Whatever else can be said about Europe's low-cost airline sector, it has rarely been dull. Over the past few months alone there has been a whirl of activity, including the easyJet flotation and the pending sale of Go. Amidst this activity, however, there remain some fundamental questions still to be answered. Are low-cost carriers really here to stay, rather than a passing phase? If so, which of the current players are likely to survive into the long term?
The latest signals coming out of the market have not always been easy to read. In November, British Airways put Go its low-cost subsidiary up for sale, having racked up losses of £47 million ($67 million) in its first two years. A few days earlier, Virgin Express in Brussels, faced with mounting costs, cancelled an order for 11 new Boeing 737 aircraft. But, at the same time, Ryanair was announcing that its second-quarter profits had jumped 54%, while the public flotation of easyJet was 10 times over-subscribed. And just as BA was abandoning Go, KLM which had already created Buzz at London Stansted, announced the launch of another low-cost subsidiary, Basiq Air to be based in Amsterdam.
Exponential growth
What remains beyond doubt is that, with their low, one-way fares and relatively high daily frequencies, these young low-cost airlines have helped to stimulate very rapid traffic growth. And they have captured a good deal of that growth for themselves. The growth phenomenon has held true even in markets where growth had slowed to a trickle and despite the fact that most of the low-cost contenders are using small, secondary airports at one or both ends of the route. A good example is the Brussels-Dublin market. In May 1997 Ryanair launched a service from Dublin to the then almost unknown airport at Charleroi, styling itself as Brussels South. Three years later Ryanair had a thrice- daily service, and total Dublin-Brussels traffic had doubled. Before Ryanair entered the market, passenger numbers between the cities stood at 170,000 per year. By 1999 it had grown to 355,000. Notably, most of this growth was captured by Ryanair.
Not only has this growth pattern been repeated elsewhere, but importantly the additional volume is not simply leisure traffic. The low-cost carriers have succeeded in attracting business travellers too. On some UK domestic services, as much as 40% of passengers are travelling on business. On international routes the proportion is less, averaging around 20%. According to Brussels Charleroi airport, 27% of passengers on Ryanair's Dublin service are travelling on business.
However, to place this all in perspective, it is worth remembering that, despite their dramatic growth rates, the European scheduled low-cost carriers are still tiny compared with their US cousins. Even by the end of last year, their combined fleet was less than half of the 290 Boeing 737s that Southwest Airlines operates. And whereas almost 15% of US domestic passengers now fly with a low-cost carrier, less then 3% of scheduled international and domestic passengers within the European Union do the same. Even in the UK, which has nurtured the low-cost sector, their share of domestic and short-haul markets is still below the US figures at 10%.
To survive in the longer term, while offering fares that are 50-75% below the normal scheduled fares, low- cost carriers obviously must maintain a sustainable cost advantage. The key question then is just how great a cost advantage these carriers truly enjoy.
It is difficult to compare the cost of low-cost carriers with those of most conventional scheduled carriers or even charter airlines because there are so many differences between them. However, British Midland does appear comparable to easyJet in several respects.
Like easyJet, British Midland flies aircraft with, on average, fewer than 150 seats. They both operate domestic and short-haul international services out of the UK. But British Midland's average sector distances in 1998 were somewhat shorter than those of easyJet - 529km (330 miles) as opposed to 764km. This would have pushed up unit costs for British Midland. On the other hand, the mainline carrier had several factors in its favour and is much larger than easyJet. In 1998 in terms of available seat kilometres (ASKs), British Midland was three times the size of easyJet, and in 1999 it was still two-and-a-half times as large. British Midland should also benefit from some economies of scale partially to offset its shorter sectors. Costs also should be depressed because almost 25% of its output has been on charter flights.
Despite all of those factors, British Midland's seat costs came in at 9.86 pence per ASK(ó22.7 per mile)for the 1998 financial year - the latest for which data is available from the UK Civil Aviation Authority. That was more than twice as high as easyJet's at 4.17p. Interestingly, Go's unit costs in its first year 1998-99 were around 4.00p per ASK, a little below the easyJet figure. How then do the low cost carriers do it?
