After a decade of rapid development, low-cost carriers in mature markets are now having to expand their horizons, both demographically and by geography, to keep their foot on the accelerator
Financial results for low-cost carriers over the past 12 months show the sector underlining its continued profitability credentials. After coming out of the 2009 meltdown relatively unscathed compared with their battered network rivals, nearly all airlines improved their financial position as demand rose.
Revenues across 36 carriers in this year's Airline Business low-cost carriers survey jumped 19% to $58.7 billion in 2010, while operating profits across nearly 30 of these airlines more than doubled to 4.2 billion last year.
While a similar pick-up in fortunes has been seen among their network rivals, most of which enjoyed the unexpectedly quick return in premium traffic last year, a look at recent profitability levels of both types of carrier highlights the robustness of low-cost operators.
Data from four years of the Airline Business low-cost carrier and world airline ranking surveys shows that while the 10 largest network carriers were highly profitable in 2006 and 2007, seven lost money in 2008 and eight were in the red in 2009 at an operating level.
Contrast this with the top 10 low-cost carriers - only two lost money in 2009, three in 2008 and one apiece in 2007 and 2006. The graph opposite shows the top 10 low-cost carriers have remained consistently profitable, albeit it at lower levels than their 10 biggest network counterparts - which have thrived in the good times and haemorrhaged in the bad.
"The [low-cost] business model has performed well through the recession, and that makes sense because business and leisure traveller are seeking value [during periods of recession]," says London-based RBS Aviation analyst Andrew Lobbenberg. While the sector has had its fair share of financial casualties over the years, impressive operating margins for many carriers testify to the robustness of the model.
"Last year turned out not be a bad year, the issue is what happens now," notes Chris Tarry, principal of aviation consultancy CTAIRA. One red flag concerns fuel. "One of the challenges is they [low-cost carriers] have to operate with a very high break-even load factor. If fuel goes up, that lifts the breakeven load factor higher," he says. While a strong economic backdrop helped sustain higher fares during the 2008 fuel price surge, this time around the climate, especially in parts of Europe is far weaker. Tarry, pointing to a glut of fares sales on European short-haul, questions whether airlines will be able to secure the higher fares.
Low-cost carriers across the regions are operating in very different environments today. Those in the more mature markets of Europe and North America have an entirely different landscape to those in burgeoning Asia and Latin America. But both face challenges in sustaining their growth.
For European and US carriers, raised on a diet of double-digit growth, operating in established markets provides a challenge in finding new routes. "In broad terms it has matured, but there is still room for growth [within Europe]," says John Strickland, former executive at UK budget carrier Buzz and director at JLS Consulting. "There are still markets that are underserved and overpriced. France is the biggest one that is still underserved. There remain significant opportunities there."
"We have a mature market," acknowledges Germanwings
managing director Thomas Winkelmann
. "It has grown very fast over the last 10 years and you are connecting every village to village in Europe. But we have had some artificial growth [as well], growth that was subsidised from governments, you create demand that is not there. And we still have a bunch of state-owned carriers."
He believes state support for struggling carriers will waver in the tough climate for European governments, creating opportunities to fill the void. "There are growth chances."
Lobbenberg also believes consolidation is likely to bring further opportunities for low-cost carriers. "I still see there is a lot of growth for the sector. If you look within Europe there is still more consolidation to come. Several second tier network and low-cost carriers could well disappear. And we continue to see passengers transfer from charter carriers to low-cost airlines. Spain has fallen to the low-cost carriers, Greece is heading that way."
There is a similar maturity issue in the birthplace of low-cost, the USA. "There is saturation to some degree, notably in the USA," says Blair Pomeroy, partner at consultants Oliver Wyman, pointing to low-cost traffic penetration of 20% in the USA. "When your market is saturated, where do you go? You find more segments [of the market] or you fly further," he says.
Certainly mature low-cost carriers have been flying further; easyJet has just begun its longest route - a 5h link from London Gatwick to the Jordanian capital Amman. "It is happening in the European market, it has happened in the USA with Southwest and JetBlue flying transcontinental, and look at Ryanair flying more and more longer Mediterranean sectors," says Strickland. "They are still looking for some shorter sectors, and they can still find them. But the average sector length is increasing."
