As the new year begins, Delta Air Lines and KLM have become the latest majors to overhaul their fare and pricing structures in response to the rising popularity of the internet and competition from low-fare carriers
It has never been easy to be simple, but more and more majors are trying to be. The move to simplify fares and pricing on shorter-haul services started in Europe post 9/11. Now, Delta's initiative to simplify the basic architecture of US airfares has brought the global trend to the top of the North American industry agenda, threatening to topple weaker carriers, but possibly altering the balance of power between legacy and low-cost carriers.
But for those contemplating change there are some fundamental questions: can carriers stimulate enough additional revenue and traffic to offset short-term revenue decline? Moreover, is the surrender of established advantages outweighed by the prospect of new business and a competitive leg-up?
Delta's move, which caps domestic one-way fares in 17,000 markets at about $500 while narrowing the variety of fare categories, comes as US airfares are already at record lows. By the end of 2004, average leisure fares were 10% lower than the year before, according to a Harrell Associates study of 100 major domestic routes. Business fares were down 8%, says Harrell, a Washington-based airline consultancy. And the move coincides with cost-cutting efforts by Delta and the rest of the industry giants, which need every penny of revenue.
Noting the likely effect on revenues, Standard & Poor's analyst Phil Baggaley says: "Fare simplification may have been inevitable, but you have to ask why Delta decided to hasten the inevitable and do it now." Delta, however, believes that it will stimulate enough new traffic to make any revenue shortfall a short-term problem rather than a permanent feature. Delta senior vice-president Paul Matsen says a test of these "SimpliFares" at its Cincinnati hub began last August and has increased traffic there by 30% and boosted revenues, although he declines to say by how much.
UBS analyst Robert Ashcroft thinks that flyers will "trade up" to higher fares because the next-highest fare is affordable rather than astronomical. "A high-end leisure traveller who would not pay an extra $900, for example, may well be willing to pay an extra $300 to get a next-day fare," he says. Others are sceptical and estimate enormous impacts, as much as $2.5 billion from cumulative industry revenues of about $70 billion (see table). Northwest Airlines, a member like Delta of SkyTeam, publicly denounced the move as harmful to a struggling industry.
Industry event
Led by American Airlines, however, other majors adopted much of the Delta approach. Even though responses were crafted to overlay Delta's route structure, the simple fact is that Delta is so large that its move is "an industry event, not a Delta event", says Lehman Brothers analyst Gary Chase. Delta overlaps more than half the routes each of American, Continental, JetBlue Airways and United Airlines, he notes. Chase says the move will prove to be "the most interesting non-fuel industry event of 2005".
The move dwarfs fare simplification efforts elsewhere, such as a continuing experiment by American at its Miami hub, or a recent simplification by Alaska Airlines, which in turn reflected a 2002 fare restructuring by America West.
The measured pace of the response distinguishes this development from the last comparable move, the 1992 "value pricing" initiative of American Airlines. That radical strategy, which American's then-chief executive Bob Crandall saw as a permanent industry restructuring, was undercut by Northwest, which transformed it into a half-price sale that helped spur a 30% drop in airline share values. Northwest has long been a "spoiler" in industry fare moves, refusing to go along with increases, and, after US Airways, is probably the most vulnerable to Delta's new initiative, notes JP Morgan analyst Jamie Baker.
Low-cost carriers put a bold face on the news, saying with no little irony they would have to raise fares to match Delta's new ones. But Southwest Airlines chief executive Gary Kelly notes that the "fare gap is narrowing, which is something that we have anticipated for years".
The move has marketing as well as financial motivations. In the past, passengers, especially business travellers, have been suspicious of the legacy carriers and their "price gouging", a perception that Delta chief executive Gerry Grinstein acknowledges. For these flyers, the dollar cuts are important, but so are Delta's changes to rules and conditions. The carrier has eliminated the long-hated Saturday night stay restrictions on most fares and trimmed its fees for changing a ticket, which had been a target of resentment. Ashcroft says: "The best customers are repeat customers and customer loyalty depends on treating customers well, which depends on customers feeling they get value from every transaction".
