18-Apr-2013 1:25 PM

Airlines in Transition part 3: How full service airlines are reshaping models to be more competitive

Analysis

Over the past three decades, airline industry profits followed a fairly consistent cyclical pattern until the turn of the twenty-first century, which has so far seen seven loss-making years. If 2013 reports a profit, as forecast by IATA, the industry will have had four years of positive results (2010 to 2013). Nevertheless, profits are insufficient to cover the cost of capital and full service carriers still face critical challenges.

The global economy is still weak, fuel prices remain high, LCCs are undermining the legacy carriers' short-haul markets and the rapid expansion of Gulf carriers is having an impact on their long-haul markets. In our third report on CAPA's Airlines in Transition conference, we look at how FSCs are responding to these challenges.

Summary

Airline industry profits have followed a cyclical pattern, but this pattern has been disrupted since the early 2000s.
Full-service carriers (FSCs) face significant challenges including weak global economy, high fuel prices, competition from low-cost carriers (LCCs), and expansion of Gulf carriers.
European airlines are particularly struggling, with weak profitability and competition from LCCs.
FSCs are responding to challenges through consolidation, operational changes, new marketing concepts, and the adoption of new business models.
FSCs can still compete in short-haul markets with LCCs if they are aggressive on costs and segment their customers.
Smaller FSCs can survive by adding value through niche markets, market knowledge, or product quality.

What is happening to the airline profit cycle?

Through the 1980s and 1990s, the airline industry profit cycle appeared to be reasonably regular, with three to four years of losses followed by five to six years of profits. Since the start of the 2000s, however, this pattern appears to have been broken. We saw losses that were deeper and lasted longer, five years, at the start of the decade (2001-2005), followed by only two years of profit (2006-2007) before a return to losses (2008-2009). Profits returned in 2010, after only two years of losses, but then fell in 2011 and 2012.

Net profit or loss of world's airlines as % of total revenues: 1980 to 2012

Among the major air traffic regions, Europe is doing particularly badly, with IATA forecasting that its airlines will report an aggregate net profit of only USD800 million in 2013. Considering that Ryanair and easyJet are forecast to report somewhere in the region of USD1.2 billion to USD1.5 billion between them, this highlights the weak state of most of Europe's airlines.

Significant challenges mean structural instability

This raises questions of whether airline profits are sufficient or are they facing a period of structural instability? In a session at CAPA's Airlines in Transition conference, Professor Rigas Doganis identified a number of challenges facing the full service carriers. The global economy remains weak, with the eurozone crisis continuing to make its presence felt and the previously rapid economic growth of China and India slowing. Fuel prices remain at historically high levels and competition from newer carriers with fresh business models has threatened the position of the traditional legacy carriers.

On long-haul routes, competition from carriers based in the Gulf and Turkish Airlines has also grown. The bigger airlines in that region are growing capacity at rates of 12% to 15% p.a. or more compared with an average of 3% for European legacy carriers in 2013.

Competition from LCCs is undermining the short-haul operations of legacy carriers, with Asia-Pacific now also significantly part of this global trend. In four of Europe's largest countries (UK, Spain, Italy, Poland), more than half of airline seats are operated by LCCs. Their average penetration across Europe was 47% in 2012, compared with 17% in 2003.

Given higher load factors, their share of passengers is higher still and their penetration of point-to-point routes is also higher. At Singapore's Changi airport, LCCs had a 30% share of passengers in 2012, up from virtually zero in 2004.

Share of LCC seats on domestic and intra-European routes: Aug-2012

Airline responses to uncertainty and instability

These challenges mean continued structural instability. There have been a number of responses by legacy airlines to these challenges. Rigas Doganis characterises these responses as follows:

Consolidation and concentration, including market exit, merger/acquisition, joining alliances, metal neutral joint ventures and bilateral alliances;
Operational change and restructuring, focusing on non-fuel costs such as labour and distribution, restructuring networks (cutting short-haul), overall capacity reduction (particularly in the US), establishing LCC subsidiaries and increasing links between legacy carriers and LCCs;
New marketing concepts, learning from LCCs, simplifying and unbundling (bringing in à la carte pricing), the use of direct sales channels, developing ancillaries; and
Scramble for new business models

The scramble for new business models

Professor Doganis identifies a number of new business models adopted by airlines which are not necessarily mutually exclusive. These include a focus on long-haul and a consequent reduction in short-haul. An example of this approach would be British Airways' disposal of BA Regional and its ceasing of franchise operations with British Mediterranean and GB Airways.

A second approach is to establish a low-cost carrier subsidiary in parallel to the airline's own short-haul operations, for example a number of Asian carriers (some of which are listed below) and Iberia Express. A modification of this approach is to hand over short-haul routes to a LCC subsidiary, except for the routes feeding the long-haul hubs (Lufthansa/Germanwings is the prime example of this).

