Increasingly the weight of opinion (and activity) is towards the evolution of the LCC model, as local conditions and the global market dictate. Inevitably this implies progressive convergence operationally with the full service carriers, including such features as international operation, long haul service and growing connectivity. Last year’s fuel price surge and now the global economic downturn have greatly accelerated this process.
After all, the rest of the world is changing, argues this faction, so we either must adapt to survive, or anyway should refocus in order to take advantage of opportunities that arise. Southwest, the reference point, adopts codesharing and partnerships, attempts to buy Frontier - that would have had it operating two aircraft types, temporarily at least - and generally moves towards operating bases at major airports, so change is in the air.
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.
In support of hybridising; evolving away from the basic model
Michael E. Levine ties these disparate threads together, in the process emphasing the different state of development of regional markets: “The "classic" LCC model of simplified procedures, point-to-point service, and intense resource use is by its nature growth-limited, because the number of airport-pair markets that will support frequent point-to-point service is limited. An LCC must operate in very dense markets alongside network airlines, draw surface-transport "feed" through very low fares, or operate infrequently with infrastructure supplied by others at low cost.
“In North America,” continues Levine, “the largest LCCs, Southwest, AirTran (nee ValuJet), and WestJet, are evolving into network airlines, with feed provided from other flights on their networks (even interlining!) and procedures and schedules modified to support this.
“In other parts of the world, the model is not yet mature enough to have reached this constraint, but this will happen. Ryanair has gone in the other direction, with relatively low frequency in many of its markets, fares low enough to attract surface "feed" and very limited ground infrastructure, so that the costs of low station density are carried by others, principally airports.”
In any event, says AirAsia X’s Azran, “I don’t think there’s ever been a single “LCC model”. There are many variants because individual airlines have to adapt to their unique market circumstances. What works for Ryanair in Europe or Southwest in America, may not be 100% translatable into a successful model in China or Australia. A lot depends on whether an LCC is a first-mover or a follower in its market, whether its primary competition are premium carriers or other LCCs, and the consumer preferences and income levels in its market.” (Nonetheless, adherence to strict cost controls allows AirAsia and Air Arabia to maintain arguably the lowest unit costs in the world.)
And formulator of the “New World Carrier”, Brett Godfrey, CEO of Virgin Blue, has no doubts about the direction of the industry: “We see increasing convergence of business models between LCCs and network carriers, and the leading indicator of this is that a lot of LCCs are getting into strategic partnerships with network carriers. I believe it was not until around the time of our New World Carrier strategy, LCCs were considered a separate species and it was a case of "never the twain shall meet". Now it is almost routine to read weekly in "Peanuts!" that another LCC with an excellent short haul network has established an interline or codeshare partnership with a long haul network carrier.
“For example”, he says, “Virgin Blue with Delta, GOL with American and JetBlue with Lufthansa. WestJet has entered into a “preferred partner” distribution relationship with oneworld carriers in Canada since only Star Alliance is represented in that domestic market, but WestJet is also entering into a relationship with the most traditional and conservative of all LCC’s, Southwest, rather than aligning itself exclusively with oneworld. “
But, to reinforce the position that Virgin Blue is adapting to its own market conditions, he adds: “That is not to say that we think the more "pure" LCC models such as Ryanair or AirAsia cannot be maintained - we see them continuing to prosper in their chosen markets. But what does have no future is the notion that there is only one cookie cutter LCC or network carrier model. Plainly, different models work best in different markets and with different competitive dynamics.”
Kevin Steele, CEO of Saudi Arabia’s Sama, sees “the move towards more hybrid LCCs accelerating, via three methods: (a) low cost solutions evolving for some of the legacy airlines’ ‘blockages to entry’ like GDS, interlining, ICH, FFS etc; (b) the need for more flexibility in the pure LCC model; and (c) legacy airlines themselves hurting more than LCCs, so either looking to set up/hive off their own LCC, or work with LCCs more (Dohop with Emirates Airline, along with Hahn Air for instance).” The Middle East is again a different and very new market for new entrant short haul airlines and is quickly spawning new variations on the basic model.