Longer sectors bring with them a cost factor. "Utilisation may remain high, but it is how that utilisation is distributed," says Strickland. "If it's divided into four round trips, then you still have four bites at the revenue cherry. But if you are only getting two round trips, you have to make sure they are bringing higher revenues. Of course there are some cost savings, but you have to consider the opportunity cost in terms of aircraft use."
Pomeroy adds flying longer means increasingly going non-domestic in the USA or outside of the EU. "They are changing the business model and as they are doing that, it is more expensive. They are flying further, which adds operational and additional security costs."
Low-cost carriers are also looking further afield than just new geographies. "They are going after more segments. They never used to be distributed through the GDS, now everybody is doing it," says Pomeroy. But while there is revenue to be gained, there is a cost side. "When you try to go after more segments, you are adding cost," he says.
Many low-cost carriers have always been pitched closer to the centre ground - indeed the likes of Air Berlin and Virgin Blue have always shunned the low-cost name tag. But if the blurring of the gap between low-cost and network carriers was driven by the latter playing catch-up, it is now a two-way street.
"If you diversify yourself and cater specifically to the business traffic, then you have a better chance to pick up demand from one of the target groups you have under-served," says Germanwings' Winkelmann. He believes it is possible to add services more cost-effectively. "They have some demands you can meet without adding cost, but generating revenues," he says, pointing to assigned seating.
Bmibaby chief executive Julian Carr says a carrier has to weigh additional cost against the revenue gain and opportunity to retain customers. "We do spend money to improve the service," he says, citing the example of distributing sweets at the end of the flight. "You weigh the cost against the loyalty [gain]."
Providing services for business travellers also helps ancillary revenues, another low-cost carriers staple. Former Monarch scheduled chief executive and Ryanair commercial director Tim Jeans argues the ability to grow these revenues is probably the biggest differentiator between legacy and low-cost carriers.
"When you can get an extra €6 [$9] just by selecting a seat, even if only half [the passengers] do it, that is a massive amount of money flying straight to your bottom line. So ancillaries have if anything widened the gap between legacy and low-cost carriers," he says. "The good thing is, while people remain very price-elastic on core revenues, there is less price sensitivity around ancillaries. I think there is a limit to the number of new charges, but the price elasticity is good. So I think there is a way to go on ancillaries."
But even on ancillaries, a paradox exists. Take the baggage fee. While associated with low-cost carriers, ironically the founder of the model stands out in the USA in not charging for bags. In fact, Southwest makes a marketing play of it. "Customers hate these fees, so that was a difficult thing for us to embrace," says chief executive Gary Kelly. "We know from our own experience if we increase fares, we will lose customers. So the economics for us weren't compelling. In the meantime we believe we have won more customers and more revenues by not charging for baggage fees."
So as low-cost carriers add product, and with it some cost, and network carriers strip out frills and costs on short-haul, the line between the models blurs further. Almost everyone can lay claim to being a hybrid.
Oliver Wyman's recent Airline Economic Analysis shows the cost per available seat kilometre between network and what it calls value carriers in the USA has narrowed to its smallest since the study began seven years ago. And there is a similar blurring on the revenue side. "One of the things that really stood out in the study is the US unit revenue - American and Virgin America are virtually identical," says Pomeroy. He notes that JetBlue is not much further behind.
"I view it as converging in all directions," he adds. "For example, American has lots of ancillaries, it has added 12 more seats [in the aircraft], while at the other end value carriers are selling through the GDS and have a frequent flyer programme."
FLIRTING WITH THE MAJORS
What remains integral to the low-cost model is a no one-size fits all answer. For example, the flirting with interline and codeshare co-operations of recent years has firmed into full on relationships for some. JetBlue, WestJet and Gol have stepped up their co-operation with network carriers, Virgin Blue is embarking on alliances with network players Air New Zealand, Etihad - and regulators permitting - Delta, while Air Berlin is taking a step further by joining oneworld. Yet others have steadfastly refused to follow.