LCC subsidiaries of Asia-Pacific FSCs

A new business model that Professor Doganis calls the 'Noah's Ark' model is to operate in all segments and he gives examples as Singapore Airlines, Malaysian Airlines, airberlin and Thai Airways. In the case of Singapore Airlines Group, he notes that it has two full service carriers, SIA and Silk Air (serving long-haul and short-haul respectively) and two LCCs, Scoot and Tiger (also serving long-haul and short-haul respectively).

Singapore Airlines' "Noah's Ark" Business Model

A number of carriers have developed metal neutral immunised joint ventures, both within the branded global alliances (e.g. Delta/Air France/KLM/Alitalia, ANA/Lufthansa) and outside them (e.g. Delta/Virgin Australia). The final new business model identified by Professor Doganis is to focus on stronger bilateral alliances cutting across the BGAs. An example of this is oneworld member Qantas' new partnership with non-aligned Emirates, under which it has almost given up operating its own long-haul services to Europe.

After setting out his analysis of the situation facing full service carriers, Professor Doganis posed a number of questions to the airline executives that formed CAPA's panel for the session. These questions were also supplemented by questions from the audience.

Can full service network airlines continue to operate profitably in short-haul markets with significant LCC competition?

The consensus among CAPA's panellists is that the answer to this question is yes. Bernard Gustin, CEO of Brussels Airlines, believes that FSCs can compete if they are aggressive on costs and segment their customers, but that they can retain both long-haul and short-haul. He qualifies his response by adding that there needs to be a level playing field, referring to what he sees as state subsidies on some short-haul routes and the support received by Gulf carriers on long-haul. His airline is now profitable on its short-haul activities, after making losses last year, although it is not yet beating its cost of capital.

In the view of IAG CEO Willie Walsh, airline profitability is not a simple divide between profitable LCCs and loss-making FSCs: there are both loss-making LCCs and profitable legacy carriers. He also draws attention to the different cost structures within the LCCs, with easyJet being high cost relative to Ryanair. Derek Sharp, Group vice president and managing director at Travelport, agrees with Mr Walsh that there are many different possible models: "It is not just LCC versus full service, there is a spectrum."

Mr Walsh adds that it is possible for legacy carriers not only to operate profitably, but also to beat the cost of capital. Legacy network carriers face the additional costs and lower asset utilisation that are associated with interlining, but connectivity between short-haul and long-haul remains vital for this group of players. Cost restructuring is, therefore, crucial and IAG set up Iberia Express as a lower cost carrier to feed the Madrid hub, but not as a no-frills airline.

For smaller legacy network carriers, it is important to have a defendable niche and Allister Paterson, SVP commercial division at Finnair, argues that the Finnish national carrier has such a niche in its Europe to Asia long-haul network. He also stresses the importance of lowering unit costs to a level where unit revenues can make a profit. A combination of a market niche and product quality means that Finnair does not need to seek the lowest cost possible, since some revenue premium is possible, but he believes that "CASK is king…The path to lower costs is well-worn. It is just a question of whether Finnair has the fortitude".

Can FSCs substantially narrow the unit cost gap with LCCs or generate much higher unit yields when competing in the same markets?

Christoph Mueller, CEO of Aer Lingus, believes that FSCs need a minimum short-haul presence for their FFPs, but he predicts that non-hub short-haul traffic will eventually be the sole territory of the no-frills carriers. Moreover, he notes that there are 500 short-haul aircraft feeding legacy networks, making losses, and argues that short-haul to short-haul connection makes no sense. In addition, in some markets there has been a modal shift from air to rail travel.

As Mr Mueller says, "we can't fix the short-haul problem on the revenue side. What about costs? Air France or Lufthansa can't cut enough - they need to cut costs by 50%". He questions whether legacy carriers can exit the short-haul feed business and is doubtful of the answer, unless they can fund the lay-off costs. In the case of Aer Lingus, progress with CASK reduction means that it can compete and, moreover, it generates a RASK premium to Ryanair. For legacy carriers, sustaining low costs in a unionised labour environment is a key challenge.

IAG's Mr Walsh rejects this latter point: "it is not about unions, but management. Management needs determination and can do it if it wants to…Cost creep is requested by unions, but made by management". He admits that change is often difficult, but it can be achieved, citing the industry's ability to adapt and survive in the face of USD120 per barrel oil.

