There are the first hints of a slowdown in Europe's short-haul market, writes Chris Tarry of CTAIRA. Analyses by Antonio Panariello of Flight Insight

Warnings have been sounded by easyJet and Ryanair, among others, and have resulted in sharp falls in their share prices. Shares in easyJet have fallen 18% and in Ryanair by about 11% from their recent peaks. But while easyJet says it is still confident of its full-year outcome, there are a number of indications to suggest that the change in the market environment may be deeper seated.

This column has argued many times that the rules of economics do apply to the airline industry and, in particular, the interaction between demand, supply and price. With some observers estimating that short-haul capacity in Europe could increase in 2007 by some 10-11%, the grounds for concern appear real. Given there is little or nothing that can be done on the cost or capacity side of the equation, airlines are responding to the softening market by seeking to grow volumes into their increased capacity. This gives a clear insight into the new economics of the short-haul business, and particularly the importance of passenger volume and ancillary revenue in both absolute and relative terms.

With the internet presenting consumers with near perfect information in terms of available prices, there is always a need to convince an intending traveller that he/she is getting a bargain. The reality appears to be that at the lower fare levels there is no real brand loyalty, and that travellers will follow the lowest price.

Bearing this in mind, the extent of the "sale" activity appears to be greater than normal as airlines seek to stimulate load factors. EasyJet's approach is clear: "We have reduced much of our lead-in fares and increased our promotional activity to sustain high load factors in weaker market conditions."

Given that the capacity for the summer season and beyond is largely fixed and it is better to have a fare-paying passenger in a seat rather than to fly with it empty, such a response is inevitable. To this end, Ryanair currently has an offer of 10 million seats from £10 ($20), including taxes and charges, and a "lowest-fare guarantee". Flybe has 5 million seats from £19.99, and easyJet has "millions of fares slashed".

In theory, a greater share of lower priced traffic will increase the breakeven load factor unless there is a corresponding reduction in cost - which in the short-term is generally impossible to achieve.

There is a need to look at the bigger picture and the increasing importance of ancillary revenue. The contribution in terms of profit and cash of ancillary revenues is clearly growing and, for a number of airlines, is already significant, although the full extent is difficult to determine given the differences in presentation adopted by individual airlines. Some show it as a contribution after any cost, while others have different methods. Bearing this in mind, the latest Ryanair results for the quarter ended December 2006 reported ancillary revenues per booked passenger of €9.23 ($12.50), up from €6.85.

EasyJet reported €6.90 per passenger for the first half of its financial year to the end of March 2007, up from €5.80 for the corresponding period a year earlier. Setting this against the average fare for the periods, in the case of Ryanair ancillary revenue as a percentage of the average fare increased from 19% to almost 24%, and for easyJet from 15% to almost 18%.

Put another way, the increase in ancillary revenue for Ryanair between the third quarter of fiscal 2006 and the corresponding period in 2007 was equivalent to a fare increase of 6.6% on the average fare. For easyJet, the increase was equivalent to an almost 3% rise in the average fare for the first six months of fiscal 2006.

In the near-term, it appears there is further scope to increase ancillary revenue. However, there are limits to this source of revenue, even in the medium-term, which will reflect both an exhaustion of opportunity as well as a limit to passenger spending - even in respect of buy-on-board opportunities on short flights where a cup of coffee isn't even a "want", never mind a need.

At this point, ancillary revenue will follow passenger volume growth. However, for now the focus is on stimulating volume, not just for traffic revenue but for the total amount of money the passenger will spend on getting from A to B. Whether this is enough to prevent forecasts from being cut remains to be seen, but it offers a new route to mitigate at least the first signs of market weakness in the short-haul European segment.

Source: Airline Business