There has also been movement on single fleets, another central plank of the low-cost model. "A single fleet is less complicated," says Carr at bmibaby, a relatively small carrier which has stuck to Boeing 737
narrowbodies. "But you have to look at what the opportunity lost is by flying a single fleet," he acknowledges. "Having a single fleet does limit some of the routes we could fly, it would give more year-round capability. So you have to look at the cost complexity against the opportunity."
When it comes to a dual fleet, size matters. "You have to be a very big operator if you are going to have a two-type fleet as you need to bring in 30 aircraft not just two or three," noted aviation consultant and former Olympic Airways chairman Rigas Doganis during the recent French Connect event in Lille.
For Southwest Airlines, that moment has come. Its acquisition of AirTran brings both 737s and 717s, but the airline believes the introduction of 86 of the latter provides enough scale to operate the fleets efficiently.
Longer-term issues around securing future aircraft, with little sign of a repeat of the bargain deals some carriers struck in the last decade, may also hinder growth. And a slowing growth brings its own cost pressure. Continued expansion enables airlines to spread some of their "legacy" costs more easily. "If you stop growing your costs will go up as staff become more senior," notes Pomeroy. "Ironically, you end up with a legacy problem."
ITS ALL ABOUT COSTS
Little surprise then that airlines continue to put the focus on tackling costs. Jeans retains his belief lowest cost will prevail and as such believes the focus must be on cost. "Relentless is the word. The moment you take your foot off the gas, therein lies the path to the ground the legacy carriers want you to be," he says.
"I still think there is a way to go on cost. On controllable costs there are a lot of airport costs," says Jeans. There is still a lot of redundancy in the infrastructure, check-in is still too cumbersome, security seems to have spawned a world of its own, and on the ramp there is still far too little self manoeuvring." He also believes pay, after restraint over the last two or three years, will come under pressure this year.
"Costs are like fingernails, they are always growing and you always have to trim them back," notes Winkelmann wryly. "The biggest danger are those costs you have no influence over - like flying taxes in Germany and the UK. That is one of the biggest dangers besides the fuel price." Illustrating the impact of such costs, Germanwings has just pushed its lowest fare up, reflecting the new German tax and fuel cost.
The oil price, having burst through the $100 per barrel of crude to orbit above the $120 mark, is a problem no carrier can avoid - even if hedging can soften the pain. "There are always new initiatives on cost, but at the moment there are not so many obvious ones to make a step change that can adjust for the impact of [higher] taxes and fuel costs, until you get to new-generation aircraft," says Strickland.
Jeans, pointing to the role low fares have had in stimulating the growth in traffic, notes adding cost will have a material impact on traffic. "At a macro level, have we seen the end of the golden age of low fares, where you could travel to Pisa for a pound? The answer is probably yes, if only because of air passenger duty and emissions trading."
If a golden age for passengers is at risk in mature markets, prospects remain high elsewhere, notably Asia and Latin America. There are some common threads with mature regions. Large home markets where low-cost travel has thrived over the past decade, such as Australia and Brazil, sees established carriers like Virgin Blue and Gol making plays for the business traveller. But low-cost air travel growth in these countries, and emerging regions as a whole, remains strong.
The challenge, however, for carriers to grow their brand is to unlock demand in more regulated markets which do not have the benefit of a large common aviation area as enjoyed in Europe and the USA (see Asian Positioning story below).
"Regulatory issues are going to impact growth," says Strickland. "We have seen strong growth in Latin America - Brazil and Mexico - and in Asia. But in a number of cases, such as Air Arabia's Middle Eastern growth and Air Asia's development, they have had to do it by creating different structures. But I think it will come. Africa is still a continent that is largely untouched,but should be ripe for low-cost travel.
"China is perfect for low-cost carriers, but currently the government there is holding it back as airlines don't have the whole range of commercial freedoms to fully exploit the model-negotiation with airports on costs for example. Any airline can do low price, but it's no good if they can't get low costs," he adds.
