ANALYSIS: Regional partnerships key to Air Canada's LCC

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Air Canada is now selling flights for its new low-cost carrier Rouge, but one may feel a sense of déjà vu when hearing about the airline's plan to enter the low-cost carrier market. That is because the Montreal-based airline has rolled out ideas for a low-cost carrier before, but reabsorbed them back into its fleet only a few years after launching them. So, what is different this time around?

Analysts say that scope clause changes from a recent pilot contract and a ready pool of older aircraft waiting to be deployed on these routes are key factors that will allow the airline to re-visit this low-cost concept.

During the airline's most recent earnings call, Air Canada's chief executive Calin Rovinescu said the airline will operate at a "materially lower cost" than the Air Canada mainline fleet and will operate on routes that the airline has not been able to make profitable.

PAST LCC BRANDS

Air Canada's previous entrance into the LCC space was driven by overall market conditions in the early 2000s, when traffic plummeted after September 11. But in the case of Rouge, one analyst says the LCC will primarily allow Air Canada to focus on its new mainline fleet rather than serving as a money-making device for the airline.

In October 2001, Air Canada introduced its no-frills brand Tango to stimulate demand for its services. The brand used 13 Airbus A320 aircraft on high-traffic routes being served by its mainline carrier.

Air Canada is also planning to transition aircraft within its mainline fleet for Rouge, but the new airline will primarily focus on leisure destinations rather than domestic routes.

In that environment, Air Canada had communicated a need to move to low-cost pricing primarily to keep up with lower business travel demand and to compete with other emerging carriers that followed the low-cost model - namely WestJet. However, with the new Rouge endeavour, Air Canada is instead looking to find savings to focus on renewing the mainline fleet with new Boeing 777 and 787 deliveries, says Walter Spracklin, analyst at RBC Capital Markets in a November research note.

"After taking a deeper look at Air Canada's planned regional LCC and fleet reorganisation initiatives, we believe management's main priority is clearly to revamp the mainline fleet," says the research note. "The LCC will likely not add much to the bottom line and we believe management would be happy to offload older aircraft and simply break-even on the LCC," it adds.

Air Canada did not stop the spin-offs at Tango. In September 2002 it unveiled Zip, a low-cost subsidiary aimed especially at Western Canada. The short-lived Calgary-based airline flew 12 Boeing 737-200 aircraft by the time it shut down in 2004, after Air Canada was able to reduce costs in its mainline fleet through labour concessions with its union groups. Zip was set up as a separate airline unlike Tango, which was a brand within the airline.

When new labour concessions were implemented, then-chief executive Robert Milton told Airline Business that there was "less of a need for a separate low cost operator," as the airline had been able to reduce its cost structure throughout the mainline fleet. Flightglobal reported that by 2003, Air Canada had transferred 20% of its mainline flights to Tango and Zip. The move to reabsorb Zip came as a change in strategy for Milton, who had previously said that the carrier would grow into an airline with its own distinctive culture.

Before closing down Zip, Air Canada had intentions for expanding the fleet to 20 aircraft. In 2004, Flightglobal reported that it wanted to double the Zip fleet to foster a network expansion in North America, a move that would have been facilitated when the carrier's Airbus A319s were replacing the older Boeing 737-200s. By that time, Tango had also changed, morphing into a fare class rather than a separate carrier.

Tango and Zip were unveiled at a time when several North American majors were introducing low-cost spinoff brands, but these other carriers in the region also ended up merging them back into their mainline operations. Delta's Song low-cost subsidiary became defunct in 2006 as part of the carrier's bankruptcy proceedings, and United's TED, which flew 56 A320s, closed in 2009 to combat high fuel prices.

In 2012, a government-appointed arbitrator chose Air Canada's agreement to end labour negotiations with the Air Canada Pilots Association. This opened up a new opportunity to revisit another attempt at starting a LCC, says Spracklin.

REGIONAL CHANGE

This new labour agreement is one of the main changes that allowed Air Canada the flexibility to re-visit an LCC that would operate at a lower cost base, says Spracklin. With the new agreements, Air Canada can find savings through regional partners. Not having that flexibility was one of the factors that kept Air Canada from fully realising the rebound in passenger growth after the downturn, especially in the domestic and Pacific segments, he says.

"Outside of improved fleet utilisation rates, Air Canada was unable to increase capacity and fully participate-largely due to both financial and union contractual constraints," says the research note. "With new collective agreements and the delivery of 37 Boeing 787 aircraft, Air Canada can now not only increase fleet capacity and lower the average fleet age; but can shift aircraft between their subsidiaries to enhance efficiencies and utilisation rates."

