Large network carriers need to drastically prune short-haul services and focus on long-haul operations to survive
The traditional airline network model appears to be in tatters. Two of the world’s largest network carriers, Delta Air Lines and Northwest Airlines, filed for bankruptcy in September. Most network carriers have made substantial losses within the past five years. The high profit levels of the late 1990s seem unlikely to return. Airlines have been battered by both external factors and industry trends.
The external factors are well known: 9/11, the SARS epidemic, the Iraq war and escalating fuel prices since mid-2004. The numerous internal trends have fundamentally changed the market. The liberalisation of traffic rights has opened up markets to increased competition. In some, overcapacity has become endemic. The growth of alliances has reinforced the major hubs and worsened the risk of overcapacity and yield erosion by offering passengers more alternative routeings.
At the same time, the phenomenal growth of low-cost carriers has undermined the operations of network airlines. By 2003, Southwest Airlines was carrying 65% of all passengers travelling in its top-100 local markets. The next largest carrier in those same markets was American Airlines, with only 7%. In 2004, low-cost carriers captured over half the market on 12 of the 15 densest scheduled routes from London to Italy (see table on page 79). Ryanair captured 43% of the total scheduled traffic on these 15 routes and is now by far the largest carrier between London and Italy. While British Airways is still battling on several routes, Alitalia now only flies to London from Rome and Milan.
The growth of internet selling has given consumers immediate access to most of the available fares. Increased market knowledge has shifted the balance of market power from the airlines to the consumers. The airline product, especially in short-haul markets, is becoming a commodity, where price is the key. In many markets, network airlines appear to have lost control of pricing.
To survive this crisis, airlines are focusing on cost-cutting, marketing efforts and the use of Information Technology to reduce distribution costs and enhance customer relations. Sadly these measures alone will not ensure profitable long-term survival. Network airlines have to take strategic decisions to adapt their business model to today’s realities.
Repairing the network model
The US majors epitomise the crisis facing large network carriers. Since 2001 they have cut their costs by up to a third, their workers have accepted swingeing wage cuts, they have reduced staff numbers by around a third and collectively they have defaulted on pension contributions to the tune of $20 billion. A couple of them have benefited from Chapter 11 bankruptcy protection, with two more doing so now. At the same time they have seen traffic growth recover in the past two years. All this should have resulted in profits. Yet in 2004 the eight majors together lost $9.2 billion, nearly double the 2003 losses of $4.8 billion. Much of this is blamed on escalating fuel prices. But it is not that simple. Despite high fuel prices, both Southwest and JetBlue Airways have been highly profitable.
The majors have failed to adapt to the challenge of the low-cost “upstarts”. They have failed to shrink their networks sufficiently and to focus on routes and markets where they have a sustainable competitive advantage. For more than 20 years they have carried on believing they can hold off the low-cost threat. They have cut costs substantially, but they are still 30-40% or more higher on a seat-kilometre basis than those of Southwest on the same or parallel routes. It is this failure to adapt that explains why the losses of the US majors over the past five years are so much larger than those of their European or Asian counterparts.
The low-cost challenge in Europe is a more recent phenomenon. But here too the large network carriers have failed to react adequately. BA has been one of the more flexible and innovative. Nevertheless, in 2004/5 its European operations produced a £26 million ($46 million) loss. Yet the European market represented nearly a third of the airline’s total production (see table on page 81). Its profits come entirely from long-haul intercontinental services. One estimate is that around 80% of BA’s profits come from just 11 long-haul routes.
Even though they feed long-haul services at London Heathrow, many of BA’s numerous European services must be losing money heavily. The same is true for the short-haul routes of most European network carriers, especially where faced with direct competition from low-cost carriers. The implications are clear.
The first task for these major network carriers must be to slash their domestic and short-haul network. The routes to be cut are those where market share, load factors and yields are heavily undermined by low-cost competitors or will be shortly.
