Lois Jones Low-cost startups are beginning to looking extremely vulnerable as more majors launch low-cost subsidiaries, ignoring the argument that the independent players should instead be left to satisfy the demand for low fares in underserved markets. By Lois Jones.

To your corners, please. To the left of the ring we have a young, fresh, unknown featherweight; in the right hand corner let me introduce our mature, slimmed-down former heavyweight champion.

The industry is on the edge of its seat as a fight of wills, strategy, customer expectations and regulatory issues commences.

Are the contestants evenly matched? On one side, no frills, virtually fat free startups, with low costs and a fresh approach. On the other, majors' low-cost subsidiaries with experience, industry knowledge and brand recognition to build on. Acting as referee are the regulatory authorities, convinced that the fight is about to get dirty. The prize at stake - a fast-growing customer base as the low-cost craze continues to whip the airline industry into an increasing frenzy.

As round one in this fight draws to a close, no clear winner is in evidence.

Niche no-frills carriers certainly have enough problems keeping their form. Historically, budget airlines have faced an uphill struggle for survival and long-term sustainability. As startup carriers grow, their overheads can escalate making it more difficult to keep fares low. What's more, when times get tough, budget carriers are left with few financial resources with which to weather the storm.

Meanwhile, large carriers with budget operations also have a number of difficulties to contend with. Although the majors undeniably have the resources to make life difficult for the startups, regulatory issues prevent them from dipping into the core airline's coffers. Majors need to beware that their budget subsidiaries do not cannibalise their existing market share and damage their brand. Moreover, as passengers' service expectations rise, it can become all too tempting to add more frills, and revert to the original product offered by the major carrier, thereby confusing the passenger.

Frank Wade of consultants SH&E says that majors operating low-cost subsidiaries can cause 'confused market perception as the customer no longer knows what he is buying. There is very little to define the difference in service between a major and its low-cost subsidiary on a short-haul route'.

As well as causing brand confusion among consumers, low-cost subsidiaries are also in danger of confusing employees, who will expect to receive the benefits associated with working for a major airline.

Wade also warns that the creation of low-cost subsidiaries can in addition detract from management focus as managers 'try to do two different things well at the same time'.

Further confusion can occur within distribution systems as it becomes difficult to segregate flights unless the subsidiary has a separate airline code to that of the major, says Wade.

Yet, despite inherent confusion, major carriers are increasingly setting up their own low-cost operations to cater for a new generation of passengers that wants low fares and win back market share lost to no-frills carriers like Southwest and EasyJet. US Airways is set to launch a low-cost subsidiary, following the example set by United Airlines and Delta Air Lines. In Europe, Alitalia is fighting off no-frills carriers with its low-cost subsidiary, Alitalia Team, and Lufthansa, which already franchises lower cost regionals under the Team Lufthansa brand, is studying a separate low-cost option. In late 1997 British Airways announced its plans to start a low-cost European operation, codenamed Blue Sky.

BA's Blue Sky is due to start operations in May 1998 from London/Stansted, using eight leased Boeing 737-300s. The initial route map for the 'new low-fare airline for Europe' is said to include four daily services to Paris, Stuttgart, Stockholm, Copenhagen, Milan and Barcelona.

BA is entering the low-cost arena in order to 'capitalise on a great, untapped market of customers excited by cheaper, more accessible travel', states Blue Sky's chief executive, Barbara Cassani, in an internal BA management document. BA's attitude is 'if the startups can do it, so can we', says a senior BA source.

Yet will BA's attempt to be all things to all people pay off? Many industry sources claim that BA is in danger of damaging its core asset, the BA brand. BA has traditionally made its profits from a high premium product, offered at a high premium price to a premium customer, yet is now moving in the completely opposite direction, they say. 'I'm not sure whether this is their business,' says a London-based analyst. The opinion is one shared by UK-based Debonair's flamboyant chairman Franco Mancassola: 'BA are very good at what they do - why are they coming down to the bottom of the barrel to slog it out with the low-cost carriers?'

BA, however, needs to beware of disappointing customers who automatically associate BA with a quality hallmark and not with a no-frills, cheap-thrills approach. 'Airlines live off a snob, brand value and none so much as BA. Passengers have fairly high expectations of how they should be treated when they fly,' says Justin Pannell, director of management consultancy MSB and former Customer First manager at BA. But Lewis Scard, BA's general manager franchises and alliances, argues that 'Blue Sky has nothing to do with the BA brand or service standards - BA simply happens to own another company, which it runs at arms length'.

