The strategies and effects of low-cost airlines

1. The strategies and effects of low-cost airlines Simon Smith

2. Contents • Who and what are the low cost airlines? • What is the market for the low cost airlines? • How much ‘lower cost’ are they, and why? • What is the impact on long-distance rail? • What are the key strategies for success? • What is the future for the low cost sector?

3. Who and what are the low cost airlines?

4. Who are the low cost airlines? • The main low cost airlines operating to/from the UK are: • Globally, the largest and most successful low cost airline is Southwest in the US

5. What are the key characteristics of low cost airlines? • The low-cost model was pioneered by Southwest Airlines in the US, and European low-cost carriers have all followed this to an extent: • high seating density and load factors • uniform aircraft types (usually the 737-300) • direct booking (internet/call centre - no sales commissions) • no frills such as “free” food/drinks, lounges or ‘air miles’ • simple systems of yield management (pricing) • use of secondary airports to cut charges and turnaround times

6. British Airways Air France Lufthansa KLM United Airlines Ryanair Southwest 0.9% 3.5% 5.7% 1.5% 11.9% 22.7% 21.8% Successful low cost airlines are very profitable • The successful low cost airlines are more profitable than established carriers • Ryanair has a market capitalisation of about £3 billion Operating margins by airline (1999)

7. What is the market for the low cost airlines?

8. Entry spurs an increase in demand (often one-off) Time of entry of lower cost carrier Data is for passengers on routes to London. Source: CAA airline/airport statistics

9. On some routes low-costs have become the majors • Growth averages 10.5% in the first two years after entry of a low cost carrier • At other times and on other routes, growth averages 4.4% • Evidence of saturation on some routes after 5-10 years • Low cost airlines are now the major operators on some routes: • For many destinations, easyJet now offers frequencies better than British Airways • Higher frequencies mean low cost airlines become more attractive to business passengers, and these are now a significant proportion of passengers for easyJet

10. Some traffic is new, but some comes from other airlines Low cost market share 46% in 2003 If ‘natural’ growth 5% per year: • 62% of low cost traffic is new or transferred from surface transport (38% from other airlines) • Traffic on other airlines would be 32% higher now without the low cost operators.

11. How much lower cost are the low costs?

12. The passengers fare varies in two ways • Different fare structures • Different overall costs

13. Low cost carriers are renowned for cheap fares... • Cheap fare offers are heavily publicised. Current available offers include: • Dublin to London €2.99 single (Ryanair) • London to Düsseldorf (almost) £0.99 single (Ryanair) • London to Edinburgh £9.99 single (easyJet) • London to Barcelona £12.99 single (easyJet) ... excluding government tax, plus on Ryanair, airport charges and a compulsory ‘wheelchair levy’, ‘insurance levy’ and charge for your credit or debit card • However, in reality most fares are higher than this: Ryanair’s average fare is around €40 per passenger and easyJet’s around €60 (excluding taxes and charges).

14. This results from different systems of yield management • Traditionally, airlines tried to design fares to charge each passenger as much as they were willing to pay, using: • Fare conditions: different degrees of flexibility, requirement to stay over a Saturday night, usually must buy a return ticket to get any discount (hence single fares often much more expensive than returns) • Different classes of service: business class may be 5-10 times the price of economy, but the service probably only costs 25% more • Distribution: cheaper fares were offered through discounters than through corporate travel agents • The availability of discount fares could be adjusted in response to variation in demand, but was generally on a flight-by-flight basis • Yield management still works (roughly) in this way for some long haul flights, especially on routes where bilateral air service agreements (ASAs) are relatively restrictive.

15. Low cost airlines use simpler, more flexible, pricing • Low cost airlines offered much simpler fares: • Seats sold first-come first-served, so passengers get cheaper fares by booking earlier; price thus automatically responds to variations in demand • The airline can also adjust the price bands if demand is greater or less than expected • All fares are one way and there is no difference in fare conditions • No attempt to buck the market by imposing ticket conditions (return trip required or Saturday night stay) to get the best fare • To an extent, British Airways and other full-service carriers have copied this, but their fares are still more inflexible than those the low-cost airlines offer. Rail operators have hardly responded at all. • Key issue: yield management through ticket restrictions only works if all competitors apply the same restrictions - so is unlikely to work in a very competitive market, where airlines have little or no market power and product differentiation is limited

16. Book in advance for cheap seats • The basic principle is that the cheapest seats are sold first - but the approaches to yield management do vary between the airlines: • easyJet - almost entirely first-come, first-served, with few special offers or sales • Ryanair - frequent “free”, “half price” or “99p” seat sales Prices for peak, shoulder and off peak flights, by advance booking period

17. Overall costs are significantly lower: • Higher seating density and no business class reduces per seat costs by 16% (easyJet relative to BMI) • Aircraft utilisation is also higher: • easyJet aircraft are in the air for 11 hours a day – BA’s equivalent aircraft fly for less than 8 hours • Costs per available seat kilometre for easyJet are 64% lower than for BMI • Costs per seat are 52% lower • The low cost airlines operate with higher load factors (fewer empty seats) so their costs per revenue passenger kilometre are even lower Operational data for 1998 from CAA 1998 airline statistics; financial data is for FY1998 (CAA 1999 airline statistics)

