US carriers are boosting their efforts to sell ancillary products after seeing the positive impact of non-ticket revenues on the balance sheets of their European and Asian counterparts
The passenger has boarded the aircraft, and is about to put his luggage in the overhead locker. He tries to open it, but is informed that to do so, he will have to put money in a slot. He then sits down and relaxes. The aircraft takes off and reaches cruise altitude. The hapless passenger decides he wants to recline his seat, but is again asked to pay for the privilege. Finally, he tries to close his window shade, but is again asked to get his wallet out.
This scenario is actually part of a television advertising campaign being conducted by Southwest Airlines, along with a flight attendant ticking off a list of charges for visiting the restroom and pushing the call button. The airline clearly seems to be differentiating itself from those airlines that are charging for services ranging from food, to checking in baggage and various other activities that, in many cases, were traditionally provided for free.
As chief executive Gary Kelly says: "We don't nickel and dime you to death." Some are wondering, however, if Southwest won't end up mimicking some of the very same practices that they are mocking. And in any case, US carriers are in the main behind Europe when it comes to maximising ancillary revenues. The airline closest to that depicted in the advert would seem to be Ryanair - although paying to lower a window shade would not be an option as they have been removed anyway.
While ancillaries currently account for 2% of revenues at Southwest, Ryanair achieved a figure of 18% in 2006 - up from 16.5% in 2005. This has made the industry stand up and take note. "The profit margins on ancillaries are much higher than the commodity based sale of airline seats, and gross profit margins may be as high as 40% with very low selling costs, particularly if sold online," says Jim Parker, financial analyst at Raymond James Associates.
However, Southwest is cautious. Kevin Krone, vice-president of marketing, sales and distribution at Southwest, says: "We have no intention of taking away any of the amenities we already offer or charging for the "frills" our customers have come to expect from us. Southwest is still one of the only airlines where you can get a snack, pillow, blanket and soft drink at no additional charge - and that's not going to change. We are working very hard to enhance our customer's experience, and we hope to release one - maybe two - projects this year." Kelly says it will soon issue a request for proposals to wire one or two of its aircraft for onboard internet that passengers would pay for.
"The key to growing ancillary revenue is scale," says Tim Marshall, financial analyst at UBS. Ryanair, with over 40 million passengers last year, is certainly using its scale. Santina Doherty, head of marketing and ancillary revenues at Ryanair, says that even at 18% of revenues, there is still more to come. "We're scratching the surface," she says. "We're really only starting to see the multiplier effect now. Two years ago, we didn't even have a manager with sole responsibility for this area."
Ryanair boss Michael O'Leary once famously predicted that one day Ryanair would be offering its tickets for free and making its money from ancillaries. Doherty, understandably perhaps, refuses to commit herself on this, but says: "Never say never - it could happen - for every passenger who flies free, we are making money on ancillaries. But the business has to be there. Without it, ancillary revenues wouldn't exist."
Measuring the performance of ancillary products is something of a black art. Carriers are keen to promote themselves to the financial community as ancillary friendly, which according to one consultant has seen a shift of some revenues from the non-ancillary to ancillary columns.
On the other hand, there is a desire not to show competitors how your ancillaries are performing. Ryanair, for instance, doesn't include baggage handling charges as an ancillary revenue.
David Leitch, head of ancillary revenue at easyJet says the UK carrier will see ancillaries running at 30% of revenues this year, but admits: "It does depend on how you analyse and cut the cake up." Again, he thinks there are more gains to be had. "There are always going to be opportunities."
While Ryanair and easyJet appear to be doing a good job of raising ancillary revenues, Marshall at UBS points out that the performance of German carrier Air Berlin, which he places at about average when compared with its low-cost peers, is particularly impressive when considered in the context that it does not charge for food and non-alcoholic drinks on board its aircraft.
AirAsia is also keen to emulate its European cousins. At present, ancillary revenues are 7% of AirAsia's turnover, but the target is to reach 15% within three years. "We can do this with our marketing muscle, our brand and passenger numbers which will reach 18 million this year," says the carrier's group chief executive Tony Fernandes.
It's latest idea is to launch an in-flight magazine which will work in tandem with its website to drive web traffic and create brand loyalty. "I see many initiatives for AirAsia using the internet in terms of building the community," says Fernandes. "We've got to find content that will relate to our passengers."
Carriers like AirAsia and Virgin Blue, as well as several European carriers, are making more money than US carriers from ancillary sources. But, after some failed US experiments, the trend is taking off. According to Jay Sorensen, president at consultancy Ideaworks: "I believe we are going to start seeing a lot more activity on ancillary product as well as unbundling."
Northwest for instance reports strong customer acceptance of its fees to select a preferred seat. United Airlines says it is considering an array of "selling-up" offers to get customers to buy extras. In June Spirit will start charging for each piece of checked baggage, with the fee lower if paid on line.
