Low-cost is perhaps the most over-used term in our industry and there's hardly an alternative if you want to survive. Today the onboard short-haul product is pretty much universal and, as key markets mature, competition is only likely to intensify
Perhaps the most fundamental change of the last decade was the emergence of a new airline model, variously referred to as low-cost, low-fare, low-frills or no-frills airlines. Most - but not all - embarking on this revolutionary phase started with a blank sheet of paper, fashioning their businesses to address the market opportunity that they saw, or thought, existed.
Between 1999 and 2008 the industry's cumulative operating profit was a mere $44 billion, translating into a margin of just 1.1%. But, over this 10-year period, three low-cost carriers - namely easyJet, Southwest Airlines and Ryanair - delivered $11.5 billion in operating profit and averaged a 10% margin. Ryanair led the field at 18.8%, followed by Southwest with 8.7% and easyJet at 6.0%.
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In Europe, Ryanair and easyJet carried 5.5 times more passengers in 2008 than they did in 2000, adding 90 million passengers to their total. Over the same period passenger numbers among members of the Association of European Airlines rose by just 32 million, representing 13% growth.
Although some low-cost carriers have survived and prospered, this has not been the case for many, and those that have battled the odds have had to evolve to some extent from their initial model. While key elements, such as the need for intense cost management, have remained unchanged, revenue must come under greater scrutiny going forward, especially as markets reach maturity.
Here at consultancy firm CTAIRA, we believe we are on the brink of another pivotal moment for the industry, which threatens to affect a number of the so-called "low-cost carriers". GDP is, and will remain, the key determinant for air travel growth. But markets are not infinite and, beyond the near-term effects of recovery, market growth in a number of regions - particularly Europe and the US - will be limited.
For individual airlines, this means that substitution effects will inevitably form a greater component of their growth. And, in this environment, not all airlines will be able to grow. For some, this will offer opportunities, but for others it will be a major challenge.
In reality, life is dynamic: like a pendulum swinging, it is a series of actions and reactions. Markets do not adjust to a new point of equilibrium instantly. And the pendulum swings towards and away from both legacy and low-cost airlines, depending on their actions.
In an environment of change, the past is unlikely to be a good guide for the future. So, while low-cost airlines may have emerged from the last decade as winners, there is no guarantee that this will be the case going forward. But this statement comes with one proviso: any business with an absolutely low cost base, supplying a product that is demanded by the market, will always be a winner.
The term "low-cost carrier" focuses on the supply side, but changes in demand have a major influence on airline financial performance. In terms of demand, it is true that low-cost airlines have developed new short-stay and VFR markets, but they have also given travellers new direct or near-direct substitutes for existing products, often at much lower fares. This reduced price serves to negate any perceived disadvantages.
The low-cost model has led to fundamental changes in the perception of short-haul air travel, driving a major fall in both fares and product expectations. And, somewhat ironically, this shift has been further-fuelled by legacy carriers' response to low-cost carriers. This means short-haul air travel is now generally regarded as a commodity product, where the product offered is a direct substitute.
SUBSTITUTION
Substitution effects are basically the result of market competition, where a company offers a sufficiently close, or even direct, alternative at a lower price. We expect to see more "head-to-head" competition between low-cost carriers, driven by market and airport access, as well as a drive among low-cost players looking to increase their business travellers market share, by securing more appropriately timed slots and increased penetration of the corporate market.
In 2008 Flightglobal Insight published a report which identified short-haul air travel as a commodity product, and we largely agree with this finding, which is important for low-cost carriers seeking to increase their average fare revenues.
Undoubtedly, once onboard, the short-haul economy flight experience is sufficiently similar to be considered as a common product. However, each flight has a different value to the travel buyer. Put simply, a peak-time flight is a different commodity to one which is off-peak. While they have common characteristics, they satisfy different requirements. This presents an opportunity for lower-cost, lower-fare airlines to shift up the price curve by providing a closer substitute to the service which attracts passengers willing to pay more.
Regardless of whether low-cost airlines were reacting to - or producing - the change in traveller behaviour, consumer habits have now changed. The low-cost or no frills label is irrelevant, so long as the airline satisfies demand for travel at a cost which the passenger perceives as good value. If this is matched with a supporting cost base, leading to profits, it will be a survivor.
The "purity" range of low-cost airlines is vast, but the reality is that the onboard product on both legacy and low-cost airlines is not significantly different. Meanwhile, the most important choice factors for business travellers are airport served, timing and frequency.
TRAFFIC RIVALRY
In addition to having an "appropriate" cost base, taking traffic from competitors is likely to be key to future revenue growth. This means airline competition is likely to become more intense, in terms of airports served, frequency and timing.
We believe that the overall rate of growth in the European short-haul market will be low, but there will be a series of substitution or redistribution effects between individual airlines. This is likely to be an increasingly important source of growth, particularly for low-cost carriers, or whatever label they choose to go under.
The label "low-cost airline" is one of the most over-worked terms in the airline industry. What passengers are seeking is the lowest fare possible for their needs; whether they fly with a so-called "low-cost" carrier or not matters very little to them. But, from a business perspective, a low cost base is a crucial factor underpinning an airline's ability to compete.
The 2008 Flightglobal Insight report says that low-cost carriers "manage their costs and then set prices accordingly", while legacy carriers "set prices and then attempt to manage cost". But the issue now is that all airlines are now price-takers, unless they operate in regulated markets or on monopoly routes.