The structure in Asia and Latin America has fuelled the creation of part-owned overseas subsidiaries (see page 41) in order for brands to expand rather than full merger and acquisitions. Consolidation until now has been little seen across the low-cost sector, bar in a few strategic cases. But it is a further tool available to operators to expand and there will be much interest in the progress of the largest in the sector to date. Southwest will cement its place at the top of the low-cost tree by acquiring AirTran - creating an airline that would have carried 113 million passengers in 2010 generating revenues of $14.7 billion. It remains to be seen if this will usher in a wave of wider low-cost carrier consolidation.
Asia's larger low-cost carriers are continuing to expand beyond their home markets and around the region as they tap on the growing demand for cheap air travel around the region.
Southeast Asia remains the region's engine for low-cost travel, although Indonesia's Lion Air and the Philippines Cebu Pacific have largely restricted themselves to their domestic market. That has left Kuala Lumpur-headquartered AirAsia and Singapore-based Jetstar Asia and Tiger Airways to expand to other countries in the region.
AirAsia has affiliates in Indonesia and Thailand, both of which could have an IPO later this year, as well as long-haul associate AirAsia X. It has also announced plans to start up an affiliate in the Philippines.
"The company is in the best position, financially, that it has ever been in providing a strong foundation for further expansion and growth in 2011," AirAsia's Group chief executive Tony Fernandes said earlier this year. The Philippine subsidiary will be based at Manila's Clark Airport, and is scheduled to begin international flights in the fourth quarter of this year. The airline plans to operate between Clark and Singapore, Hong Kong, Taiwan, China, Thailand, South Korea and Japan.
"Our choice of Clark underlines the airline's commitment to developing transportation and tourism hubs outside Manila. This is part of our plan to contribute to the development of the country as a whole," says chief executive Marianne Hontiveros.
Clark will be the 13th regional hub of the AirAsia group, in addition to its bases in Malaysia, Thailand and Indonesia. Increasingly, however, AirAsia is finding that it has to share its turf with Singapore Airlines' associate Tiger, which has announced plans of its own for the Philippine and Thai market.
In February, Tiger said it would buy a 32.5% stake in Philippine low-cost carrier Seair, following a marketing partnership between the two airlines late last year. The initial partnership allowed Tiger to market Seair's flights on its website, while Seair operated A320 family aircraft leased from Tiger on its international flights.
Tiger's chief executive Tony Davis says that by taking a stake in Seair, his airline would be able to take a bigger share in "a major market opportunity for low cost airlines". The move would also allow Seair to compete more effectively against local market leader Cebu Pacific, which had a successful IPO last year and is rapidly expanding both its fleet and network.
It is in Thailand, however, that Tiger may be able to make the biggest dent in AirAsia's expansion plans. It has formed a joint venture with national carrier Thai Airways to start up a Bangkok-based low-cost airline. While the start of operations at ThaiTiger Airways, the name the new carrier has been given, has been delayed from the first quarter of 2011 to the third quarter of the year due to ongoing difficulties in getting government approval, there appears to be a significant amount of determination to make it a success.
"We will operate on the routes where there is a lot of demand for low-cost travel. Why should we leave the market to the competition? Thai will concentrate on the full service market, and this joint venture will add to our revenues at a low investment cost by riding on the growth in the South-East Asian air travel market," Thai president Piyasvasti Amranand.
Qantas subsidiary Jetstar, however, believes it is the Asia Pacific's leading low-cost carrier in terms of revenue and has long been operating low cost services in Australia and to regional destinations. While it also has a Vietnamese subsidiary, it is Singapore-based Jetstar Asia, in which Qantas has a 49% stake, which has become the focus of its expansion in the region.
Apart from plans to rapidly grow its short-haul network in the coming years, Jetstar Asia has also begun long-haul services to Melbourne and Auckland. It has secured rights for flights to Tokyo's Narita airport, and is also eyeing destinations such as Beijing and Shanghai in China and Rome and Athens in Europe.