EasyJet's charismatic chairman Stelios Haji-Ioannou insists, however, that 'whatever name BA gives it, people will refer to the venture as a BA subsidiary. Then you enter into the problems of the "so where is my lunch?" mentality'. EasyJet, meanwhile, has from the outset stuck to a strictly no-frills philosophy, therefore it cannot disappoint or confuse customers, he adds.

Haji-Ioannou claims that Blue Sky is a complete clone of EasyJet's business plan. Blue Sky copies EasyJet's use of 737-300s, its ticketless travel and even its limited leg-room.

The similarities in business plans are not surprising 'considering BA wanted to buy us,' says Haji-Ioannou. He sees BA's withdrawal of its attempt to purchase the Luton-based no-frills carrier - because 'they couldn't get regulatory approval due to it being an anticompetitive bid' - as indicative of Blue Sky's potential for anticompetitive behaviour.

In Haji-Ioannou's opinion, Blue Sky is a flagrant attempt to oust Easyjet and its no-frills compatriots from the market. EasyJet has lodged an informal complaint with the European Commission over Blue Sky's potential abuse of BA's dominant position to serve as a 'warning shot', and will launch a specific, formal complaint the moment Blue Sky puts a foot out of place, says Haji-Ioannou.

EasyJet claims that BA 'will write a blank cheque' for Blue Sky and cross-subsidise the operations from its core business. He adds that BA's admission that Blue Sky will need three years to break even is a concession that the airline cannot remain financially viable. 'There's no doubt that BA will transfer funds to Blue Sky - it's just too tempting,' says one consultant. Blue Sky is also likely to benefit from the buying power associated with the BA name. BA dismisses all these claims.

However, one senior European Commission official sees BA's creation of Blue Sky as simply a natural, competitive response to market demands. 'BA is allowed to create any carrier it likes - after all, that's why we've had liberalisation,' he says. Nevertheless, the Commission will be watching Blue Sky's movements closely, to determine whether it is legitimate for carriers like BA to preempt competition with Blue Sky, before rivals such as EasyJet have achieved critical mass. 'If Blue Sky only competes on certain routes served by startups to get rid of them, and if these subsidiaries are subsidised from an airline's core business, then we'll act,' he continues.

Debonair's Mancassola says that Blue Sky should be called 'Air Terminator' and views it as a 'hit squad set to go around and eliminate competition. BA is addicted to market share and wants to dominate the market and eliminate competition'.

While BA and other majors operating low-cost subsidiaries need to take care to remain within regulatory parameters, they also need to beware of slipping back into higher cost habits. 'I spent 60p (101 cents) designing EasyJet's livery in front of a Mac, whereas BA spent £60 million (US$101 million) for a Soho design agency to redesign their tails. How long do you seriously think BA can remain low-cost?' asks Haji-Ioannou.

Although Blue Sky will start off on a purely no-frills basis, as it grows the pressure will mount to take on a lot of additional costs and turn into a miniature version of BA. 'No-one in BA is qualified via experience to run a low-cost airline,' an analyst points out.

And experience is needed to ensure that Blue Sky does not cannibalise BA's existing core business, luring lucrative business passengers away with cheap fares. 'Why the hell pay £150 Club Class when you can pay a fraction with a BA cheapo flight?' questions Haji-Ioannou.

BA has already been successful with its low-fare 'World Offers', points out Pannell. It has further created a successful, low-cost formula via its use of BA franchisees, which proudly spread the BA brand and quality hallmark operating on routes at a lower cost than BA itself could achieve.

BA's Scard insists that Blue Sky and BA franchisees can co-exist, since franchisees may be lower in cost than BA mainline but do not operate at the lowest cost possible. For franchisees, 'using the BA brand and its intellectual property has associated costs. Unlike the BA franchisees, a number of startups have decided not to take these costs onboard and to operate only rudimentary systems. Totally low-cost carriers have considerably less equity than franchisees; they sell on price', says Scard.

Perhaps the best proof of how a major's experiment with the low-cost end of the market can fail is Continental Airlines' aborted attempt with its subsidiary, Continental Lite. Continental abandoned its attempt at a low-cost subsidiary after running the operation from 1992-4. A spokesman attributes CAL-Lite's failure to the fact that 'low fares did not cause demand to grow as anticipated', and to the market weakness of smaller communities - 'the size of the market wasn't large enough'.

CAL-Lite made a further miscalculation by using a mixture of different aircraft types, and some critics say that it should have fed Continental's hubs rather than operating point-to-point. Moreover, the airline did not differentiate its product from that of its mainline operation, often using both Continental and CAL-Lite brands on the same route, with customers not knowing from day to day which they would be flying on.