In Japan, the reasons for evolving the model are quite different, reflecting in turn the very specific conditions of that market, long dominated by major full service airlines, All Nippon Airways and Japan Airlines. According to Yasuyushi Motu, former CEO and now adviser to the President of Starflyer, “Under the downtrend economy we face, the LCC is likely to have a tough time since its business model depends on newly generated demand and high load factors which are now no longer easy to achieve.” Expressing a common theme, the “LCC or small airline has to grow (it is not allowed to stop) since it lives with a very small margin of profit, which is shrinking because of unavoidable 'age costs' such as maintenance and labor costs.”
This drives his conclusion, at least for Japan, that “I think the LCC is required to re-engineer its business model by 'downsizing', changing its ‘revenue management' strategy and entering into 'alliances' - including international operations.” But, in this environment, “another niche model such as small aircraft (point to point), low fare business class, and low priced charter may become popular and competitive.” Even though there may be failed precedents for one or two of these niche models, elsewhere, that doesn’t necessarily mean that they won’t work in north Asia.
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The long haul low cost airline
The long haul-low cost airline is one specific varietal that has often been dismissed as a viable operation. Does the long haul model have a future? We asked this question in the body of the report. For a long time it looked as if the underlying logic of short haul low cost operation would not translate; higher seating density and aircraft utilisation leverage simply was not available. And the failure of Hong Kong’s Oasis, for one, suggested that the doubters might be right.
But in the Asia Pacific region, at least three – very different – airlines are doing just that: Qantas subsidiary, Jetstar, AirAsia, in the form of subsidiary AirAsia X, and Viva Macau, the longest surviving long haul low cost operator, feeding “Asia’ Las Vegas”.
Jetstar, with its A330 fleet, is progressively expanding internationally, flying predominantly to tourism destinations, but also substituting for its full service parent on routes where a lower cost base is essential to profitability. Thus, for example, Jetstar recently commenced service to Tokyo Narita, replacing Qantas.
There are big plans for Jetstar too; most of the 100+ B787s ordered by Qantas Group were destined for the low cost operation and it will eventually be the first in the group to fly the B787-9 type, when they arrive. Jetstar codeshares and interlines with Qantas internationally and domestically, shares lounges, frequent flyer programme and a range of purchasing activities.
AirAsiaX appears to be developing a format that not only makes long haul-low cost possible, but allows its CEO to suggest that, startlingly, it may be the long term survival ingredient for LCCs: “One key competitive differentiator for AirAsia will be its long-haul affiliate, AirAsia X. We are only now discovering the tremendous potential that long-haul trunk routes brings to the core short-haul regional business – in terms of passenger feed, brand extension and operating scale. ‘Purist’ LCCs that are steadfastly staying only in the narrowbody space will be competitively disadvantaged, as will legacy carriers that are not investing in next-generation long-haul aircraft with their game-changing superior economics.”
This may be visionary, it may be a prescription only for successful expansion in Asia’s largely international markets – but, whatever, it is a strategy from the cutting edge of low cost airline thinking, as AirAsia X is on the brink of expanding from its Kuala Lumpur base into another “hub” in the UAE, as well as heading eastwards into the US West Coast, to complement its Australian and Chinese points. Like the London Stansted service established last year, this will serve an airport which has multiple low cost operators: Oakland.
Viva Macau (not to be confused with Air Macau, whose monopoly of unused bilateral rights inhibits Viva Macau’s China expansion), which commenced long haul operations in 2005, is still small, now with three B767s, but is in the black and starting to consolidate. As the longest surviving long-haul LCC, its inbound tourist model is specific to its home base, recently concluding a joint marketing arrangement with the local tourism board.
In Europe, Air Berlin has evolved in (and from) many directions, effectively blurring the distinction with full service operation, but with a very low cost bias; it operates long haul, it offers full connectivity, but it maintains a low cost profile. It could be seen as an example of an airline that has metamorphosed into a long haul low cost operator too. With its mixed fleet, it operates not only a dense network in Europe, but also flies to points in Asia, Africa, North America and the Caribbean.
