LCC opportunities: going international vs staying domestic, ancillary revs, partnerships and yield

Almost by definition, the opportunities presented to the LCC sector imply introducing some form of differentiation, at least temporarily. In an industry whose product is constantly challenged to avoid being a mere commodity, it is difficult to maintain a difference for long, be it technically, operationally or for example in in-flight services. Imitation comes quickly. But some carriers stand out, at least holding on to a special position for many years; again, Southwest has been one of these.

So, when we talk of opportunities in the future, airlines will automatically look to how they can leverage their own special features to gain an edge. And, unlike threats, opportunities take on a more varied and regional appearance, as differing market conditions intervene.

This extract is from the ‘Great Expectations’ section of CAPA’s Global LCC Outlook report, available for free download at: www.centreforaviation.com/lcc/report

In the chapter, the report draws together the views of low cost airline CEOs from each region, together with those of industry experts, Professor Michael E. Levine, Dr Julius Maldutis, Professor Nawal Taneja and investor, Bill Franke of Indigo Partners. The chapter attempts to draw together the various threads, linking at the same time the views of airlines from each region. And, despite the varying levels of LCC development and the domestic/international differences, a perhaps surprising level of similarity of outlook emerges.

Going international: increasingly the focus for many

For most Asia Pacific LCCs, the concept of going international is both a daily challenge and an opportunity. With regulation the only real inhibitor to unlocking massive growth in the region, international operations (that is, where bilateral air services agreements regulate behaviour) have become second nature – at least aspirationally.

But the international lure is not limited to Asia Pacific, with north American airlines seemingly increasingly keen to escape the limitations of a congested domestic market, which has until now been the staple diet. European airlines, more familiar with cross-border services, are constantly nudging destinations outside the 27 states of the EU “domestic” market, including countries where the EU has established open skies arrangements, such as in north Africa.

In Asia, Japan’s Starflyer for example, sees a major opportunity in an opening up of international access: “Starflyer will start new routes, not only domestic (Haneda - Fukuoka), but also international routes to east Asia,” says Starflyer’s Motu. He expects that “new schemes of business collaboration to share the risk and revenue for international operations may bring Starflyer another development,” looking towards codeshares and similar ways of expanding the marketing reach.

For a carrier like AirAsia, which grows within an international framework, “the opportunities are, thankfully, numerous”, says CEO Azran; “One key competitive differentiator for AirAsia will be its long-haul affiliate, AirAsia X. We are only now discovering the tremendous potential that long-haul trunk routes brings to the core short-haul regional business – in terms of passenger feed, brand extension and operating scale. ‘Purist’ LCCs that are steadfastly staying only in the narrowbody space will be competitively disadvantaged, as will legacy carriers that are not investing in next-generation long-haul aircraft with their game-changing superior economics.” AirAsia already has cross-border joint venture companies based in Thailand – Thai AirAsia – and Indonesia – Indonesia AirAsia, although the colloquial branding tends to be simply AirAsia.

Jetstar, already mentioned in the context of low cost long-haul operations, sees Asian expansion as its future. Bruce Buchanan notes, ”Asia is the world’s fastest growing aviation market, and inside two decades will be the world’s largest. The investment in our Pan Asian strategy through direct services from Australia and strategic Qantas Group investments in both Singaporean and Vietnamese based carriers, present unquestioned opportunities.”

The multi-front approach of Jetstar’s long and short haul operations would also allow these operations to link in with the “Asian hub” which Jetstar is planning for its A330 operations, mentioned above. Jetstar also interlines with full service parent, Qantas, in Singapore.

Singapore’s Tiger Airways has meanwhile already established a base in Australia, using that country’s liberal access provisions, and links its Australian and Singapore based operations over Australia’s Perth Airport; Tiger suspended previous links over northern port, Darwin, citing excessive charges. But, unlike its head-to head competitor, Tiger maintains a simple model “based on Europe's successful Ryanair, which uses its very low cost base to offer competitively low fares on a consistent basis”. Connectivity for it is the standard self-help approach, which enables it to maintain the low cost base.

