Two airlines have emerged as Air Canada's challengers, yet they control less than one-third of the market and Air Canada is set to launch a discount airline of its own. So what are their chances?

Canadian aviation has emerged from a 20-month transformation. The country's two major carriers - Air Canada and Canadian Airlines International - became one, prompting a swarm of newcomers and then a flurry of failures and consolidation. When the turbulence ended, Air Canada was left with only two rivals instead of the five that once seemed possible. Those two seem to be here to stay, but nothing about their relationship with Air Canada suggests it will be cosy.

Back when Air Canada and Canadian flew wingtip to wingtip, Ottawa had a formal two-airline policy overseas and, according to many, an informal one at home. It allowed only one airline per overseas route until traffic exceeded certain levels. At home, Ottawa and the western provinces used such devices as subsidies and tax holidays to keep Canadian in the air. Because everyone understood this was the way the nation's aviation worked, other airlines stuck to charters and new entrants were rare.

All that ended when Air Canada took over Canadian in December 1999 and the window of opportunity opened. Charters suddenly converted to scheduled service and startups bloomed. Robert Milton, Air Canada's chief executive, remarked: "Competition is alive and well. Air Canada is now being challenged by a new generation of airlines which didn't exist a few years ago."

Not that Air Canada sat still when faced by these new rivals. Indeed, its response was sufficiently strident to prompt investigations and several warnings from the competition bureau about predatory misconduct.

By the first quarter of this year, after a flurry of skirmishes, the expansion phase had spluttered out. By May all the startups were gone. CanJet, launched from Halifax; Royal Airlines, which switched from charters to scheduled flights at Montreal; and RootsAir, which lasted only six weeks, all vanished. Canada 3000 acquired the first two and Skyservice, RootsAir's parent, decided there was more to be gained by working with Air Canada.

"I don't believe any more small carriers will move into the Canadian sector," predicts Clive Beddoe, WestJet's president and chief executive. "I don't think we're going to see much capital coming other than to support the successful carriers that are here."

So the window of opportunity has shut, and the survivors of this shake-out are the two carriers that were around before it began - WestJet and Canada 3000.ÊBoth are now larger and stronger because of it.

The open window gave WestJet, a discount airline based in Calgary, the impetus to grow. But to say WestJet "seized" the opportunity would be only half right. Geographically, it was cautious. Its initial foray into eastern Canada, traditionally an Air Canada stronghold, was to just one new destination: Hamilton.

Hamilton was a good place to start. Every Canadian who ever planned a low-cost carrier wanted a Hamilton hub. An unconstrained, inexpensive airport only 72km (45 miles) from slot-restricted Toronto, Hamilton could be for Toronto what Stansted is for London.

Caution still characterises WestJet's eastern Canada strategy. Its only flights from Hamilton to the east are to Ottawa and Moncton, New Brunswick.

What the company lacks in geographic coverage, however, it has made up for in capacity growth. Last year WestJet boosted available seat kilometres (ASKs) by 53%, and that was only the start. It ordered 26 Boeing 737-700s and agreed to lease 10 more from GE Capital Aviation Services (GECAS). A further 48 are optioned for its own account with lease options from GECAS for 10 more. The -700s will start arriving as it retires its current fleet of 22 737-200s over the next few years, and WestJet will keep growing.

Lower costs

This has prompted Air Canada's Milton to note that if WestJet takes delivery of all the 737-700s it has on order and option, its domestic operation will be as large as that of the former Canadian Airlines by 2004, "with dramatically lower costs and a healthy balance sheet".

The 737-700s could move WestJet into longer stage lengths, but the airline is not abandoning its Southwest-style strategy of building frequencies to established destinations rather than aiming for a sprawling route map.

Canada 3000 has followed a far different route to growth. Previously known as both a charter and low-cost scheduled carrier, it has boosted the scheduled side of its operations from 65% to at least 75%, added a business class, and grown through its acquisition of Royal Aviation and CanJet. "These give us the ability with a combined fleet to serve markets now that we previously couldn't have thought of doing for at least a couple of years," says Angus Kinnear, Canada 3000's president. "If you do it one aircraft at a time, it takes you an awful long time to build up to this level of operation."

Royal gave Canada 3000 a Montreal hub, CanJet gave it valuable new slots at its Toronto base, and both boosted its short-haul presence in eastern Canada. "This will give us the ability to set up a network from coast to coast - from Victoria, British Columbia, to St John's, Newfoundland, - which will penetrate most of the medium-sized cities in Canada," Kinnear told analysts recently.

These acquisitions more than double Canada 3000's fleet, but the mixed types it inherited will take time to standardise. It now flies Airbus A310s, A320s, A330s, and Boeing 737-200s and 757-200s. By early 2004, Kinnear hopes to have an all-Airbus fleet that includes A340s. It will continue to need different aircraft types for its mix of short, transcontinental and overseas routes.

Upgrading the carrier's scheduled services was achieved mostly by the simple step of converting charter flights into scheduled frequencies. However, adding business class marked a fundamental shift in Canada 3000's strategic thinking: it symbolises a move away from the airline's discount roots. Canada 3000 insists it is not trying to replace Canadian, but knows that if it does not offer two-class service, business travellers and foreign airlines seeking an interline partner will go to Air Canada by default.

As Canada 3000 and WestJet have grown, Air Canada's share of the domestic market has shrunk from a high of 80% to 73%, with the remaining 27% split almost evenly between its two rivals. Despite this growth, neither of them aspires to take Air Canada head-on. Canada 3000 president Kinnear predicts the present 73:27 split will stabilise around 70:30.

David Collenette, minister of transport, and Konrad von Finckenstein, competition commissioner, have a running debate about whether this is good enough and, if not, what to do about it.