The front runner by some margin in the USA, however, is Las Vegas-based Allegiant Air. Sorensen says that on a per passenger basis they are up there with Ryanair (see table). In part, he puts this down to some unique advantages. For one, the carrier mainly serves out-of-the way markets. "They are big fish in a small pond, so can afford to be a bit more experimental because they live in isolation," he says. Secondly, he points to the uniqueness of the destinations like Las Vegas and Orlando that it serves. These are almost purely leisure markets that are seen as more attractive for ancillary sales. Against this background, Sorensen says the carrier's ability to operate non-stop flights with very low fares allows it to offer a basic model, with a la carte pricing on top.
Speaking at this year's Airline Business Network route planning event in March, Allegiant's chief executive, Maurice Gallagher, said the carrier currently makes on average $18-19 per passenger from ancillaries, and added: "We believe this industry is stuck in a 'we don't do that' mentality. This is the only business I know where people give you something free when you walk in the store."
The largest ancillary revenue component at Allegiant is hotel rooms packaged with air travel. "They hold a lot of hotel inventory in Las Vegas," says Sorensen. "They can go into a hotel or casino and talk about markets that they practically own. They are not major markets, but if someone's coming from those markets, they are very likely flying on Allegiant.
"The major carriers hand that process off to a third party. Allegiant seem to be doing a lot of this in-house. It's a natural progression - the airlines generate a tremendous amount of traffic to these destinations," says Sorensen. He asks: "Why should they not control that traffic? There are three components to a vacation, the air travel, the hotel and the car rental. Everyone knows that the first one to be booked is air, usually followed by hotel, followed by car. He who holds the air, holds the gold."
Sorensen sees others following Allegiant and Spirit in the USA. "This ancillary revenue model will spread and be adopted by more and more carriers, including some of the majors in the next three years."
He adds, however, that US carriers are concerned that they will be viewed as cheap, in the negative sense of the word. Andrew Watterson at Mercer Management Consulting says that European low-cost carriers have the advantage of starting with a much cleaner sheet of paper. "They were young in their life and did not have to take account of former customers with a fixed idea in their mind of what it meant to fly with a certain airline," he explains. US carriers, Watterson says, "are talking about wanting to tap into ancillary revenues without regressing on their value proposition. They are trying to find a new way forward. Clearly they don't want to charge for what they were giving away for free - it makes it hard to follow Allegiant if you take that stance."
As US carriers experiment with their ancillary revenue strategies, Watterson says the evidence so far is that catering is top of the list. "Coffee, tea and sodas are key - if you can sell them it makes the difference between an OK ancillary revenue business and a good ancillary revenue business. Alcohol is also a good one - and some small snack foods."
Air Berlin, in its flotation prospectus last year, said that its top earner was in-flight sales of alcohol and merchandise, which brought in €15 million (€20 million) in 2005, nearly three times as much as the next best performer, excess baggage charges at €5.2 million.
Air Berlin says its recently introduced gourmet menu, which offers passengers the chance to pay extra for a meal from one of Germany's top restaurants, Sansibar, is its best ancillary product. It helped boost these revenues from €30.8 million in 2005 to €58.1 million last year, with per passenger spending up from €2.30 to €3.40.
Where paid for catering has been tested in the US, Watterson says "customers are reacting positively if you have a good product". But, he adds: "The big barrier is selling soft drinks. There have been a couple of test cases at American and Northwest Airlines and they have been pulled back. That seems to be a big dividing point."
If customer acceptance could be achieved, the rewards are high, says Watterson. "Soft drinks is quite a big cost - you still have a lot of the logistics despite having pulled a lot of the catering." But many are reluctant to charge. For now at least, it looks like airlines and casinos will be the only places in the USA where you can get a free drink.
Free drinks may not be on the menu, but there is plenty of evidence that US carriers are working out how they can get closer to the European low-cost ancillary performance. Sorensen says that US majors have been carrying out consumer surveys with the clear intent of unbundling fare products. "They are all looking at this as a means of being able to offer lower fares and allow people to buy up a better type of service."
Pay to get onboard
The recent softness in bookings at Southwest Airlines, that will make it difficult to achieve management goals of 15% annual earnings growth from passenger ticket sales, is pushing the low-fares carrier to boost ancillary revenues, believes James Parker of consultancy Raymond James Associates.
The carrier has recently been performing tests with different boarding methods, and Parker believes that fee-based assigned seating or priority boarding will likely replace the current open arrangement. Southwest's Kevin Krone, says: "We are exploring new ways to board our aircraft. However, we have not made any firm decisions. We are carefully collecting all the data and listening to our customer feedback."
If 20% of Southwest's estimated 92 million passengers in 2008 purchased an assigned seat for $10, Parker estimates this would generate incremental revenue of $184 million. Assuming a pre-tax margin of 90%, this would produce additional net income of 12 cents a share.