What do restaurants and airlines have in common? Unless the diner has chosen poorly or the passenger is in first class, it is unlikely to be the food. Which leaves the common misconception that it is easy to set up and run a restaurant or an airline.
Over the last two years, it has been easy to feel sorry for the little guys who have bravely attempted to set up the US airline equivalent of the family diner. Their struggle for survival, juxtaposed against the record revenues, profits and load factors recorded by the major carriers, has turned the US airline picture of the late 1990s into a David and Goliath story, but one in which the giant gobbles all the food.
Yet a growing number of analysts, consultants and bankers are speaking out against the popular notion - and one which gained considerable momentum in Washington DC last year - that predatory behaviour by the majors is the chief slayer of new competition. It is more likely, they say, that David lacks a sound business plan. As one industry expert has put it: "New entrant airlines don't need help failing - they do a pretty good job on their own."
The financial success of the US major carriers in the late 1990s has brought unique problems. The same carriers that only a few years earlier had themselves looked like an endangered species have been forced over the last 12 months into the ironic position of having to defend their success at Congressional and Department of Justice hearings.
Almost unlike any other industry - and perhaps a hangover from the pre-deregulation days - it is as if the government and politicians still believe they should interfere with an airline when it is unsuccessful or, heaven forbid, too successful.
The latter has not been much of a problem for the start-ups in the late 1990s. But, while the Department of Transportation is counting on its new anti-predatory behaviour guidelines to even the balance, some industry experts are offering their own advice to start-ups to avoid the misery of an encounter with the bankruptcy court.
Threat or threatened?
So how bad is the situation for start-ups? Pretty bad, says Michael Zea, principal at Mercer Management Consulting in Washington DC. In a piece of research which is aimed at highlighting what the majors should do to protect profitability against new competitors, Zea starts off by admitting there is not much to worry about on the surface.
"Many airline executives do not take seriously the threat of a low-cost entrant. Robust profits and low-cost failures have buoyed their confidence," says Zea - who points out that only 35% of the airlines that have initiated operations in the USA since 1979 are still successful.
"It is true that significant barriers to entry exist for any new entrant airline, particularly low-cost start-ups, whether in North America, Europe or elsewhere. A new low-cost airline faces a daunting challenge in competing against the established majors, which have developed massive scale economies and other marketing-based advantages. These include the connecting synergies of hub complexes and alliances, intricate travel agency incentive schemes, capacity shortages at major airport and powerful frequent flyer programmes."
In other words, the deck is stacked against a new entrant. But is this phenomenon new? David Ulmer, senior vice president at the Roberts, Roach & Associates consultancy in California, thinks not. He has an attention-catching way of proving the point. Once upon a time, he says, new entrants thrived under deregulation. Eight new entrants had carried more than 1 million passengers; more than one in five passengers flew on a new entrant; and 60% of the US population was served by a new entrant.
Then it all went wrong: the major carrier "dinosaurs" fought back with improved cost structures, new competitive tools such as yield management systems and loyalty programmes, and mergers and codeshares. Several years later it was a bleaker picture for the low costs. Only two new entrants had carried more than 1 million passengers and only one in eight passengers had flown on a new entrant. Sounds familiar? Ulmer's story is not set in the 1990s, however, but between 1983 and 1988. "The entrance of new entrants into the industry is very cyclical, just as the industry itself is cyclical," says Ulmer. "In fact, if you compare the survival rates of new entrants in the 1990s with those from between 1978 and 1989, they are not bad compared with restaurants. It's simply a function of competition. New entrants don't stop anybody from competing."
The hub weapon
But the post-deregulatory era of the US industry has changed the ballgame for new entrants, says Ulmer, because the majors have adapted to the new marketplace by developing megahubs. Ulmer defines a megahub as having at least 6 million enplanements a year. On that basis, there are 12 megahubs in the USA, each dominated by one major carrier. The only exception is Chicago O'Hare, where two major carriers have hubs - American Airlines and United Airlines. Then there are14 small hubs of around 1 million enplanements a year. "There will be no more megahubs, but there will be more small hubs," says Ulmer.
Start-ups in the USA, therefore, must take into account that they are entering a market that has matured into a megahub network. "Service into hubs and the increased frequencies they provide creates empty seats - a lot of empty seats at off peak times - and the major carriers are always finding new price structures to fill these seats themselves. So start-ups are not horizontal competitors with the majors. They can never compete with American because of American's network. They have to find something new - a sustainable market niche."
Ulmer believes there are five basic success factors that a new entrant carrier needs to survive. "Four might keep you alive for a while, but you need all of them to stay in business," he says.
Those key factors are:
*Sufficient management capabilities;
*Lowest cost producer;
*Adequate financial capitalisation;
*Strategic plan based on market opportunities;
*Consistent implementation of product and plan.
Some experts are particularly vocal on management capabilities. Darryl Jenkins, director of the Aviation Institute at the George Washington University in Washington DC, points out that over 97% of the carriers that filed for bankruptcy in the 1990s had senior executives who had been involved in a previous Chapter 11. Over 75% had executives who were involved in two bankruptcies. "On the other hand, there is good news," says Jenkins. "When Continental came out of its second bankruptcy, it hired an executive [Gordon Bethune] who turned around the company in only one year. The same is true of America West. There is hope and it lies in the executive offices."