An amalgam of airlines (including LTU, former British Airways low cost subsidiary dba, and minority shares in NIKI and Belair), Air Berlin is quickly responsive to needs to trim long haul service as quickly as it starts them up. But, based in a country whose flag carrier is one of the most powerful in the world and which has dominated German aviation for decades, Air Berlin clearly sees Lufthansa as a major target. If a proposed strategic partnership and cross-shareholding agreement with TUI Travel is approved this autumn, it will become a seriously competitive force. Meanwhile, its strategy is generating ever-improving yields at a time when full service airlines are suffering the opposite fate.
Australia’s Jetstar has no doubts that the long haul path is the way to go. It already operates a fleet of A330-300 aircraft, with more on order and, says CEO Bruce Buchanan, “Future long-haul expansion to Europe from Australia – via an Asian hub - for Jetstar does present a great opportunity, and with the decision to lease an additional four-five A330 aircraft in lieu of the arrival of the Dreamliner B787s, this remains a possibility in the next two – three years.” Meanwhile, Jetstar has already established a range of long-haul services from Australia.
With Asian growth markets firmly in view, Buchanan says also, “Over the next three years, I believe we will see the Jetstar brand in particular to continue to strengthen and grow across Asia and the Asia Pacific region. Our focus has been and will continue to be Asia…Across the Asia Pacific region as more people grasp low fares air travel as a convenient and affordable way to travel within their own countries and across the region opportunities will emerge.” Jetstar here is talking a strategy somewhat like that of AirAsia, where a set of short-haul hubs is complemented by long haul operations, implying a two-aircraft type fleet.
Coming from another direction, JetBlue’s strategy is to access longhaul markets through codeshare at this stage at least, exploiting its relationship with part owner Lufthansa, although it also has wider aspirations in the “Americas” (see below). This vision does not necessarily rely on operating long haul aircraft, with the immediate frame relying on codeshare. But JetBlue has shown it has no qualms about moving away from a single-aircraft type model adopting two aircraft types, with its complementary fleet of Embraer-190 regional jets.
Another large low cost airline whose name has been associated with the concept of long haul operations is Ryanair. CEO, Michael O’Leary has made clear he wishes to embark on a long haul service, at least across the Atlantic, although, he says, this will have to wait until lease costs come down; Ryanair has also made strenuous efforts to acquire control of Irish flag carrier, Aer Lingus.
However, COO Michael Cawley stresses that the long haul strategy is not part of the airline’s DNA: “Michael O’Leary’s long haul project is entirely independent of Ryanair. Short haul traffic is where the value is. And buying Aer Lingus is not about long haul either, it is to drive (Aer Lingus)’s cost down substantially. They can’t make it on their own, they just don’t have the efficiency, and we see that we can do it for them. Why Aer Lingus? – because we know them better than we know the other airlines.”
Thus, while the long haul low cost model may for the time being be a particularly Asian phenomenon, the seeds are there for imitation more widely, either directly or through partnering. Once these operations are seen to be viable, others will inevitably try to go there. As Vueling’s Alex Cruz says, “More people will try long haul low cost just because Tony (Fernandes) and Azran (Osman-Rani) are doing it and it seems it is working.”
But, regardless of whether the short haul airline itself expands into long haul markets, it many LCCs are committing to enter international markets – one way or another.
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The dangers? – Being stuck in the middle. “Tweenies” are vulnerable?
Higher cost and lower premium is a potentially dangerous place to be. Moving up market can endanger the cost priority very quickly.
Bill Franke is an unequivocal unbeliever: “We have watched with interest as a number of carriers that were quite successful in their early days have given it up as they approach 5+ years of operation. Some hormonal change occurs in the brain of the management and their boards of directors and they lose discipline and commitment to their model that created their success. In today’s difficult economic times, that loss of focus on costs has decimated several carriers, now stuck with a model somewhere between low cost and full service. “Tweenies” are not where one wants to make a bet.”
The Virgin Blue evolution is however the most far-reaching of any LCC, to the extent that it is now, on many counts, very much a full service carrier, but – and here is the key – it is doing the same job but at a much lower cost. The carrier now operates B737NGs as its core fleet still, but it also flies new B777s longhaul and Embraer-170s and -190s on smaller regional routes.
Godfrey insists this is where the carrier needs to be, as, “in general the hybrid model is the middle ground from which the vast bulk of the market, whether business or leisure, can be addressed.