Against this background, and using the basis of the Flightglobal Insight definition, while low-cost carriers may be able to make some efficiency improvements, their scope and opportunity for structural and significant cost change is almost by definition negligible.
This means the route to reducing breakeven load factors, other than from falling fuel prices, is through higher average fare revenues. This is important as the scope to structurally expand ancillary revenues is diminishing or negligible, and there is some evidence of diminishing returns beginning to set in as a result of the behavioural changes following the introduction of baggage charges.
Management and owners want to maximise profit and company value, while customers rank the factors that are important to them and assign a value to each, which reflects the price that they are prepared to pay. All airlines provide a common product - a flight between two points - and the recent trend towards unbundling means that passengers have the opportunity to price-up the various elements of air travel and choose what they want to buy.
There is a need, or at least a desire, for all low-cost carriers to raise their average fare. But to succeed at individual market level, airlines need to offer a similar product, at a lower fare and the lowest possible cost base. This is pretty simple in theory and may underlie a recent Ryanair press release, which stated: "In order to match easyJet, we would have to double our average fares, something we have no intention of doing, because this winter we will lower our fares even further to ensure a tougher winter for high-fare airlines like easyJet, British Airways and others."
The comments could also be seen as a statement of intent, because markets established by easyJet offer substitution opportunities for Ryanair - a suggestion which seems to be backed up by some recent base and related announcements from Ryanair, as well as some press speculation regarding Barcelona.
At the end of the day, however, customers are not interested in the mathematics of average fares. They are interested in the fare. But it matters to the industry. In its financial year to 31 March 2009, Ryanair's average booked fare was €40.02, capped off with €10.21 in ancillary revenues. For the year to 30 September 2009, easyJet reported an average fare of £47.57 and revenue per passenger of £59.00.
Despite fuel being a particular issue in 2008, Ryanair's experience shows the huge significance of ancillary revenue. Using ticket revenue alone, it needed to sell 98% of seats available to breakeven. It actually sold 81%. And during the year average fares fell by almost €3.70, while ancillary revenue per passenger increased by just over €0.60.
YIELDS UNDER PRESSURE
When Ryanair's interim results were released, the Irish carrier said it saw "no point in continuing to grow rapidly in a declining yield environment". This gives a clear perspective on the revenue outlook, which we agree with. At the same time, cost constraints are putting airlines under additional pressure and Ryanair adds that Boeing "is unwilling to play its part in our cost reduction programme by passing on some of the enormous savings which Boeing have enjoyed both from suppliers and more efficient manufacturing".
Regardless of which model an airline pursues, business travellers are particularly important - no doubt that is why you have to signify your journey purpose when booking on easyJet, so that they can track your behaviour and travel needs.
CAA survey data shows that passengers are using low-cost airports for business trips. In 2008 some 16.7% of passengers at London Gatwick were business travellers, while over at Luton the total was 18.8% . The figure was even higher at Stansted, hitting 19%, but of these Gatwick is seen as the higher-yield market, with the potential to attract traffic which currently uses Heathrow.
As soon as the downturn took hold, there was much talk about the potential for business travellers to switch from legacy or fuller service airlines. But the reality of this prophecy depends on how close the offers are in terms of airport served, timing and frequency. Meanwhile, the onboard product is an area where there is increasingly little difference.
As the downturn progressed, low-cost airline management teams hoped to benefit from an increase in business travellers moving away from legacy carriers. In fact, this trend has been evident in the UK for some time and was highlighted in a review of business travel trends, published by the CAA in May 2009.
This report showed that the proportion of business travellers flying short-haul routes in the business class cabin fell from 40% in 1996 to just 10% by 2007. Heathrow also lost out during this time of change. Between 1996 and 2007 the number of passengers flying for business purposes on short-haul, non-domestic, routes grew by some 6.7 million or 44%. But almost all of this growth - 6.3 million passengers - did not involve Heathrow. In Europe, and the UK in particular, the short-haul market has entered maturity, bringing new challenges and opportunities.
BUSINESS BUDGET
Business travellers are now also cost-conscious, although they remain less price-sensitive than leisure travellers, and corporate demand is for the "peak time commodity" which by definition has a higher price. Indeed, easyJet management has stated that its business passengers tend to pay some 20% more than its average fare of £47.57.
For business travellers, the larger the number of competing alternatives, the better. And for low-cost carriers, which have already made significant in-roads into the business travel market, this represents a future opportunity to benefit from further substitution effects. But their success will depend on gaining peak time airport access and "getting closer" to the corporate sector.
For those that decide to take this route, this is likely to give rise to a further business model evolution - but it will also lead to some tough decisions as airline models move further away from their "pure low-cost" origins. This strategy may well have worked successfully in the past, but we may well be at a stage where the alternative to change or evolution is not that attractive.
We expect this decade to be a time of continuing change for the short-haul airline industry in Europe. For some of the current participants, there are clearly some big decisions ahead. The market is close to maturity and the nature of the growth will mean there will be fewer winners at the end of the current decade - and perhaps even fewer survivors.
The industry will undoubtedly take on a different shape and composition, compared to today. We watch these developments with considerable interest and I am sure we will not be alone.
About the author: Aviation analyst Chris Tarry is head of independent consultancy CTAIRA and lectures at the UK's London School of Economics
Source: Airline Business
