Ever since the low-cost formula began to take root in Europe a couple of years ago, industry observers have been waiting keenly for the first start-up to fail. Even the low-cost pioneers themselves have expressed surprise that their number is still intact. But the game has barely started and as the stakes grow, so will the dangers.
New capacity is due to pour onto the market over the next few years from the leading low-cost players as they spill onto new European routes. Between them, Ryanair and easyJet have orders arriving for 40 new generation Boeing 737s worth $2.5 billion and 35 more on option. Add to that Debonair's plan to launch the Boeing 717, plus further growth from Virgin Express, and the founding fathers of European low cost are on course to more than double capacity again over the next four years.
As they expand, the carriers are beginning to come into direct competition, not only with the region's flag carriers, but each other. British Airways has already added to the fray with the launch of its Go operation out of London, home to three of the big four. Its presence brings some dark echoes of the US experience, where the majors belatedly, but effectively, began the fight back against their new challengers. KLM, too, has offerings of its own. Lufthansa and others are mulling their response.
There is also growing pressure for the sector to begin delivering profits, especially for those that joined the round of share listings over the past couple of years. Debonair only recently limped back into the black and previously stable Virgin Express has seen profits dip alarmingly over the last year. Even with Ryanair making respectable returns and privately owned easyJet declaring it is now in profit, the net margins for the sector as a whole are unlikely to stray much above 1%.
High-cost Europe
Neither have fears entirely disappeared over the fundamentals of replicating the US low-cost formula in high-cost Europe, with its added hurdles of heavy congestion, rail alternatives, lingering national barriers and lower demand for Visiting Friends and Relatives (VFR). Nor is it clear that the US experiment itself is in good health, Southwest Airlines allowing.
It is true that Europe has fewer of the high-volume city pairs that provided a launch pad for US counterparts, and most of the densest are out of the London market. Doubters argue that, with the bulk of these already exploited, the next phase will see fierce head-to-head battles between low-cost carriers on increasingly crowded routes.
Michael O'Leary, chief executive at Ryanair, the largest of the low-cost players, remains typically untroubled by such doubts. He argues that there has always been direct competition for the "discretionary tourist market" where price matters more than destination. Ryanair's broad philosophy is that it can make money on any route where it can fly three times a day to a low-cost airport. That would encompass any market with low-cost potential for around 200,000 passengers a year. He acknowledges that the lack of suitable secondary airports could be a block.
High infrastructure costs in France, Germany and some of its neighbours have limited the options for domestic start-ups. Yet there are signs that this is changing, with smaller airports beginning to market more aggressively around the major cities - Frankfurt and Paris included.
Comparison with the US model suggests Europe's experiment still has plenty of scope to run. Something like 25% of US domestic passengers fly with low-cost carriers. The figure within Europe, including domestic markets, is closer to 5%. Even taking into account a lower potential, there should be room for the passenger share to reach around 15% and for revenues to double. That would add over 20 million passengers and more than $1 billion in revenues - just about enough to fulfil existing growth plans.
Europe has at least one other difference from the USA - a giant holiday charter market. The charter carriers, arguably Europe's original low-cost carriers, account for around 15-20% of the short-haul passengers within the region and over half on international routes. They have virtually unbeatable seat costs thanks to a mix of longer routes, larger aircraft and their unique guarantee of seats from the tour operators.
There are no signs yet that the big UK charter carriers are preparing for any exciting adventure in the scheduled sector. Recent preoccupations have rather been with managing vertical integration into the region's four or five emerging leisure travel giants. German charters have converted some flights to scheduled, albeit on existing charter routes, but few anywhere have committed to low cost in earnest.
Competition could yet emerge, however. There are growing overlaps on traditional holiday destinations in the Mediterranean, which could spur a response if or when the travel companies begin to feel the competition.
Consumer choice
What is not in doubt is that a mix of low fares and relentless publicity is helping the new entrepreneurs to stimulate new demand, just as they did in the US early days.
Unveiling another six routes earlier this year, O'Leary pointed to Ryanair's experience on the northern Italian destinations launched last year from London Stansted. On both Venice and Rimini/Bologna, Ryanair had built a market share of better than 20% within six months of start-up. As Go followed onto the routes, it gained a share of around 15-20%. On both routes, the market grew dramatically, suggesting that the new entrants, like their US counterparts, had stimulated new demand rather than robbing passengers from incumbents Alitalia and BA.
However, O'Leary believes that there is evidence of a steady downward trend in yields for the established carriers as business traffic migrates through the cabin and eventually out to the low-cost carriers, at least once the frequencies are sufficiently attractive. "Where we're up to three flights a day we've seen 35-40% business traffic," says O'Leary. That is already true for flights out of the Dublin base, and services from London to Scandinavia appear to be on track for similar levels. Debonair, helped by its frills, already claims 60% business traffic.