Von Finckenstein calls it "unacceptable" that Air Canada is 10 times larger than its closest rival, and believes it gives the flag carrier too much power over fares and capacity. More initiatives are needed to stimulate competition, he says. For instance, he calls on Ottawa to relax foreign ownership caps - now at 25% - offer cabotage to foreign carriers or even allow foreigners to set up local airlines the way Australia has done.

For his part, Collenette feels that these measures ultimately would hurt Canada 3000 and WestJet more than Air Canada. "We're happy so far with the way competition has come on," he says. "We need about two years to see how the merger has gone and what the environment is before we start making major structural and policy changes."

Competition review

In July, von Finckenstein gained an ally when a government transport review panel released a report on competition in Canada's skies. It said expansion by Canada 3000, WestJet and such charters as Air Transat "have not significantly lessened Air Canada's grip on the domestic market". Air Canada's dominance extends even to foreign markets, the panel said, explaining that, as the company could charge higher interline prorates to non-Star Alliance-affiliated carriers, it "can reduce travel options and inhibit effective competition".

It looked as if von Finckenstein might have the last word on the Skyservice plan to operate a discount airline for Air Canada. But Air Canada reached an accord with its pilots in July and now plans to launch its own discount unit. That agreement has allowed Air Canada to sidestep the need for regulatory approval, which did not look promising.

Analysts say that Air Canada's entry into the discount end of the market - the only segment that continues to grow during Canada's slowdown - must worry WestJet and Canada 3000. They doubt Air Canada will undercut its rivals' fares - except on an introductory basis - but it can use still use its network clout and loyalty plan to woo passengers.

WestJet could feel the initial brunt of this because Air Canada plans to launch its new airline in the west. Yet WestJet is putting on a brave face. "The reality is Air Canada has used low fares against us since we started flying, at tremendous impact to them and their bottom line," says WestJet president Clive Beddoe. "They have had a high-cost structure and a low-fare structure. On stage lengths typical of WestJet's, Beddoe claims his costs are only C8.1¢ per ASK (US8.5¢ per mile) compared with Air Canada's 17.5¢.

Unit costs will be lower at Air Canada's discount unit, but it is not clear whether they will be low enough to compete with unit costs at WestJet and Canada 3000. Pilots at Air Canada's new subsidiary will still be Air Canada employees with benefits, pensions and seniority credits. Analysts who have examined the issue doubt that Air Canada can match WestJet's costs.

Furthermore, the country's competition laws contain a unique feature that works against Air Canada. In most nations, a dominant airline may match rival fares even if they are below its own variable costs. Not so in Canada: Air Canada can meet its competition's prices only if it stays above its own costs.

So far, the competition bureau has taken a tough stance on what Air Canada must count in those costs. More sparring seems inevitable, but it may be that Air Canada cannot match its rivals' fares.

If so, can WestJet and Canada 3000 make further inroads into its 70%-plus share of the market? Ted Larkin, aviation analyst with HSBC Securities, thinks they already have. Larkin analysed capacity on Canada's 15 busiest routes, revealing that Air Canada had only 61% of the seats. Its overall market share is higher because of the secondary routes it operates only at Ottawa's insistence, such as Prince Rupert to Vancouver, where the transport agency in March ordered Air Canada to cut its monopoly fare. Its rivals happily ignore most of those smaller markets.

On the larger contested routes, Larkin found that Air Canada was, unsurprisingly, strongest in Canada's east. On transcontinental routes, Air Canada's share was only slightly above 50%. In western Canada, Air Canada flew no more than half of all seats.

In sum, the growth of Canada 3000 and WestJet has decidedly cut into Air Canada's dominance in those markets where they have chosen to compete.

So, of the two, which is most likely to keep cutting into that dominance? So far, their performances are identical, even though their approaches are different. Each has a distinct vision for itself and focuses on a different market segment.

Adding business class and a frequent flier programme puts Canada 3000 in the high-yield race with Air Canada. WestJet has no loyalty programme and no plans for business class. Canada 3000 is mostly a long-haul carrier with a Toronto hub; WestJet is short- to medium-haul with several mini-hubs. Canada 3000 serves the USA, Mexico, Europe, Australia, New Zealand, the Pacific islands and India. WestJet could add US flights in two to four years, but has no other foreign plans.

Canada 3000 is likely to feed more traffic to and from foreign airlines. It has not been asked and is not ready to join any global alliance, but the demise of Canadian Airlines left a vacuum in Canada for oneworld. Canada 3000's decision to join AAdvantage in May moves it closer to that group.

Kinnear says foreign carriers are keen to interline with Canada 3000, not only because Air Canada is the only alternative, but because it now offers two-class service. Canada 3000 already has 21 interline accords. WestJet has none.

WestJet seeks simply to keep on being Canada's most profitable airline, operating as a successful northern version of Southwest. Against these differences, Ted Larkin says of the future of Canadian competition: "We see Air Canada as best configured to retain the frequent flier who is prepared to pay the premium required for scheduling flexibility."

WestJet is best positioned to capture low-fare, short-haul traffic, says Larkin. "That leaves the middle-ground traveller to be won over. This is the market we see being hotly contested as Air Canada offers some attractively priced capacity on its network; as Canada 3000 introduces its new schedule and offers AAdvantage points; and as WestJet introduces long stage-length routes with its new 737-700 aircraft."

Bill Lamberton, WestJet's marketing vice-president, adds: "Canada was not big enough for two airlines when Air Canada and Canadian flew the same network wingtip to wingtip, offering the same services, basically fighting over market share. However, now that service is stratified, Canada is big enough for two. Whether it is big enough for three, time will tell."

Canada's shakeout may be over, but the competition between its survivors has only started.

Source: Airline Business