Cost advantage
The start-ups begin with two initial cost advantages arising from the very nature of their operation, namely higher seating density and higher daily aircraft utilisation. By doing away with business class, by reducing or removing galleys, and by cutting the seat pitch, low- cost carriers can significantly increase the number of seats available on their aircraft. On its Boeing 737-300s, easyJet packs in 148 seats. British Midland has 132 seats for the same type, but its six-abreast seating is converted to five abreast to cater for business class. With an average configuration of say eight business class rows, British Midland's seat capacity on its Boeing 737-300 aircraft drops from 132 to 124, compared to easyJet's 148. If all their operating costs were similar, the fact that easyJet has 24 more seats in the aircraft would result in its seat costs being 16% lower than British Midland's when operating identical aircraft.
Low-cost carriers are also able to schedule for and achieve much faster turnround of their aircraft. The factors are straightforward: use of uncongested secondary airports (wherever possible); reduced cleaning time required due to the lack of catering; more rapid embarkation as a result of free seating; and the absence of freight to load or off-load. This - plus the longer stage lengths - in turn helps them to push up the daily utilisation achieved by their aircraft. Thus in 1999 while easyJet flew its 737-300s on average for 10.2 block hours per day, British Midland managed only 8.5h for the same aircraft and British Airways even less at 7.5h.
A direct cost comparison between British Midland and easyJet demonstrates where the gaps lie in that particular case (see Table 1 above). Also, it is possible to calculate more general figures about the cost advantages that a low-cost carrier should have over a conventional airline (see Table 2 right). It is clear from that cascade analysis that the low-cost airlines should be able to operate at seat costs which are only 40-45% of those of a mainline rival.
The analysis assumes that the conventional airlines operate on the same or parallel routes, and that they achieved broadly similar passenger load factors. While in 1998 British Midland and easyJet did achieve very similar loads, in 1999 easyJet's seat factor was 77% compared to 62% on British Midland's scheduled services. If the load factor differential is as high as 15% then the low-cost carriers cost per passenger drops to around 33% of the conventional airline's passenger cost.
Revenue Advantages
To break even at their very low fares, low-cost carriers need to achieve high-load factors and high yields year round. This means that they too must practice effective yield management. They can do this more easily and simply than the conventional carriers because, with rare exceptions, such as Virgin Express, they only sell point-to-point single sector tickets. To simplify the task further there is only one ticket price available at any one time for each flight.
The marketing strategy is to start selling the cheapest advertised fares when bookings for flights open and then to progressively move to higher fares as departure dates approach or as sales at the lower fares pass certain pre-planned levels. It is a simple process that can be easily automated. Yields end up well above the lowest advertised fares.
The major revenue advantage enjoyed by low-cost airlines is that, where they sell direct to the public without using agents, passengers must pay by credit card at the time of the booking. They cannot make a reservation without paying. This means that airlines, such as Go or easyJet who only sell direct, generate all their cash revenue in advance of the flight. This contrasts with their conventional competitors who sell through various agencies worldwide and may not receive all the payments for individual flights until several months after the departure date.
The revenue advantages are compounded by the fact that bookings, once made and paid for, cannot be changed, except in some cases on payment of a surcharge, and tickets normally cannot be refunded. This means that there are very few "no shows" on departure.
Challenges ahead
It is still no easy ride. European low-cost carriers face a number of difficulties. The first real problem is that competition is intensifying both between themselves and from the conventional airlines fighting back to retain their market shares on key routes. Following the launch of Buzz a year ago, there are now three low-cost carriers based at Stansted serving the London market and another not far away at Luton airport. KLM is launching Basiq Air in direct response to easyJet's decision to open a base at Amsterdam.
Today, there are ten or so routes out of London, such as Frankfurt, Milan, Venice, Madrid, Barcelona and Malaga, plus some UK domestic routes, where two low- cost operators plus two or more conventional carriers are operating. Price and frequency competition is bound to become increasingly intense. One will see frequent seat sale periods when fares drop to ridiculously low and uneconomic levels. Competitive pressures will worsen if more European conventional airlines follow BA and KLM and launch into the sector. It is also inevitable that, as existing low-cost operators add new routes, they will increasingly compete against each other.
A second problem is the very real risk of over-capacity arising if growth rates overheat. Ryanair has been geared to grow at about 20-25% each year and plans to expand at this rate for the next five years. It expects to add another 36 aircraft to its 737 fleet over the next four years while easyJet has 30 aircraft on order.
Go, easyJet and Buzz are all planning to grow very rapidly at annual rates of 20% or more. They will be joined by Basiq Air and other newcomers. Yet the early success of Southwest in the USA - contrasting with the failure of other low-cost entrants - was due in part to its strategy of steady but low growth. In the early years it targeted annual growth of no more than 10% and it is only more recently that growth of 15% has become more frequent. It took Southwest a dozen years to reach a fleet size of 50 aircraft. It may well be that the European low-cost carriers by growing too rapidly are endangering their own survival. Overly rapid growth creates strong pressure to reduce fares to fill up excess capacity. It may also involve launching many new routes that are marginal or may face intense competition from other low-cost airlines.