Delta's move has met with an enthusiastic public reception, with a 60% increase in visits to delta.com and the website's first $10 million sales day. That exactly matches the carrier's hopes.
On the other side of the Atlantic, KLM is the latest of a handful of European majors that have simplified their fare structures, and like fellow SkyTeam Alliance member Delta, KLM has linked the fares to its internet strategy. Aer Lingus, Air France, British Airways, Lufthansa and SAS have been at the vanguard of this movement.
On 1 January, KLM became the latest to revamp its fare structure. "The market is changing and it's not temporary," says Erik Varwijk, managing director KLM Netherlands. With the internet becoming a "mature medium" and with increasing competition from low-cost carriers, now is the time to act, he says.
Initially, KLM's new structure will only apply to the Dutch market for European flights, but it will be rolled out to others when the timing is right, says Varwijk. The carrier is now selling only four basic fare categories with clear travel terms and a transparent fare structure. Ticket prices will fall on all of KLM's 66 routes from Amsterdam with reductions of up to 40%.
Some restrictions have gone, although KLM's cheapest fare categories still feature minimum stays, which carriers like Aer Lingus have eliminated. Matthew Davis, director global consulting at American Express Corporate Services, broadly welcomes these fare initiatives, but would like to see more restrictions lifted, especially the minimum stay requirements. If they stay, smart business travellers will continue the practice of arbitrage, where two cheap return tickets are bought for a journey with one left unused, he says.
Price over comfort
Changes in how business travellers buy tickets have been important in KLM's thinking, says Varwijk, with price overtaking comfort as the main consideration on short-haul routes. KLM has been seeing the gap widen between published business class fares, or Select Class as KLM brands it, and discounted fares negotiated by its corporate customers, he says. "This gap has become too wide," he says, with small and medium corporate customers losing out. The new fares are particularly targeted at winning more business from this sector.
KLM's plan takes place alongside a further overhaul of its travel agents commission structure. This is now basically an incentivised scheme with agents obtaining a payment from the carrier depending on their volume of business with KLM, whether they conduct internet bookings and sell e-tickets and if they help promote KLM. For others the standard commission is zero.
This change, accompanied by greater internet sales and the use of e-tickets, will save KLM money. Accordingly, despite the fare reductions, the carrier expects the move will be revenue and margin positive, says Varwijk. "At the same time we hope it will improve our marketshare out of Amsterdam," he adds.
BA and Lufthansa began simplifying their fare structures in 2002 in response to strong low-cost carrier competition. BA started with a permanent European fare reduction that year and followed it in 2003 with a complete overhaul of its complex fare structure, which featured 2 million fares, into three basic types of ticket. It swept away 75% of fares.
Lufthansa standardised its fare concept for domestic and UK services in late 2002, simplifying fare classes and removing restrictions, says Christian Tillmans, vice-president revenue management. The carrier has redefined the way it steers ticket sales through revenue management, he says. For instance, the cheapest fares are not usually available seven days before departure. The strategy has paid off, with average European yields falling a little, but overall volumes rising, says Tillmans.
But neither BA nor Lufthansa are keen on going to even greater consumer booking flexibility by offering cheap one-way fares as low-cost carriers do and Aer Lingus has followed. Lufthansa tested the concept on some routes last summer, and may do it again, but "generally we are not really in favour of making complete one-way structures," says Tillmans.
The practice of fares restructuring is almost exclusively US and European, with Asian markets at a different stage in their evolution and low-fare competition in its infancy. Only in Australasia has it taken hold, with Air New Zealand launching its Express Class fares initiative for domestic flights in late 2002 and since adding trans-Tasman and Pacific services.
| Revenue fall if Delta fares are followed | |
| Carrier | Shortfall ($m) |
| American Airlines | 600 |
| Delta Air Lines | 600 |
| United Airlines | 500 |
| Northwest Airlines | 400 |
| Continental Airlines | 250 |
| US Airways | 200 |
| US legacy majors | 2,550 |
NOTE: Estimated revenue shortfalls in 2005 if the industry follows Delta. Source: Merrill Lynch.
DAVID FIELD WASHINGTON/ MARK PILLING LONDON
Source: Airline Business