Of the US carriers, JetBlue sees international service as a major prospect as its second decade beckons. CEO Dave Barger sees the carrier’s platform of a decade of operations as just the starting point for expansion into the Americas: “Since the airline industry deregulated in 1978 in the United States, there have been very few new entrants that have earned the ability to operate in the second decade.  This threat or challenge, though, provides an opportunity for our airline to focus on continuing to build our brand across ‘The Americas’ and the global landscape with strategic partners such as Lufthansa.”

With publicly announced plans to codeshare with Canada’s WestJet and Mexico’s Volaris, Southwest is clearly well committed at least to some limited future international operations, real or virtual. Gary Kelly remains more focused on domestic opportunities, although targeting “new markets” will undoubtedly need to include cross-border linkages of some form, as competitors push the boundaries. WestJet already operates Caribbean services in addition to its primarily domestic routes, as do several US carriers.

In addition to its Southwest codeshare agreement, WestJet has also announced arrangements with SkyTeam and oneworld Alliance carriers to link into their international networks, competing with and taking advantage of Air Canada’s exclusively Star Alliance relationships. A stumbling block to more integrated relationships is the problems the carrier is having in upgrading from its standalone distribution system into one which can communicate effectively with the “community” based GDSs of the network airlines.

As noted above, European carriers are variously involved in international non-EU operations, a relatively natural extension of their already highly international scope. easyJet was a first in Europe to establish a cross-border joint venture with non-EU Switzerland, in order to permit the carrier to establish a base there. Neighbouring non-EU states however raise difficulties which make operations non-viable. Ryanair’s Cowley nominates Turkey for example as a “major untapped market”. Turkey is a potential EU member, but movement is slow. Meanwhile, bilateral capacity restrictions rule out serious low cost operations.

In the Middle East, almost by definition the bulk of LCC operations is also international; only some limited Saudi Arabian and Egyptian services are domestic. Otherwise generally protective and restrictive policies apply in states in the region. Consequently it is the UAE, with its open skies policy, which both supports and receives the bulk of LCC operations. Many of these involve nearby India, whose low cost carriers are still subject to Indian restrictions against international operations; only state owned Air India’s wholly owned subsidiary, Air India Express, reciprocates.

But the UAE has spawned one of the most successful LCCs in the world in Air Arabia. The Sharjah based carrier has expanded beyond its home base with cross-border subsidiaries in Morocco and, more recently, Egypt. “Why do we do it?” asks CEO Adel Ali rhetorically. “With the name Air Arabia we need to be pan-Arab.” He explains his geographic expansion strategy in the following terms: “Market size? UAE being at one end and Morocco the other, Egypt comes in the middle. Egypt comes with no LCC base there, a large inbound tourist market from west and east, a large domestic market with a population over 80 million, over 15 secondary airports, a large Egyptian community outside Egypt…” So far, almost a no-brainer.

And there is more: “It will link Morocco - and Egypt will link in most European points; plus Egypt links to Gulf in number of point direct and via the Levant…”

The permutations just pile one on another, especially in a region where lingering access restrictions limit the opportunities for other competitors quickly to respond. The first mover rewards in international expansion can be significant. But Ali stresses that it is “vital to pick the right partners. Getting it wrong can be very costly.” In Egypt, for example, Air Arabia’s local majority partner is Travco Group, a leading tourism and hospitality group in the region.

Staying at home: the domestic focus

But for some, the rewards of staying close to home are both more attractive and less risky. Ryanair’s Cawley for example has no interest in long haul. In stressing that talk of a long haul operation is a separate initiative of CEO O’Leary, Michael Cawley says “short haul is where the growth is” – especially in Europe, in contrast to the well-exploited US market. “We are still flying a fraction of what they are in the US. In Europe we have longer holidays, lots of displaced ethnic groups travelling back and forth and numerous capital cities as destinations.” Reeling off a list of European cities, he says “there are still a large number of major and smaller cities where there is no Ryanair. These are very ripe markets, which low fares can unlock.”

For similar reasons, China’s almost solitary LCC, Spring Airlines, sees the simplest opportunity lying before it, in the unexploited domestic market. Spring President, Wang Zhenghua says, “Spring Airlines will benefit from the fast development of the Chinese economy. China’s GDP is expected to increase at 8% annually and the civil aviation industry will be increasing at 14% every year. Therefore, we are forecasting Spring Airlines will develop at 40% year on year.” With that sort of expansion prospects, who needs international operations at this stage?

