Entering the market and rapidly building up aircraft and destinations is the easy part for the management teams of low-cost carriers. The tough bit is making money doing it

Entrepreneurs from around the globe continue to flock to this industry to create a low-cost carrier in their region. A glance at the Airline Business 2006 low-cost ranking shows why: virtually every carrier saw stellar double-digit revenue growth in 2006. As the traffic ranking shows, there were equally striking rises in passenger numbers.

But move along to the profit line and the number of carriers able to turn strong revenues into strong profits is less impressive. At the operating level most of the largest low-cost players are solidly profitable, whereas some of the newer entrants still have ground to make up.

In terms of operating margin, only Ryanair, Gol and AirAsia performed well enough last year to post results in the high teens or better. For some of the younger players, the journey into the black is far from over. In the USA, while Southwest Airlines managed to sustain its record-breaking run of profits, AirTran, Frontier and JetBlue Airways all struggled, with only AirTran managing a profit at the net level.

Whether entering a mature or an emerging market, there is no guarantee the low-cost formula will create a rash of industry millionaires. But there seems no shortage of those willing to try.

Low entry barriers

"Superficially the opportunity is there for everyone," says Tim Jeans, managing director of the UK's Monarch Airlines, a traditional leisure carrier that is growing its low-fare operation. "The costs of entry are low, the regulatory barriers in Europe are almost non-existent and cash flows are fantastic because of the internet." Regulatory hurdles in regions like Asia and Middle East are higher, but even previously closed markets like Saudi Arabia are opening up.

However, this industry has an ever-present Achilles heel. "The difference is always that in any form of air transport the margins are ridiculously thin," says Jeans. "Very few carriers really make a real rate of return. Many can struggle on almost indefinitely as long as ticket revenue comes in ahead of travel."

As the ranking demonstrates, revenue growth is not the problem. "We have no difficulty filling aircraft. The only significant variable is yield - that is the great sensitivity," says Jeans. Monarch does not release its financial data, but Jeans says it is profitable, with a strategy that bends the traditional low-fares model with extra legroom seating that "generates huge amounts of incremental revenue and, most importantly, repeat business", he says.

It is also critical for almost every low-cost entrant to add capacity rapidly, expand constantly into new destinations and grab market share as fast as possible. "Once you have built a critical mass in a market it makes you difficult to dislodge," says Jeans, whose carrier is market leader in 27 of its 35 routes.

Slovakian low-cost player SkyEurope has been building its critical mass from bases in Austria, the Czech Republic, Hungary, Slovakia and Poland as fast as it can. "In the airline business you have to extend your investment in new markets immediately," says chief executive Christian Mandl. "In three years we will have built an airline the size of [Hungarian flag carrier] Malev, the difference is we are not based in a single country - we have a pan-European brand."

SkyEurope has sacrificed short-term profits to quickly penetrate the market. With its costs half those of network rivals CSA Czech Airlines, Malev or Poland's LOT, "we are in a much better position than the national carriers. We have great prospects," says Mandl. Now, he believes, it has gained critical mass - with annual passenger numbers nearing three million - and is "focusing on profitability and not growth", he says.

SkyEurope has some distance to go, having made a net loss of $67 million last year. Inroads will be made this year as it lowers unit costs by 5% and boosts load factor to 80%, says Mandl. These moves will help it reach its target of an operating profit in 2007.

India's Air Deccan may be operating in a different market, but is at a similar stage in its evolution as SkyEurope. It is nearly four years old, while the European carrier is one year older. "All our focus now is on how to get as fast as possible to profitability," says Capt GR Gopinath, group managing director of Air Deccan. Its last results for the year to June 2006 saw it post a net loss of $75 million on revenues of $275 million.

He notes that the carrier has the classic dilemma of many fast-growing players. "I could stop adding aircraft, but that would be the death knell. But when you are still adding aircraft you need funding to sustain the growth." A public offering in June last year raised $79 million and a deal to raise $100 million from a consortium of European banks in October will go a long way towards giving it the cash needed to grow.

Gopinath has no illusions about the task ahead and the need to turn the financial corner. "Air Deccan is not an non-governmental association," he says, referring to charitable or non-governmental organisations. But India is a tough place to make money in the airline business. "Right after we started another five airlines started," he notes. Now the market is being fought over by Air Deccan, Go Air, Indigo, Paramount and SpiceJet.

India's competitive edge

Such intense competition, coupled with a shortage of slots and airport capacity, means aviation, unlike other deregulated industries such as telecommunications, will take longer to become profitable. Some may not make it, but there are plenty of carriers eyeing the aircraft they have on order. For example, the heads of Middle Eastern low-cost carriers Air Arabia and Jazeera Airways, Adel Ali and Marwan Boodai, expect at least one Indian player will defer or cancel some of their Airbus A320 orders, or shut down. Air Deccan, Go Air and Indigo - all unprofitable - have outstanding orders for over 150 A320s.

Gopinath is determined his carrier will not fail. "Our model is very robust and sound," he says. And the difference he needs to make up to become profitable is only a few dollars. "Our average revenue per seat is about Rp2,750 [$64]. What I should be getting, to be in profit, is Rp2,950." This will come from "running a tighter ship, better efficiency in aircraft utilisation and increasing ancillary revenues", he says.