“No-one accuses Toyota or Honda of being "stuck" between BMW and Hyundai, he says. We have a view on what the airline of the future will look like and fully intend leading the charge to get there. What is plainly clear to us however is that this ‘airline of the future’ must focus on the vast and rising middle market masses.”
Right or wrong, it does seem that the weight of opinion is moving to Godfrey’s side. The underlying issue is how to respond to the pressures of a commoditised, crowded marketplace. Seeking yield and wider operating options have a magnetic attraction at this stage.
If nothing else, regional market variations make this likely, according to Vueling CEO, Alex Cruz, “More competition in each region will force regional low cost airlines to evolve from a product perspective, with only a very few exceptions such as Ryanair and AirAsia. The “untouchable” areas will be “touched” but LCC-style: providing for business passengers and developing products for them, providing connections, etc.” But, the ever present danger – “This is likely to drive costs upwards small amounts.” Ensuring they are only small amounts is the hard bit.
Jetstar already sits firmly in this middle ground and is alert to this caution. Says CEO, Bruce Buchanan, “The concept of a one size fits all LCC model has quickly vanished. In particular, low fare airlines wanting to move from the periphery and into the mainstream of any market must be able to adapt as required to both the customer demands and the key fundamentals of that market.” That said, “maintaining the lowest cost is critical to success. Without sustainably lowering costs over time many carriers, as IATA continues to point out, will simply no longer be around, or are not able maintain a sustainable operation over the medium to longer term.”
And in the Gulf, Sama’s CEO Kevin Steele sees the hybridisation process accelerating: “via three methods; first of all, low cost solutions evolving for some of the legacy airlines ‘blockages to entry’ like GDS and interlining; secondly, the need for more flexibility in pure LCC model itself; and thirdly, as legacy airlines themselves hurt more than LCCs, so either look to set up or hive off their own LCC, or work more closely with LCCs.”
The other side of the coin: FSC problems – the worst place of all: the middle ground, but with higher costs and lower fares
But, without doubt no place to be is high cost, with declining yields. This has to be the worst of all worlds. It is hardly a secret that many full service airlines are consequently in disarray, talking of fundamental reappraisal of their basic model. In many ways this would be a good thing.
Nawal Taneja believes it will not just be good, but may be inevitable, as conditions change: “Consumer behavior, particularly relating to purchases, will change dramatically as a result of numerous forces…The continuous decline since mid-2008 in premium demand in international markets served by major full-service airlines is a profound change in that the major premium market is not likely to recover fully. The reasons appear to be, (a) that most businesses are controlling their travel budgets and, (b) that many individual travelers who pay for their own tickets do not consider the premium class, price-service options to be valuable. These trends are similar to those observed in the premium segment of the hospitality industry.”
Bill Franke also believes legacy carriers are staring down the barrel: “Meanwhile, the U.S and European legacy guys, faced with costs they cannot recover from their passengers - particularly in these difficult economic times - are resorting to the more obvious of the ancillary revenue tactics of their LCC competitors. Baggage fees, fees for blankets, loss of food service and the like are good examples. This has done little for passengers’ attitudes toward these carriers: it is one thing if you pay very low fares and have the on-board choices to make.
This crisis of identity goes right to the heart of the airline’s branding. Franke continues, “It is another thing if you are paying a legacy’s high fares and think you are getting something for it only to face a charge for a blanket. I think this ancillary revenue effort by legacy carriers will only push more passengers to the LCC model where you get what you pay for, no pretenses about it. If you fly SQ, you know with certainty what you will get for that higher fare. If you fly Tiger, you also know what you won’t get for that very low fare. The guys in between are the ones in trouble.”
Consolidation – inevitable, but not common just yet
As observed at the beginning of this chapter, market exit has not been a feature of the airline industry to date, although the record for independent airlines more closely resembles a free market. Regulation has distorted the process of natural selection, just as it has made other forms of rationalisation, like merger and acquisition, difficult. Consolidation has been made harder where “flag” names carried along with them the nationalism of independence. In Europe, Lufthansa is bucking this tradition, as it buys neighbouring foreign (EU) airlines, while maintaining their brand names.