The lure of low-fares was tested last year in a poll carried out by the Consumers Association, a independent UKwatchdog with bite. It gathered opinions from a fairly even mix of leisure and business passengers at four airports -Dublin, Glasgow, Manchester and Stansted.
Most leisure travellers duly revealed that they had chosen their airline largely on price. But the availability of a local airport ranked a high second for leisure and business alike. The prime criteria for the business traveller was less obvious. It rested not on loyalty schemes or convenience, but company travel policy.
Least encouraging was the relatively low awareness of the low-cost option, remarkable given the barrage of publicity that swamped the UK throughout much of last year. One-third of travellers had simply "never considered" flying low cost and 15% of leisure customers were not even aware of the sector. Of the half that had already used a low-cost carrier, most were keen to go back - reckoning on average that they might take an extra two or three flights a year, thanks to low fares.
One other point worth noting is the perception of Go. While BA may have been pleased with a broadly positive response to its new start-up, it may do well to ponder on the comments that the national carrier's presence had helped lend credibility to the whole low-cost market.
Keeping costs low
Market potential aside, there is still the nagging question over whether the economics indeed stack up. The basic rules, tested in the USA, show that the low-fares sector tends to hold a 30-40% cost advantage over the established airlines.
Mark Darby, aviation consultant at Deloitte & Touche, estimates that the established carriers therefore need to have fares at least double those of their new challengers on a given city pair. The low-cost carriers would, however, hit break-even at 65-70% load factors against 60% for higher-yielding majors.
He adds that by no means all of the costs are controllable. Areas such as navigation charges or fuel are largely non-negotiable. The margin for action on other areas is slight, including the fixed costs of maintenance, aircraft and flightcrew. Even pilot pay rates need to be competitive, as Virgin Express discovered last year when it ran short of crews, lured away to mainline fleets.
The real potential seems to lie in two areas. First, is the use of secondary airports. Quite apart from the low fees, there is the opportunity for the fast turnaround needed to keep aircraft productive. Darby calculates that carriers will need to aim at more than 9.5h flying a day before the maintenance and availability savings begin to offset the purchase price of their new aircraft acquisitions. Given that low-cost carriers typically fly on sector lengths of well under 2h, that is a tough challenge.
A second target for real savings lies with passenger costs. The no-frills philosophy pioneered by Southwest is legend, but perhaps more significant is the ability to avoid distribution charges, cutting agent commissions and computer reservation system (CRS) fees.
It is the departure from this formula that has made the sceptics most wary. The obvious example is Debonair, with chairman Franco Mancasola's insistence on quality - arguing that Europe is not ready for "peanuts and gym shoes". The formula, including an 11,000-strong frequent flyer scheme, may have won a business travel award this year, but Darby is among those who warn of the risks in offering "higher-cost" products, but at low fares.
Both Debonair and Virgin Express have broken ranks in another way, by flying services on behalf of the flag carriers. Debonair hires out capacity to Air France while Virgin makes around 30% of revenues flying for Sabena. A betrayal perhaps, but also a comfortable stream of income to fall-back on.
Even Ryanair, with its strict ban on frills, uses the travel agents and, overcoming obvious distaste, the major CRS providers, too. Commercial director Tim Jeans is ready to acknowledge the costs - including 7.5% commission - but argues that it extends the sales reach to hundreds of retail outlets. He adds that customers still trust agents.
Taking its lead from its US mentors, easyJet started out by slapping its telephone number on the side of its aircraft and selling only through call centres and the internet - with a ticketless and near paperless reservation system. Go, too, has followed suit. Avoiding agents, however, brings a corresponding higher commitment to advertising. Ryanair points out that it has had to carry out minimal promotion at European destinations, with the low fares selling themselves through local agents, says O'Leary. A boon indeed for Ryanair, which has shunned any airport that vaguely resembles a hub.
By contrast, easyJet has been more wary of the unknown when venturing into Europe, instead playing safe outside the UK with such high-profile hubs as Amsterdam Schiphol. That can bring stiff penalties of its own for utilisation, reliability and cost. Last year, Virgin Express finally moved part of its fleet to a second base at Shannon to escape the high costs of Brussels. Ryanair itself has waged a loud campaign against the costs at its own home base in Dublin.
Whichever of these low-cost strategies proves to be a fatal blunder and which, if any, a stroke of business genius, has yet to be seen. The betting is still on a bout of consolidation to come. Darby is still among those predicting an imminent exit or two among those who are tempted to take their eye off the goal of tight financial controls and give in to the temptation to dilute the low-cost formula.
Source: Airline Business