The competitive edge that carriers such as Air Deccan and SkyEurope feel in their markets is not as sharp for the Middle Eastern start-ups. The region's low-cost pioneers Air Arabia and Jazeera have benefited from higher demand than supply in the Middle East-India market as well as in most regional Middle East markets. Air Arabia, which launched in 2003, has been profitable since its second year, making $29 million last year. Jazeera, which launched in late 2005, was already in the black last year, reporting a $9 million profit. "We have better margins than low-cost carriers elsewhere," says Boodai.

Boodai and Ali also credit their early successes to refraining from expanding too quickly. Air Arabia only operates nine leased aircraft and has commitments to lease another five. Jazeera operates five with another five on order.

"We're not going to be in a race for number of aircraft. The question is do you have the right number of aircraft for the business to be profitable," Ali says. "We want to run a business that is an airline. A lot of people seem to run an airline and then to try to turn it into a business. Our mindset is we must have a successful business." Boodai has a similar philosophy: "We won't expand for the sake of expanding. We want to expand to make money."

AirAsia is continuing to expand fast and is having a good year in financial terms. "We're delivering where others are just telling a story," says Tony Fernandes, group chief executive. In its ­second quarter to the end of December it made a net profit of 150.1 million ringgit ($43 million), a record performance.

Having 51% of the Malaysian market certainly helps, but Fernandes believes the personal touch is also essential. "I honestly believe the fact we are owner operated is a major factor. Entrepreneur-driven airlines are a better recipe for low-cost carriers," he says. "It's a culture, a religion for us, a passion for us."

"We're delivering where others are just telling a story" Tony Fernandes, group chief executive, AirAsia

AirAsia is similarly dedicated to keeping costs rock bottom. "The model is a Ryanair model," says Fernandes. "From an operational point of view they are the best. The key focus is discipline and the fact that we can change in seconds - there is no way others can react as quickly as we can."

It is hard to believe AirAsia is only five years old. It has fought battles with governments and regulators to gain market access and acceptance. However, the region has steadily been liberalising putting the carrier in the best position it has ever been in. "For the first time AirAsia can be compared with Ryanair and Southwest as we've got the same playing field," says Fernandes.

The need to continue growing at pace will cramp AirAsia's profits a little in the coming years. "We keep investing and developing and that pulls down our margin," says Fernandes. "I'll be thrilled if we can still grow and achieve my target of a 15% net margin," he adds.

Another powerful ingredient in the low-cost recipe for success is to begin with lots of money. "We were clearly under-capitalised in the beginning," recalls Fernandes. AirAsia put this right in late 2004 with an IPO that netted it $227 million. JetBlue is always cited as the model to follow when it raised $130 million for its formation in 2000.

Spanish start-up Vueling Airlines, which will complete its first year of operations in July, went public in December. The €100 million ($135 million) raised will help sustain its expansion which has been faster than planned. "It is interesting to note that our business plan spoke of 20 aircraft in five years - we will be close to 50 in that time," says Carlos Muñoz, chief executive.

With revenues that soared 110% in 2006 to €235 million, Vueling is the "second fastest low-cost airline in terms of growth globally - the fastest was JetBlue", notes Muñoz. It managed an operating margin of 1.5% in 2005 and 12% last year, he says. The carrier slipped into the red to the tune of $13.6 million in 2006, but Muñoz is confident this year will show a strong performance. "We are looking for our first net profit and to improve our operating profit to 22%. We have a revenue target of €425 million."

Like many others before him, Muñoz is sticking to most elements of the established low-cost formula. "We have really executed low-cost by the book. We've got all the basics such as direct distribution of 95% of tickets and generating lots of ancillary revenues."

But there is more to it than that. "Many people offer more than naked low-cost," says Muñoz. "You must be a cost leader - that is absolutely essential. But at the same time you must worry about the client experience."

Accordingly, Vueling has worked hard on creating a strong brand. "We believe very much in our positioning as a second generation low-cost airline," he says. This means taking the basic model and bolting on some extras. For example, Vueling took the strategic decision to assign seats and launch a frequent flyer programme, says Muñoz.

Other strategic moves were to ­operate always from primary airports and to concentrate on offering high frequencies. The final element in Vueling's favour is its choice of market. "Choosing south-west Europe was the right strategy. Compared with the UK and Ireland this region was under-competed by low-cost carriers," explains Muñoz.

Whether it is in Mexico City or Mumbai, the attraction of the low-cost sector is so powerful that investors and entrepreneurs will keep turning up. Many can stick it out for a long time - there have been remarkably few failures. In Europe the most obvious was Italy's Volare, grounded in late 2004.

"It doesn't matter if the margin is 1% or 11%, they will keep going," says Jeans of Monarch. "The level of profitability seems almost immaterial because the appetite for growth is always there."

To read our chief executive interviews with Adel Ali, Marwan Boodai, Tony Fernandes and Christian Mandl click here

Source: Airline Business