But otherwise examples are few: KLM, with Kenya Airways and Virgin in Nigeria, recently unwound, among a handful. Air France-KLM is more an exception than a model at this stage. Lufthansa’s acquisition of neighbouring airlines, along with its investment in carriers like germanwings (100%) and JetBlue (19%) does provide some precedent, as do the various serial investor combinations; however these are mostly far removed from genuine corporate consolidation. An attempt last year to combine British Airways and Qantas was stillborn. The political and legal impediments to such relationships are immense. Strong forces in the US even oppose the use of alliances to enhance marketing and operational viability.
However, especially in Europe, there are precedents for mergers involving LCCs – as well as for their exiting the market. The current difficult economic conditions, following hard on a year of excessive fuel costs, are creating conditions where the attractions of merger become greater, or even overpowering. Some of the more marginal models, which may have survived in more benign times, have gone to the wall.
Ryanair’s Michael Cawley describes a simple equation to define the targets in this process: “Consolidation will occur between so called low cost and low fare airlines. Many airlines with higher costs are finding they can’t simply be low fare.” As he observes, “the vast majority of LCCs is losing money. At some stage they have to change – and consolidation (or market exit) is a way”. In the increasingly cutthroat European market, Cawley notes that “No other airline in Europe has made money two years in a row, apart from Ryanair and easyJet”.
This phenomenon of low fare/low cost differentiation is of course not just limited to independent LCCs. The full service airlines which, while bearing higher costs, have previously been able to cross-subsidise low fares with higher yielding traffic, are now examining their options. The reality that the current low yield market is not going to go away for a considerable time is forcing a realisation that stopgap solutions will not suffice. The likelihood of their entering this consolidation marketplace increases daily.
But for Ryanair at least, consolidation is not on the cards, says Cawley: “There is nothing in it for us to consolidate; why would we try to integrate something that is so fundamentally different from us? They all have weaker models, they’re less efficient, have poorer distribution models, pay more for their aircraft and airport charges - and simply don’t fit.” (That said, one European airline that does operate with a similar style is Wizz Air, one of the Indigo Partners’ stable; and Ryanair seems to be waltzing operationally with Wizz, as their respective markets barely overlap, but intersect largely in complementary ways. But Cawley says Ryanair doesn’t want to be in Hungary, owing to its high charges.)
Ryanair’s expansion has been mostly organic, although it did buy KLM’s low fare subsidiary, Buzz (along with its Stansted slots), in 2003, and retains a so-far unproductive minority shareholding in Aer Lingus. The Irish flag carrier is the only airline where Ryanair would look to integrate and indeed has tried actively to consummate the relationship: “We know them better than anyone else; they can’t make it on their own. And the convergence would be instant and appreciable,” Cawley believes.
Vueling’s Alex Cruz agrees with the industry consolidation diagnosis, as established airlines assert themselves, “more consolidation is likely to take place as the big LCCs continue to gain market share, squeezing the others”.
airbaltic’s CCO Tero Taskila, takes a longer view too, as the industry evolves through the next few years, suggesting that the growing similarity of full service and LCC models makes intermarriage more feasible: “The industry will see consolidation and the new generation of hybrid airlines. LCCs get closer to mainline carriers (airbaltic’s network model for example) and mainline carriers getting closer to LCCs (such as Finnair, BA removing free food). Once the consolidation (or capacity reduction) has reached its pinnacle, there will be carriers who will start offering niche again (full business class etc. a la Silver Wings) but currently such models are not sustainable.”
And Southwest CEO Gary Kelly adds another twist, seeing consolidation (particularly of others) as an opportunity to expand: “The very nature of the changing landscape of the airline industry provides constant opportunity, including consolidation and reduced capacity that allows Southwest to target new markets…”
So, while the prospect of consolidation is apparently not controversial, examples remain relatively scarce, even domestically. As Brett Godfrey of Virgin Blue observes, in the context of higher fuel prices adding stress to LCCs, this will “put more pressure on airlines with ageing fleets and poorer profitability. For many of these, being acquired may be their salvation, but in general airline consolidation and liberalisation of markets across borders in particular is still occurring very slowly compared to other industries.”
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