Under the new pilot agreement, Air Canada does not have a restriction on the 75-seat turboprops it is deploying for its regional carriers and has the flexibility to operate up to 60 76-seat regional jets through regional partners, said Rovinescu in Air Canada's most recent earnings call.

"The new agreement improves our competitive position by allowing certain adjustments to our relationship with feeder airlines and the makeup of the mainline fleet," he said. "As a result, we can now do business with several regional partners in Canada, whereas in the past, we were limited in this regard, and that competition should be healthy."

Air Canada quickly made changes to take advantage of the new scope clause to find cost savings. The carrier is transferring its entire fleet of 15 Embraer 175s to Montreal-based Sky Regional Airlines under an updated fleet plan announced in October. The regional will operate the aircraft under a capacity purchase agreement.

In October, Air Canada also moved to deploy Jazz Aviation's new Bombardier Q400s on routes from Calgary and Edmonton starting in February and March to cities such as Fort McMurray, Regina and Yellowknife. WestJet is now unveiling its own regional airline almost a decade later, and plans to introduce the routes it will fly later this month.

Rovinescu said during a third quarter 2012 investment call that the carrier's growth strategy is still within the lower cost environment, but it will focus on adding capacity in both the mainline and LCC areas.

"From our perspective, we are looking at this thing as being a significant tool in the Air Canada toolkit and it will have a materially lower cost all in when you look at the configuration, when you look at the other labour that is involved, when you look at the, you know, structure that the organisation operates with, it will have a lower cost than Air Canada and Air Canada mainline."

GROWTH STRATEGY

Air Canada has identified plans to grow Rouge to a substantial fleet size, but it is starting out slowly. The airline says it could fly up to 20 Boeing 767-300ER aircraft and 30 Airbus A319s in the fleet, but it is only starting out with two of each aircraft type this July. The additional aircraft would be gradually added as Air Canada receives two Boeing 777s scheduled for delivery in 2013 and 37 firm orders for the Boeing 787-8, scheduled between 2014 through 2020.

Rouge has initially introduced three routes to Europe and 10 destinations within the Caribbean, and many of them are already routes that Air Canada flies to out of the Montreal and Toronto. It has identified starting service primarily out of Toronto at first.

Air Canada has commissioned a new management team to run Rouge as part of its leisure group, unlike Tango or Zip. The business will be headed by former Thomas Cook North America chief Michael Friisdahl.

The airline has not unveiled many more details about Rouge's culture, but Alberta-based aviation consultant Rick Erickson says that Rouge having a culture independent from Air Canada could be a key to its success, especially considering it will be offering a different aircraft layout with more seats that is different from the usual offerings.

"I think what we're going to see is a carrier that is purposefully set up with its own culture," says Erickson. He adds: "we're probably going to see a focus on a different kind of personality."

Air Canada has not disclosed much more about the routes it wants to add, but Spracklin says Air Canada's LCC would target markets similar to Jetstar, Qantas' low-cost subsidiary, which he says he believes the carrier is trying to emulate.

PREMIUM FOCUS

The Rouge 767-600s and Airbus A319s aircraft will have more seats installed than the mainline carrier, but Air Canada is intent on providing an option for its premium customers on the new carrier. Instead of offering single-class layouts like Tango and Zip, the aircraft will feature some more upscale amenities aimed at business travellers and premium customers.

The Boeing 767 fleet will be outfitted with a premium product, as well as an extra legroom section in economy. The Airbus A319s will be configured with an extra legroom section instead of the single-class configuration that those aircraft fly with on the mainline fleet.

But the move to integrate a premium feel into the LCC model is not new, either. Air Canada's Milton told Airline Business in 2002 that he intended to start up a new spinoff called Elite, which would be a low-cost carrier specifically aimed at the business and premium markets. The airline, which never got off the ground, was originally scheduled to make its debut in mid-2003 if business travel improved, but that was before the carrier decided to reabsorb Zip and Tango.

Whether Air Canada's new LCC shows long-term success remains to be seen. While Air Canada is doing some things the same way, like transitioning its mainline fleet to the new carrier, it is now able to focus on making otherwise unprofitable leisure destinations part of the low-cost model instead of putting focus on domestic destinations with Tango and Zip. The new scope clause now allows regional service to be operated with an airline partner, presenting new opportunities for the airline.