Continental has no plans to repeat the low-cost experiment, yet other US majors are adamant they can succeed where Continental Lite failed. US Airways is set to launch a low-cost subsidiary, which industry sources claim will not fly in and out of US Airways' hubs. Shuttle by United is growing ever stronger, feeding high-yield business passengers to United Airlines' hubs in Los Angeles and San Francisco. The Shuttle's focus on feeding its majors' hubs is far more successful than its former strategy of chasing Southwest on the no-frills' carrier's routes. 'United was beaten back into its hubs when it went after Southwest,' says Russell Winter, vice president of marketing and planning at Kansas City-based low-cost airline, Vanguard.

A clear recipe for a low-cost subsidiary to work is for it 'to operate on an underserved market, separate to that catered for by the major, as well as a different geographical region on a point-to-point basis', says Winter.

Further proof of a major running a successful low-cost operation is Delta Air Lines' subsidiary, Delta Express. The subsidiary is attempting to counter Southwest's low-fare approach by operating a dedicated fleet of 25 Boeing 737s from Orlando. Delta Express claims that it has put concerns to rest over the viability of a low-fare carrier as a business unit of a major airline and is 'the only successful low-fare division launched by a major airline'. The low-fare initiative, set up in October 1996, is operated as a business unit within Delta by Delta personnel, with daily services connecting 11 US midwest and northeast cities with Orlando and four other Florida destinations.

W E 'Skip'Barnette, vice president at Delta Express, boasts of an 'on-time performance nearing 90 per cent - our customer satisfaction levels are high, and our load factors are averaging 71 per cent', he says.

Paulette Corbin, managing director of Delta Express, claims that the subsidiary is 'stimulating new traffic rather than siphoning off traffic from mainline operations'. A research study conducted by Delta in May 1997 showed that 75 per cent of Delta Express passengers were new flyers and not from Delta's existing customer base.

Corbin further insists that Delta Express has recognised the need to portray a very clear, persistent message of what the product is, namely that 'Delta Express will get you there reliably, safely and on time'.

Corbin concedes that the major pitfall is 'the tremendous pressure to revert to what the main airline is doing'. But she insists that Delta Express manages to differentiate its product from that of its low-fare competitors by offering services such as advanced seat assignments, electronic ticketing, curb-side check-in and mileage credit in Delta's SkyMiles frequent flyer programme.

The main way in which Delta Express keeps its costs low, at 3.5 cents per available seat mile, is through pilot concessions, says Corbin. Indeed, one of the most shocking revelations of the low-cost subsidiaries is that often employees from the core airline opt to transfer to the airline's low-cost arm, despite the poorer working conditions.

As well as the case of Delta pilots opting to transfer to Delta Express, many Alitalia pilots have chosen to move over to the Italian flag carrier's low-cost subsidiary, Alitalia Team, for the same pay, yet more hours. 'There is no contamination of previous bad habits in Alitalia Team and there is a different kind of mentality in the company,' says one Alitalia Team pilot who opted to transfer from Alitalia.

Pilots see a future in Alitalia Team yet no longer believe in the sustainability of Alitalia, explains Captain Sneider of Alitalia pilots' union, Anpac. 'At the end of the day we will be left just with Alitalia Team as Alitalia winds up day by day,' Sneider says. The idea that Alitalia Team will eventually prove more successful than Alitalia itself is clear evidence in favour of a low-cost subsidiary's viability.

Lufthansa has yet to decide whether to resurrect the low-cost subsidiary concept, after Lufthansa Express failed, but is pursuing franchising. Jörg Schwingeler, coordinator Team Lufthansa, insists that the franchise brand complements the main airline. 'We need a very lean organisation to be profitable on thin routes, hence the need for Team Lufthansa,' says Schwingeler.

Indeed, in many respects majors' low-cost subsidiaries are better positioned than no-frills carriers for future survival. Many US low-cost airlines are now having to merge to gain the critical mass needed to survive the majors' ruthless tactics, and the US Department of Transportation has acknowledged that low-cost competition could be in danger of disappearing altogether.

'The US experience has shown that budget airlines suffer from a high mortality rate - survival depends on finding a sustainable approach that includes both customer service and price sensitivity', says Pannell.

US experience points to the fact that competing solely on price tends to become difficult for no-frills carriers in the long term, as startups are forced to compete on the same routes at the lowest fares. Rising customer expectations and the need for product differentiation may call for a 'sustainable approach that includes both customer service and price sensitivity - In 10 years' time, carriers will move more up market again and be forced to add in frills and extras', argues Pannell.

With low fares as their sole selling point, no-frills carriers may be extremely vulnerable as majors' low-cost subsidiaries piggyback on the power of a well known brand, and fall back on the major's experience and financial resources, to weather bad storms and add in extra services to meet customer demands.

Source: Airline Business