Controlling costs is the third problem area. Low-cost airlines are no longer in the start-up phase when they were able to negotiate the best deals with airports and service providers. In the next two years, many key contracts will need to be renegotiated. Will the low-cost carriers get as good deals the second time around as they did when they were genuinely new entrants? EasyJet's recent acrimonious dispute with Luton Airport, which wanted to increase its airport charges by more than fourfold, highlights the potential difficulties that all low-cost airlines will increasingly face. Ryanair has already had the same problem at Manchester.
As low-cost carriers become more established there may also be greater pressure from unions and employees to push up salaries and consequently wage costs. The threat of a pilots' strike at Ryanair in late November is evidence of a changing climate in industrial relations. There is also a risk that as overall size increases - Ryanair already carries more passengers than Aer Lingus - head office staff numbers and costs will escalate.
The final challenge is whether they can compete effectively in the region's largest low-fare short-haul markets - those currently served by Europe's charter airlines. The new entrants have launched services on several routes where the charter airlines are dominant. From London these include routes to Palma and Malaga in Spain, Faro in Portugal and Rimini, Alghero, Ancona in Italy. The rapid expansion planned by low-cost operators means that further incursions into markets dominated by the charter airlines are likely.
A backlash from the charter carriers is inevitable. The charter airlines can, after all, operate at even lower seat costs than the scheduled low-cost upstarts, thanks to their use of larger aircraft and higher utilisation rates through night flying. Their selling costs are also minimal. Moreover, their passenger load factors are 85-95% as opposed to 70-80%. Admittedly they do provide a few frills on board such as meals.
Charter airlines will hit back by marketing seat-only sales on their flights more aggressively. This is already happening in Germany. They have realised that such business can make a major contribution to their economics. Many of their flights are now shown as "scheduled" to increase customer awareness and the charters too are beginning to sell through the Internet. They can offer more leisure destinations and often cheaper one-way or return fares than the low-cost carriers.
How to ensure survival ?
So how should the low-cost airlines set about ensuring their survival? First they must maintain a sustainable competitive advantage over their conventional competitors. This means keeping it simple. They must focus on the essentials of the low-cost product in order to maintain a 55-60% cost advantage while offering a product which, despite the absence of frills, is very highly rated by passengers in terms of value for money.
They must also stick to short-haul routes using a single aircraft type offering high density seating and operating, where possible, from secondary airports. Frequencies should be relatively high and punctuality and regularity among the best. Sales should be 100% direct by telephone or, ideally, via the Internet -and ticketless. On-board catering should be minimal and of good quality but not free.
Fares must be simple, one-way and point-to-point. Transfer traffic or hub feeding should be avoided. Many functions should be out-sourced to minimise their cost. Airlines that lose a clear focus and diverge from these essential features of the low-cost product are likely to lose their way as Debonair did two years ago and as Virgin Express seems to be now doing. The suggestion that Iberia might buy Go and use it to feed its Madrid hub is a recipe for disaster.
The second requirement for long-term survival is to ensure that on most routes they become the number one or number two carrier in terms of market share. On major routes, such as London-Amsterdam, being second or third may be enough. This dominance, combined with their low fares, gives them a very powerful defensive position should new competitors attempt to enter, while also ensuring a strong cash flow base on which to mount further expansion. Southwest's survival and success is due in no small measure to its growth strategy, which has focused on becoming dominant in most of its markets. By the mid-1990s it was the largest carrier in 93 of its top 100 markets.
This is also an explicit objective of Ryanair's growth. Ryanair is the dominant carrier on London-Turin and London-Genoa. It replaced Aer Lingus as the largest carrier on many of the UK-to-Ireland routes some years ago. Because they are younger, neither easyJet, Go, Buzz nor Virgin Express have yet achieved similar dominance in their markets, though easyJet is the second carrier on London-Nice. Growing to become the largest or second-largest carrier on most of the routes they serve must be a prime objective if low-cost carriers are to survive as major players.
There is still all to play for among Europe's new breed of low-cost players. Competition does not look set to ease, especially in the UK market on which most are heavily reliant. Given that competition between low-cost carriers must rise as their networks overlap, it seems unlikely that all will survive into old age.
Source: Airline Business