In South Africa, LCC Mango, which shares the same parents as SAA, is permitted no international aspirations by its parent at this stage, but sees that its high quality of service allows it to respond effectively to business demand, a market it has not yet tapped. Says CEO Nico Buizedenhuit, “Given the shift in consumer purchase patterns and the increasing importance of value, Mango is in the position where it is well equipped to meet the requirements of the price-sensitive business traveller, especially considering the fact that the Company outperforms both its domestic full service and low cost competitors.”

India’s SpiceJet, similarly confined domestically, in this case pursuant to Indian legislation until it has existed for five years, looks to excel in its own patch as a means of survival. “The opportunity is that with the advantage of having the newest airplanes, motivated workforce, and a focus on service, SpiceJet can offer a value proposition to its customers that the competitors will find difficult to match,” says CEO Sanjay Aggarwal.

Ancillary Revenues

As with many other topics, variations in outlook vary widely on where ancillary revenues are headed, depending on region, state of development of the airlines concerned, local economies and, for example average stage lengths flown.

Ancillary revenues have rapidly become the main focus of LCCs and full service airlines alike, as passenger yields decline. The low cost airlines began the move, as an “equitable” fee for service, once the basic operation was unbundled from such costs as baggage handling, changing reservations and in-flight food and beverage service. As these evolved from being roughly revenue neutral to being major centres of income, the full service airlines, notably in the US, have come to feed at the same trough, driven from their usual pastures as passenger demand dried up.

Bill Franke of Indigo Partners says: “We see ancillary revenue as the biggest LCC step change over the last three years and I would expect that trend to continue. I am sure there is a point at which the “a mall in the sky” concept runs its course, but that won’t happen as long as the passenger wants a low fare and is willing to pay for whatever else he/she wants.

Ryanair is less sanguine about the future of ancillary revenues. “Ancillaries are maxing out,” says Cawley. “We are already deriving up to about 22% of revenue and this is getting close to the natural limit. From here on, ancillary revenue will only grow in line with traffic.” Anyway, other opportunities for sales are not core: “We’re not retailers. We’re not into selling life assurance.”

Long haul international ancillaries perhaps remain an untapped resource though. AirAsia X’s Azran thinks it will be essential to explore the opportunities there: “LCCs must figure out how to keep extending their brand into new revenue-generating opportunities. Margins from the sale of seats will inevitably keep shrinking. LCCs must therefore compensate this loss with new revenue sources – from ones that are related to the passengers’ travel experience, to opportunities that are completely unrelated to flying…winning ideas will differ by market, but LCCs must keep evolving and creating new revenue sources – particularly ideas that reinforce the LCC’s brand as a leading consumer goods/lifestyle brand for its targeted customer demographic.”

As long haul low cost operations expand, coinciding with consumer-useful technology advances such as in-flight internet access and interactivity, this will surely become a potentially fertile source of revenue. Holding passengers confined in a small place in an aircraft for several hours must inevitably spawn opportunities to deliver products of mutual value, well outside those currently traded.

After all, every commercial flight touches two airports, each of which is happily generating large amounts of revenue from every passenger. The retail spend of travellers at airports around the world dramatically exceeds the profits (and the losses!) of the entire airline industry.

There is a further largely unexploited opportunity. As the Qantas Group model, with its enormously successful FFP[1] becomes more widely understood, it is hard to believe that a cost-neutral loyalty programme, spinning off the notoriety of many LCC websites, will not become a standard feature of revenue strategies. Describing revenue from this source as “ancillary” catapults Qantas to number one globally as a generator of non-ticket income.

There is a lot more to ancillary revenue raising than the mundane collection of baggage taxes. Now that the full service airlines have begun to turn their mind to these other sources of income, the pool of ingenuity is greatly widened. There is much innovation still to be witnessed.

To grow or not to grow?

There is constant pressure for an airline company to grow. Sometimes-excessive growth is embarked upon, simply, it seems, to please the stock analysts. But the global economic slowdown has forced many airlines to rethink their expansion plans. With the largest overhanging list of orders in history, this has caused some grief, especially for the full service airlines whose premium markets have withered. Luckily for many, the delays in A380 and B787 production has offered some respite, but single aisle aircraft are still rolling off the production lines at near record levels.