Aer Lingus' Christoph Mueller, Brussels Airlines' Bernard Gustin, Finnair's Allister Paterson and IAG's Willie Walsh (from left to right) at CAPA's AIT conference in Dublin: 11-Apr-2013

The IAG experience suggests that FSCs may be better able to narrow the cost gap if they establish a new subsidiary. According to Mr Walsh, Iberia Express has non-fuel unit costs that are 40% below Iberia's and the IAG subsidiary was profitable by Jun-2012 and over its first year of operations (it started in late Mar-2012). He does not believe that British Airways needs to achieve the same level of cost cuts as it is more long-haul weighted than is IAG sister carrier Iberia: 80% of BA's ASKs are long-haul (but only 30% of passengers). The governance structure of IAG is designed to enable different models for different markets. Mr Walsh argues that "IAG allows multiple brands and models without contamination".

On the question of low-cost long-haul, Mr Walsh says "long-haul is low-cost". Operators looking to establish in this segment will look to lower labour costs by basing employees in low labour cost countries, but he questions in what other areas they can achieve a significant cost advantage. He does not believe that the cost opportunity is as radical as it was on short-haul for LCCs.

Brussels Airlines could not cut unit costs by 50%, but Mr Gustin says that it has cut them by 15%. Echoing Mr Paterson's analysis of Finnair's situation, he believes that he needs to get his airline's CASK as low as possible and then to provide a service to a market with a niche or product that attracts a premium. For Brussels Airlines, this niche is its Africa network from Europe. Mr Gustin also sees airlines as providers of fast-moving consumer goods (FMCGs) and this necessitates responding to consumer needs. Travelport's Mr Sharp agrees that fully narrowing the cost gap does not need to be the goal: "FSCs don't need to get costs down to LCC levels, as the value proposition is different".

Can FSCs run profitable LCC subsidiaries - and under what conditions?

For Aer Lingus' Mr Mueller, cost creep will always be a problem, but he believes that it is possible for FSCs to run a profitable LCC subsidiary. However, it is not possible to create a successful LCC from the components of a legacy carrier. With this in mind, he believes that Vueling should continue to be successful under IAG ownership, but he questions whether Lufthansa/Germanwings will work. Lufthansa's dilemma may be that its collective bargaining agreements may not allow a completely new LCC with new conditions of employment.

From Mr Gustin's point of view as a CEO with a very close relationship with Lufthansa, the transfer of non-hub traffic by Lufthansa to Germanwings will succeed. He argues that this is not a question of ownership, but of management willingness. Germanwings is a separate entity, but benefits from the purchasing power of the Lufthansa Group.

Among the panellists, this question is most pertinent to Mr Walsh, given IAG's bid to buy Vueling. In his view, the key difference between this bid and other examples of legacy carriers owning LCCs is that IAG, the bidder, is a holding company. It is not BA or Iberia that will run Vueling if the bid is successful. When BA established its LCC subsidiary Go, it did not get the governance right in Mr Walsh's view: "Go was profitable, but it competed with BA, which was madness".

By contrast, Vueling will be a stand-alone, separate brand and there will only be co-operation with other IAG companies if it enhances value to shareholders. The roles of Iberia Express and Vueling within the group will be different, with the former a hub feeder at a lower cost than Iberia and the latter a point-to-point pan-European no-frills operator that also codeshares with BA and Iberia.

See related article: Vueling: a Spanish success story coveted by IAG

Will smaller full service network airlines survive in the medium term when faced with competition from large global airlines in long-haul and LCCs in their short-haul markets?

The consensus view among CAPA's panellists on this question is that smaller full service carriers need to add value through a niche, market knowledge, or product quality. As Mr Gustin puts it, "if their sole proposition is to fly the flag, then they won't survive."

In the case of Brussels Airlines, the niche is the Brussels market and its sub-Saharan Africa network, where it operates to a number of destinations not served by the Lufthansa Group. For Finnair, the niche is using Helsinki's geographic position on great circle routes between Europe and Asia to attract connecting traffic between the two continents.

See related articles:

Brussels Airlines to expand in Africa and launch New York but cut back in Europe

Finnair to open new flight to Hanoi as part of next phase of Asia-Europe growth strategy

Mr Walsh cautions that consolidation in the US has seen small international carriers disappear. He argues that other small carriers failed when trying to serve markets that were too small and so it is vital to have a strong O&D market.

Will the successful airline of the future operate the SIA 'Noah's Ark' model - operating separate airlines both full service and low-cost in both short- and long-haul markets?

CAPA's panellists questioned how this model can differentiate its products and noted the challenges in running a number of subsidiaries. Nevertheless, Lufthansa has operated many brands at the same time and profitably and this is possible with a dedicated management team.

What are your biggest obstructions and challenges faced?

A range of different issues were raised, including taxes and air passenger duty and the introduction of the 787 (Mr Walsh); foreign ownership rules and consumer demand in Ireland and the UK (Mr Mueller); the single European sky and the capacity of the industry to change and focus on the consumer (Mr Gustin); establishing the right cost base for growth (Mr Paterson); and the continued evolution of the business model to develop new products and services (Mr Sharp).