ANALYSIS: Market conditions ripe for low-cost expansion

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CTAIRA analyst Chris Tarry suggests that with market conditions resembling those of a decade ago, the situations looks ideal for certain airlines to evolve.

In its simplest terms, the theory of evolution suggests you adapt to changing circumstances or die - and this is no different in business.

The most recent data provides further evidence of what is, for European airlines at least, a change in the operating environment to a "new norm" - and what we came to know as "business as usual" is no longer an option. A patchy recovery and absence of the traditional cycle means there is no "upswing" to ride, and real improvements in reported performance will owe more to structural change.

The objective of any corporate strategy is for a company to not only survive, but move on to a state of competitive and sustainable prosperity. However, for a number of European airlines it is the delivery of necessary structural change to ensure survival - rather than that necessary for "prosperity" - which remains the key challenge. It is not one that will be rewarded with rapid and meaningful improvement.

July-September quarter results for European airlines brought a mixed bag, but nothing particularly unexpected. However, in some cases the stock markets over-reacted to some relatively small profit improvements without necessarily considering the underlying cash generation of the companies concerned, as disposals seemed to be a major source of cash for Air France during the period.

At one end of the spectrum, Ryanair's results demonstrated the importance of cash and a strong balance sheet. It was particularly well placed in this area, reporting €3.9 billion ($4.9 billion) gross and net cash of more than €249 million at the end of the six months to September 2012.

At the other end of the spectrum, a results announcement from IAG reported that Iberia lost some €262 million in the first nine months of 2012. British Airways is reported to have made a profit of some €280 million.

Taking a broader perspective for Air France, Iberia, SAS and Lufthansa, there is a general common cause underlying their problems, the need to reduce costs, shrink substantially - especially in the case of Iberia - and generate more cash. There is also a common focus on improving performance, with cash generation being an explicit target at both SAS and Air France. While all managements have plans to move their airlines to a position of sustainable prosperity, there is no certainty of success, no matter how good the plan might be.

Having embarked on a programme where success depends on delivering internal improvements, the risk is that attention is diverted from changes in the external environment and the ability to respond to actions taken by competitors is reduced. You may have a degree of control over your own actions, but not those of your competitors and an increased "inward focus" is usually seen as an opportunity by rivals. But the time taken to reach the target, especially in the case of Air France and Iberia, is measured in years, at a time when competitors will not be standing still.

With the attention of a number of European legacy carriers now focused on long-term turnaround programmes, this seems almost a repeat of conditions from a decade ago. However, current conditions are not exactly akin to those at the start of the last decade given change on the supply side.

At that time, we saw rapid growth of the low-cost sector initially via EasyJet and Ryanair, which both placed significant orders for new aircraft in 2002 and effectively accelerated when the legacy carriers were adjusting to the post 9/11 environment.

Now the opportunity is more about taking higher-value traffic than simply volume. In a market with a low rate of fundamental traffic growth, and where neither of the largest low-cost carriers have a significant number of firm orders to be delivered in the near term, their focus will be on taking a greater share of that higher-value traffic. This will be through a series of switching and substitution effects in what is an increasingly mature market. However, it is undoubtedly an opportunity.

While Ryanair management describes the airline as "ultra-low-cost" - and it does have the lowest seat mile costs - its challenge, successfully met since financial year 2010, has been to increase average fares which have risen by 30%, with ancillary revenues up some 17% during the period. For EasyJet, which did not suffer a decline in average passenger revenues during the height of the financial crisis, the increase over the corresponding period has been closer to 7%. The average revenue per passenger for EasyJet at the end of its last financial year was £64 ($102). The average revenue per passenger for Ryanair at the end of its last financial year was €56.

While remaining pure in a number of respects, some market-facing aspects of budget airlines have changed on the cost side to address the market opportunity. But even in this market sector not all airlines will achieve competitive prosperity and, for some, survival will come on to the management agenda, if not there already. By the same token, not all legacy airlines should be considered to be in decline, and many already operate in competitive prosperity. But membership of this group is becoming ever more difficult.