So, while full service airlines have been cutting back on capacity – around 10% net reduction across the world this year – LCCs have taken different approaches, depending for example on whether they have large order books, where they are positioned in their particular market and what their options are for sustainable expansion.

The industry has never witnessed capacity reductions on current levels right across the world and we can expect many surprises once the market turns. Airlines will simply not be prepared for this life after near-death, and there is no road map.  Jim Parker of Raymond James believes “there is likely to be a slow rebuilding of capacity in the new economic cycle ahead and then slower and less risky growth as the new economic cycle moves forward in the growth phase.”

That assumes airline managements (and investors) will learn the lessons of the new order and act appropriately. If that sort of discipline – self imposed or otherwise – occurs in the US, it is unlikely to be the case in emerging markets, where much of the future growth will be. Implied in that scenario is an even more rapid shift in the global aviation balance than previously projected.

Not everyone is contracting:
Selected LCC passenger growth rates: Jan-Sep 2009

		Factor	year-on-year
North America	Allegiant	RPM	+28.9%
	Southwest	RPM	+0.1%
	WestJet	RPM	-0.3%
	JetBlue	RPM	-2.8%
	AirTran	RPM	-4.5%
	Frontier	RPM	-14.5%
Europe	Vueling[2]	PAX	+23.0%
	Norwegian	PAX	+15.0%
	Ryanair	PAX	+13.0%
	easyJet	PAX	+1.7%
	airberlin	PAX	-5.1%
	Blue1	PAX	-10.4%
Asia Pacific	SpiceJet	PAX	+52.2%
	AirAsia[3]	PAX	+24.0%
	Jetstar[4]	PAX	+10.8%
	Virgin Blue2	PAX	+3.9%

Source: Centre for Asia Pacific Aviation & company reports

For a few, the slowdown offers an ideal strategic opportunity to grab market share, while others are feeling the heat. Because its has the lowest fares, says Michael Cawley, Ryanair is “going to grow this year at a faster rate (in seat numbers) than any airline has ever grown in the world.” Even if tempered, Ryanair’s expansion in real terms is equivalent to adding decent sized airline each year. This at a time when its main competitor, easyJet has undergone considerable wrangling at board level about whether it should be growing at all, to decide eventually that modest growth is appropriate.

AirAsia’s Tony Fernandes says that, downturn or no downturn, “Our strategy remains consistent - that we want to continue to connect the dots between all the 65 destinations we have opened,” noting that the fast growth market of “India will be a key for us”. The carrier is growing at over 20% this year.

In the US and Canada, most LCCs have scaled back their expansion plans. For Dave Barger, sustainable traffic growth is the key for JetBlue: “the contrarian business model is the right model for the future – it is possible to balance the needs of crewmembers, customers and shareholders over the long-term.  To this end, JetBlue is focused on earning the respect of all three constituencies by charting a path of sustainable profitable growth – we learned how to grow too fast in the past; now it’s time to put that lesson to use!”

Southwest too, in the face of a sequence of unheard of quarterly losses, is scaling back. But it is not all bad news for US airlines. AirTran projects its “best year ever”, according to CEO, Bob Fornaro, although it too is taking a very cautious stance on expansion. As illustrated elsewhere in this report, investors are apparently convinced by AirTran’s bullish outlook and its current stock performance, well above the airline sector.

However, Allegiant, with its unique model, is surging ahead, albeit off a much smaller base. At near-30% growth, its expansion rate is exceptional in the devastated US market.

And scaling back – or finding new markets – may be the way in Japan’s high cost market, says Starflyer’s Motu. The management dilemma is confronting: “In such a down-trending economy, the LCC is likely to have a tough time, since its business model depends on newly generated demand and high load factors, which are no longer easy to achieve. An LCC... has to grow (it is not allowed to stop) since it lives with a very small profit margin, which is shrinking because of unavoidable 'age cost' such as maintenance cost and labor. In these circumstances, I think the LCC is required to re-engineer its business model by 'down sizing', 'different revenue management' and 'alliances' including international operations.” He hints that the solution for Starflyer is a new “business collaboration to share the risk and revenue for international operations - which may bring Starflyer another development.”

Partnering to expand market access

This potential solution is echoed globally.