Cost benchmark
Costs are also critical. As Ulmer points out, not every low-fares carrier is also a low-cost carrier. The cost benchmark for any start-up, many agree, has been set by Southwest Airlines, itself a start-up in 1971 and the carrier that most analysts point to as a model for success. Mercer Management's Zea describes Southwest's attitude towards maintaining a low cost structure as zealous. "Southwest has consistently maintained a 30-40% cost advantage over the US majors since 1980, despite incredible growth," says Zea. "The advantage is passed along to customers in the form of low fares, which in turn dramatically stimulate markets, further insulating Southwest from an effective competitive response. Southwest has maintained its cost advantage by sticking closely to its successful route and marketing formula and spending on technology as it improves productivity."
Ulmer believes that Southwest's costs of less than 7¢ per available seat mile (11¢ per seat kilometre)are significant for all start-ups in the USA. "It's no fluke that the lowest-cost producer in this industry has also been consistently the most profitable," says Ulmer. "Southwest's cost curve is the cost of entry into this industry and if you cannot hit this cost curve, you are a Dodo."
Ulmer, who joined ValuJet soon after its start-up in 1994 as vice-president of planning, pricing and scheduling, says ValuJet knew it had to keep its costs below Southwest's and was able to do so through a range of initiatives. "We designed the product from the bottom up to not involve cost," he says. "As a start-up, you know you cannot produce the revenues of the majors. It's a different game - it's not about revenues, but about costs." ValuJet, therefore, deliberately kept 10% of its fleet sitting at its base in Atlanta because they were DC-9s and ageing aircraft are less reliable than new." We were rocketed when we had to cancel a flight because we has to buy flights from Delta, so we put back-up aircraft in the business plan," says Ulmer. ValuJet also used E-ticketing and a simplified, six-level fare structure to keep down costs. On average, a reservation agent took just 3min on the telephone to complete a sale - compared with more than 6min at rival Delta.
Ulmer emphasises that a US start-up has no hope of ever coming near the marginal costs of its major competitors because, with load factors of the majors averaging 70%, they can sell 30% of their seats free. "You know what their load factors are. You cannot play a market share game; you have to play a market expansion game," he says. "You have to exploit new business opportunities."
Managing growth
The Aviation Institute's Jenkins says few start-ups have been able to manage growth with the discipline that Southwest has shown. "The problem with growth is managing it," he says.
"It takes up every available cent, causes costs to go up rapidly and results in confusion for management, which often get reports back too late to really know what is going on. This rapid growth manifests itself in a variety of ways. The most obvious is that breakeven load factors begin to go up," he adds.
Capital is another important factor for survival. "You need a lot of capital to start up," says Ulmer. "This is not a shoestring business." He picks out Western Pacific, a Denver-based start-up that entered bankruptcy last year. Here, there was better initial financing than with most other start-ups, but the airline ran through millions of dollars in capital during its short life. "They were spending money on airplanes, gates, hangars and facilities before they were profitable. They were spending money like they were a big airline and there was no planning to that spending," he says.
Southwest, by comparison, is frugal, but is not afraid to spend to save. Zea highlights several technologies that Southwest has invested in selectively, including headup displays in the cockpit to increase schedule reliability and aircraft utilisation, and analogue instruments, even for new orders, to retain the training and maintenance costs of a standard fleet.
The news for start-ups is not all gloom. Observers see hope for at least a couple of start-ups in the USA and believe there is reason for optimism for some of the European carriers that are venturing into the same game. In particular, Denver-based Frontier Airlines has attracted attention in the USA as it seemed to turn a financial corner last year and produced a profit while keeping costs down.
"They've got costs under control while revenues are up considerably," says Ulmer. "They are certainly approaching all the statistics. They were very thin on capitalisation, but their management has been around for some time now. They have a strategic plan and they are sticking to it. I believe there is room in the Denver market for them and United."
Frontier also performs well, along with AirTran Airlines (the former ValuJet) in a low-cost strategic scorecard produced by Mercer Management. The scorecard assesses each start-up's performance on its ability to dominate short-haul, high-density, markets using secondary airports; maintain a low cost structure; differentiate and provide a unique service culture; and manage finances conservatively.
"Frontier and AirTran appear to be more vigorous challengers," says Zea. "They have maintained at least a minimal level of competitiveness across the scorecard and are, unsurprisingly, proving very difficult to push out of the market."
In comparison, the scorecard highlights the weaknesses of failed US start-ups, such as Continental Lite, VistaJet and Western Pacific. "They were particularly weak in the areas of route selection and definition of a unique culture. This positioned them as also-rans in a weak market. Their soft underbellies were immediately attacked by established incumbents, which had low load factors and high brand preference in the market," says Zea.
Strategic successes
Mercer Management's scorecard also assesses recent European low-cost entrants Virgin Express and EasyJet and Canadian entrant WestJet and gives high marks to all. "They have closely emulated many of Southwest's key success factors and have quickly established profitable operations," says Zea.
Ulmer believes there are mixed fortunes ahead for the low-fares airlines that the majors have themselves set up to compete further. Delta Express, he says, is "very focused" and has been able to achieve the efficiencies it needs to be a low-cost carrier because of that strong focus. US Airways' MetroJet, on the other hand, is saddled with the high cost structure embedded in the major. "They don't seem focused at all, but are just chasing the low costs," says Ulmer.
Potential airline owners should take note. With a strong focus, the right strategic plan and a hefty dose of innovation, there could still be new niches out there to exploit. Or there is always that business plan for a new restaurant that can be dusted off.
Source: Airline Business