Large network carriers should maintain operations on shorter routes with a high business component and routes that provide a significant volume of feeder traffic to their longer-haul operations, especially where they can protect their local traffic by offering some competitive advantage, such as much higher frequencies or serving an airport closer to the city centre. On some discontinued routes they could try to maintain feeder traffic using lower-cost local partners or franchisees as several airlines already do.
The second and linked strategic decision that carriers face should be to concentrate their operations and growth on long-haul markets, as they are generally the most profitable. They are also the routes where any operating and cost advantages of the low-cost model are minimised. For large network carriers the business model of the future must be focused on long-haul transcontinental and intercontinental services operating through major hubs, but with a drastically pruned short-haul network.
Virgin Atlantic illustrates this network model. It is an entirely long-haul airline operating no domestic or short-haul services. Traffic feed, if any, is provided through bilateral alliances with other carriers. Cathay Pacific, which until very recently had few services into China from its Hong Kong base, has a similar model, as does Singapore Airlines.
Some major network carriers have recently moved in this direction by expanding their long-haul operations while reducing short-haul capacity, though not enough. Air Canada, Continental Airlines and American are among them. In September Delta announced it would expand service to 41 international destinations while reducing domestic flights to Cincinnati, its second largest hub, by a quarter.
Large network airlines must also take steps to reduce the chronic overcapacity in many of these markets. First, they need to reduce the number of players. This can be done through cross-border or domestic acquisitions and mergers, which will eliminate competitors and create larger, more powerful airlines each dominating two or more major long-haul hubs. The purchase of KLM by Air France in 2004 was indicative of this strategy. Consolidation will be accelerated through airline collapses, of which several are likely in the USA, or through the purchase of ailing carriers, such as Lufthansa’s recent purchase of Swiss International Air Lines.
Until now, airline consolidation has been largely within individual countries, such as the 2004 merger of Japan Airlines with Japan Air Systems. The next step is consolidation across borders. This is becoming easier as the nationality rule in bilateral air services agreements is progressively relaxed.
Second, consolidation should be reinforced by more effective schedule and capacity co-ordination by partner airlines in each of the global alliances. Alliances need to move beyond revenue generation and cost reduction to a joint-venture phase. This means reducing the number of hubs in each alliance. For example, it is clearly uneconomic for the Star Alliance to maintain six hubs in central Europe – Frankfurt, Munich, Copenhagen, Vienna, Zurich and Warsaw.
Third, airlines should develop long-haul services in niche markets where they can be dominant, either because they are the only operator or because they have some geographical advantage. An example is Iberia and its partners that together dominate the Europe-Latin America market in terms of both frequencies and number of points served. New, smaller and more economic long-haul aircraft have made it viable for airlines to launch services on thinner long-haul routes, such as Air Canada’s Toronto-Delhi flight, where they can be the only operator.
Several network carriers have responded to the low-cost threat by setting up their own low-cost subsidiary. Whether this is more viable than pulling out of threatened short-haul markets is unclear. The signs are not good. BA and KLM both attempted this strategy and abandoned it. Air Canada has experienced mixed fortunes, but is persevering; Qantas has been more successful with Jetstar.
This strategy faces two potential problems. First, attempts to transform part of an existing operation into a low-cost airline are unlikely to be successful because it is so difficult to dramatically reduce the high embedded costs of an established carrier to the levels of competing low-cost carriers. This is why KLM’s Buzz failed and why Independence Air in the USA is struggling to survive. America West claims to have made the conversion to a low-cost operator successfully, but has posted substantial losses over the past four years.
Second, the low-cost subsidiary may start to eat into the parent airline’s traffic. Then what happens? United Airlines found itself in the absurd position of having to hold back the expansion of Ted, its low-cost subsidiary. In September 2004, Glenn Tilton, United’s chairman and chief executive, highlighted the dilemma: “We need to rein in Ted’s growth. We launched it to service a leisure-only market and not enter business routes.”