The international constraints of regulation deeply colour an airline’s strategy when it operates beyond national borders. For Saudi-based Sama’s CEO, Kevin Steele, the “greatest opportunity is to work with other airlines, both LCCs and legacy carriers, to jointly tap the extremely high potential markets to/from Saudi Arabia.”. And, apart from the market access that cooperation brings, a small carrier can expand its shadow considerably in this way, as here, where he says, “demand continues to outstrip supply”. In some cases where the market is still regulated (as, for example the Saudi international market is), there is an additional advantage: entry for others is restricted.

This value of partnering is more than an option, to extrapolate on a point Mango’s Nico Buizedenhuit makes: “Given the increasingly homogeneous nature of short-haul air travel supply, price (and, by implication, seat production cost) and reach (including marketing and distribution) becomes of paramount importance.” In this commoditised market, getting the brand right is critical, but for smaller airlines, widening the marketing shadow needs partners.

This goes a long way to explaining why north American low cost airlines are now embarking on similar tracks - although international partnering has not generally been a strategy of first choice, as long as remaining within domestic walls made life a lot easier. But now a crowded home market which no longer offers easy growth prospects, obliges outbound exploration.

WestJet, with its Southwest and oneworld and SkyTeam partners, JetBlue with Lufthansa, Southwest with Volaris as well as WestJet, each see this as an inevitable course.

Julius Maldutis envisages the possibility of “many mergers using the Southwest model”. And, as the practice spreads, the LCCs encroach progressively further into the previously sacrosanct territory of the network airlines.

China’s solitary LCC, Spring Airlines, elevates the need for inter-LCC cooperation to a collective strategic one: “There’s no alliance for LCCs so far; all existing alliances are for full services carriers. It is also not popular for LCCs to codeshare with other airlines/LCCs, so mostly the LCC is forced to work alone. We would like to see more international cooperation among LCCs, on a strategic level or operational level.” This is true – apart from the European Low Fares Association, there is not even a forum for LCCs to link multilaterally.

To return to Japanese LCC, Starflyer’s Yasushi Muto; his outlook is similar: “LCCs and other new airlines may be required to build a strategic alliance for the next development stage.” Clearly, in looking to expand through partnership, in Starflyer’s case the prospect of linking with the bigger legacy airlines does not appeal.

But partnering is not for everyone, as Michael Cawley has pointed out. Polluting your own model is a risk that follows with each level of cooperation. Then Ryanair is of sufficient scale now that it can dominate in its own right.

Positioning as the Quality Product

It is often surprising for observers how much emphasis LCCs place on reliability. This could be a reaction to the difficulties that some of the early companies experienced, with older aircraft and limited funding. So often their detractors were able to point to unreliability and poor performance. But the transformation has been made possible for the modern day operator, with new aircraft, simple turnaround procedures and their accent on efficiency (=cost). As this has occurred and many older legacy airlines are  often forced to operate ageing fleets at congested hubs, LCCs have made a virtue of what used to be a significant criticism of them.

They are not always on time of course and the thinness of backup resources can mean more than the usual heartache for travellers when things do go wrong. But the statistics do tend to favour LCCs in many markets on head to head on-time reliability.

Added to this, as the legacy airlines’ products increasingly suffer reduced frills, quality becomes the preserve of the low cost airlines. Virgin America’s David Cush notes, “In the US market, the LCCs are seen as the best quality carriers.  Higher quality and lower price is a winning combination.”

This is a big feature and makes for opportunities: “As the total corporate travel pie shrinks and as LCCs take a bigger slice of what remains, this will put increasing pressure on legacy carriers, giving LCCs even more opportunities”, Cush says. 

This aspect of de-commoditising the product was a part of the Song Airlines strategy (which proved very popular, but unprofitable as a Delta subsidiary) and has been most successfully developed by JetBlue. As CEO Dave Barger observes, “the LCC model can also be viewed as one that offers truly good value from both a pricing and product point-of-view – new aircraft, assigned seats, cabin comfort and inflight entertainment can in fact be enjoyed at low fares.” But, he stresses, the product is not just of mechanical, hardware superiority, but of its people, a feature which Southwest also applied from day one and, against the odds, has largely managed to retain for over three decades.

The quality trade-off made by US airlines as they scramble for ancillary revenues has not helped.

