hubs. A lurking challenge is mainland Chinese carriers who are full of potential but with a long list of necessary changes, most of them firstly in the domestic market. Lufthansa could very well insulate itself against the challenge by having a deeper partnership with a full-service carrier or looking at the rapidly growing but still young LCC scene in North Asia.

For Lufthansa to adopt a relatively innovative response in the Indian and Southeast Asian markets would be considered a major breakthrough. But, even if management is sufficiently creative to seize the opportunities, they must drag along - or persuade - a lot of baggage from their established operations. Some of that, in the form of brand and yield premium, is a positive; the other could be a showstopper.

But if a carrier like Lufthansa can do it, it could in fact be the start of a further round of innovation and evolution to partnership models.

It should be lost on no-one that Lufthansa, the glue holding Star Alliance together and the member adamant about keeping Middle East carriers out as members or partners of members, has realised it is time to seek new partnership channels.

That is the first step. It is not easy to get to there, but it will be even harder to implement. Innovation offers success, but it also often invites failure. There has to be a willingness to be able to absorb failures en route to the next plateau. That is not something that most established airlines are geared to accepting in these uncertain times.

Airlines in Transition, 11/12 April 2013

CAPA's second annual Airlines in Transition conference takes place in Dublin on 11-Apr-2013 to 12-Apr-2013 and covers the topic of airline hybridisation. Airline CEO speakers so far include Willie Walsh (IAG), Dave Barger (JetBlue), Alex Cruz (Vueling), Christoph Mueller (Aer Lingus), Adel Ali (Air Arabia), Kevin George (Monarch Airlines), Antonio Menezes (SATA) and Patrick Yeung (Dragonair) and many others. For more information, see the CAPA conference home page: Airlines in Transition 2013