Strategies for smaller network carriers
Smaller and medium-sized network airlines require different strategies. These airlines are mainly government-owned or influenced. They tend to be overstaffed and are characterised by operating an over-extended network. They suffer from the so-called “Sabena syndrome”. That is, they operate a long-haul network which is overextended in relation to the size of their home market and which can no longer compete effectively with the largest, long-haul carriers serving many more destinations and at higher frequencies from well-organised hubs. Because their home market is weak they are very dependent on high-frequency short-haul services to feed their long-haul flights. But to attract such traffic and compete against the larger network airlines, they need to offer heavily discounted fares. As a result, many of their long-haul routes are unprofitable as are many short-haul routes that are operated simply as feeders.
Before Sabena’s collapse in 2001, low-yield connecting passengers represented over 65% of its traffic on many of its European services, including Paris-Brussels, one of its densest European routes. The old Swissair faced similar problems.
Swiss, Alitalia, SAS and other smaller or medium-sized traditional network carriers in Europe, the USA and elsewhere face a fundamental dilemma. They are too large to be considered niche players, but too small to be competitive global players. At the same time their unit operating costs are too high to enable them to compete against low-cost carriers.
They should adopt the opposite strategy to that recommended for the larger network carriers. They need to down-size and reduce their long-haul operations, except where they have a real competitive advantage, and focus on becoming regional niche carriers. That is, regional operators specialising on a particular country or region. Some may operate a limited number of long-haul routes from their hub to satisfy a particular demand arising from an ethnic, historical or commercial link. For instance, Air Portugal might continue to serve niche markets in Brazil while the strong ethnic links between Ireland and parts of the USA would enable Aer Lingus to maintain transatlantic services.
To survive with this reduced network strategy, these airlines must achieve two aims. They must firstly cut their costs drastically so as to reduce the cost advantage of the low-cost carriers. Aer Lingus has shown what is possible. In three years between 2001 and 2004 it cut its unit costs by 35%. The second objective must be to ensure that, because they cannot match low-cost carriers on cost, they are able to offer passengers particular services that enable them to charge slightly higher fares and maintain passenger loyalty. This might be achieved through effective branding, higher frequencies, and operating from better or more convenient airports. The twin-track approach entails drastic cost reduction combined with establishing a defensible market niche.
For smaller or medium carriers, launching a low-cost subsidiary or converting themselves into one may appear a particularly attractive strategy as their markets are primarily short haul. But the reservations outlined earlier apply here too. The optimum strategy for airlines might well be to adopt as many low-cost features as possible to further reduce costs and improve marketing so as to compete more effectively with low-cost carriers. This may include targeting 90-100% online selling, no in-flight catering or business-class cabins for short sectors, single-type fleet and faster turnarounds. This is the strategy adopted, so far successfully, by Aer Lingus.
While becoming regional niche carriers, medium-sized network carriers have two further strategic options to consider. The first is whether they should become alliance partners or franchisees of the larger network carriers, feeding the latter’s long-haul services. This would be an attractive option, as they would benefit in traffic terms by being marketed and sold worldwide by the larger carrier, while maintaining their managerial and financial independence.
The second option would be to become a subsidiary of a large network dominator or even merge with it. Independent decision-making would be lost. On the other hand, the financial base of the airline taken over might be strengthened by having a larger and potentially stronger parent. For the board of Swiss, this was the attraction of the 2005 bid from Lufthansa.
The strategies discussed relate primarily to US and European airlines, where the twin impact of liberalisation and of low-cost carriers has been most acutely felt. But as these trends spread to markets in Asia and elsewhere, their airlines too will face similar strategic options in order to survive.
Those airline executives hoping that a sharp drop in the oil price will act as a universal panacea and solve their airline’s longer-term structural problems are deluded. Whatever happens to oil, network carriers must rethink their business models if they are to survive the harsh realities of today’s market.