Bill Franke accordingly points the blame for this squarely at the legacy airlines: “Baggage fees, fees for blankets, loss of food service and the like are good examples. This has done little for passengers’ attitudes toward these carriers: it is one thing if you pay very low fares and have the on-board choices to make. It is another thing if you are paying a legacy’s high fares and think you are getting something for it only to face a charge for a blanket.”

This self-inflicted brand destruction has not been mirrored in other regions, so the equation has not shifted as far elsewhere in the world in favour of LCCs – yet.

It is ironic perhaps that LCCs are now able to adopt the higher ground – albeit at the same time as that ground is levelling off. Gary Kelly also ascribes a lot of the credit for this to the legacy carriers: “The current economic volatility has turned even the legacy airliners into discount carriers. We are currently seeing the continued convergence of LCC and Legacy carriers toward a single model of service. Carriers are now differentiating themselves through the product and services they now offer: Wi-Fi, In-Flight entertainment, Bags Fly Free, etc.”

The growing consensus is that the low cost new entrants are setting the bar for performance and consumer satisfaction. In India, for example, where domestic service standards are already high, SpiceJet CEO’s Sanjay Aggarwal believes that, “economy class service in the next three years would be same whether you fly the LCC or the FSC. However, an LCC such as SpiceJet, with a significant cost advantage over others, will be able to effectively compete and succeed.”

In South Africa too, Nico Bezuidenhout, CEO of Mango: “Interestingly enough, the LCC model can also be viewed as one that offers truly good value from both a pricing and product point-of-view – new aircraft, assigned seats, cabin comfort and inflight entertainment can in fact be enjoyed at low fares.” This is where the convergence of models is most apparent; he continues, “The increased consumer value-focus affects full service and low cost carriers in differing degrees: LCC’s are adding more frills in an attempt to better meet the perceived requirements of the new potential target market whilst full service carriers are removing some frills or introducing al carte pricing in an attempt to reduce cost, offer better value and retain custom.” 

For bmibaby, the quality formula is key to a successful outlook. CEO Nigel Turner’s two-model split will need to materialise. So, for the LCC, a broad form of differentiation does offer potential, which also gives the option to compete at the low price end of the market: “Opportunities arise for bmibaby with the awareness that you can have a quality low cost carrier and that customers will recognise and chose this differentiated type of low cost airline.”

Internationally, quality leadership can be a lot more complex, not the least because this is familiar territory for the major network airlines, whose high quality product is tailored for international routes. Their ability also to combine through bilateral and multilateral alliances and partnerships to expand their reach makes them highly competitive.

And internationally, while an LCC’s technical and operational quality may be strong, AirAsiaX’s CEO observes, customer service must in the end be the differentiator: “It will be progressively more difficult to find truly unique sources of differentiation on cost and scale alone. As markets get crowded and direct competition intensifies, even the lowest-cost LCC must start to use customer service as a competitive differentiator. This will be a challenge because customers inevitably have different preferences in different markets.”

For high a cost legacy airline this promises an uncomfortable future.

And the winners are…

“’LCC’ is not a magic formula whose incantation means inevitable airline success”, Professor Michael E. Levine.

“Winning LCCs will be the ones that identify the most important service attributes and become excellent at delivering the service at each customer touchpoint, compared to their competition”, says Azran. “We believe that successful airlines are those capable of adapting to enforced changes and adopting it to move forward. Every challenge offers an opportunity after all,” concludes Adel Ali from Air Arabia.

But the winners will have to work for it. The future is not all rosy.

In Professor Levine’s objective and restrained outlook, “"LCC" is not a magic formula whose incantation means inevitable airline success. In a competitive market, all airlines are under pressure to produce whatever product they produce at the lowest possible cost. This pressure will continue to increase over the next few years.

“If "LCC" means high-frequency, intense resource use, low-amenity, point-to-point service, the market for that product is limited by route density and overall demand levels.  If it means trying to have lower costs than competitors through labor cost advantages, these advantages tend to erode over time as seniority grows and the size of the labor force encourages unionisation efforts.  Starting and maintaining an LCC will not be a "no-brainer".  Each LCC will need a strategy that identifies lasting competitive advantages that are difficult to duplicate.”

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[1] See “Qantas’ successful LCC subsidiary: A one-airline convergence of airline models” in this report

[2] Includes the consolidation with clickair

[3] Apr-Jun 2009

[4] Jan-Aug 2009