18. Passenger services costs Full cost short haul airline Aircraft related costs Commission Low cost airline Station costs Advertising and promotions costs Sales and reservations costs Airport and ANS charges Aircraft fuel and oil Cabin crew Flight crew Other operating costs 0 5 10 15 20 25 Cost per 000 RPK (£) Breakdown of cost saving

19. Ryanair has negotiated good (illegal?) deals with airports • Airport charges are typically in total £10-15 per passenger • Ryanair has reversed this and it is, in effect, paid to land at some airports. Airports may do this because: • Regional/local governments want Ryanair to come to their airports, perceiving that there are economic benefits to the region from this • Actual evidence is mixed - positive at Prestwick, negative at Blackpool • Airports can make money on associated services (catering, retail) • Airports may also make a profit from ground transport concessions (buses, car hire) • However, in some cases this is funded either through • direct subsidy from the regional government; or • cross-subsidy from other airlines • Newquay airport has been driven into losses as a result of the Ryanair deal it signed, and the local MP has called for the deal to be scrapped

20. The Charleroi ruling challenges this • At Charleroi, Ryanair was receiving: • Reduction in airport charges of €1-2 per passenger (illegal) • Reduction in ground handling charges from €8-13 to €1 per passenger (illegal) • “One-shot” flat rate incentives for starting up new routes, such as contribution to recruitment costs, hotels etc (illegal) • Route start-up aid - for example, shared marketing costs (legal, provided it is proportionate, does not exceed 50% of cost, is limited in duration and competitively available - none of which apply to Ryanair’s deal at Charleroi) • The Commission claims that Ryanair may be able to keep 70% of aid provided, but it is hard to see how (pay back €10 million?) • Impact could be about €15 per round-trip passenger • EC is now investigating other Ryanair deals (eg. Pau in France) • Probably only has a significant effect on Ryanair - easyJet claims not to receive equivalent subsidies and welcomes the ruling • Ryanair is appealing: this appears to be a delaying tactic only, but the delay could be quite long

21. What is the impact on long-distance rail?

22. Traffic will be taken from long-distance rail as well Airline costs per passenger, and rail fares, from Barcelona

23. It’s not clear what rail operators can do about this • For short journeys (less than 3 hours) rail is likely to remain dominant: air journey times longer, particularly if (inconvenient) secondary airports used • For longer journeys, rail operators could try to cut costs - but this is difficult, in a heavily unionised environment • Internet sales could cut ticket costs significantly (currently 6-10% of total fare), improve load factors and help passengers find lowest fares: • SNCF is pioneering here - you can print your own ticket, which is scanned on board the train; some trains (idtgv) are internet booking only • Other rail operators are years behind airlines • A few niche services have successfully competed on quality (France-Spain Hotel Trains), but others are just withdrawing services: SNCB and NS have both withdrawn all the international long-distance trains they operated • However, so far, low-cost airlines are only competing with rail on the longest distance routes • Ferry operators (and Eurotunnel) also severely hit: have had to cut prices by up to 80%

24. Rail market share will fall • The market share curve may shift downwards, with the biggest impact being on long distance journeys (over 3-4 hours) 100% 80% 60% Rail market share 40% 20% 0% 00:00 02:00 04:00 06:00 08:00 10:00 Rail journey time (hours)

25. Adapting the yield management system is key • Discounted tickets, if they exist at all, tend to be restrictive: Eurostar’s cheapest single to Paris is £149. easyJet costs from £17.99 (inc tax). • Rail fares vary less than air fares, and are therefore lower in peak periods (when airlines make most of their money) but higher for the rest of the year • In some countries, this is because rail fares are legally a tax which therefore cannot be varied, except by ministerial decree (!) • not the case in the UK, but regulation of Saver and season tickets limits potential for yield management • 60-day booking limit (often much less in the UK, for various reasons) for most rail fares no longer appropriate • Airline yield management systems cannot be directly transferred to rail • Passengers board en-route - systems not designed to handle this • Rail is a network: some passengers may have to use specific trains to make connections - if they can’t use them at the right price, won’t travel by rail at all

26. What are the key strategies for success?

27. Despite the overall success of the sector, most fail • Almost all low cost airlines launched in the US (except Southwest) have failed • recent failures include Pro Air and ValuJet • Virgin Express reduced its network significantly in 2000, closing an Irish-based subsidiary • In the UK, AB Airlines, Debonair, Duo and Now have failed; ‘Now’ went bankrupt before the first flight had taken off • Go lost £47m in its first two years • Buzz was sold to Ryanair for a nominal sum (£15m)

28. To survive, airlines need to be genuinely low cost: • Virgin Express suffers from high Belgian labour costs, and from inheriting overheads from the predecessor charter airline • Debonair attempted to operate in the middle-ground, offering some frills • Buzz suffered from a mixed, unsuitable fleet and from inheriting overheads and higher costs from KLM UK • costs per 000 ASK for KLM UK were £84 in 1999-2000 (easyJet £49)

29. easyJet is lower cost – but only Ryanair is really cheap • Differences in strategy between easyJet and Ryanair are becoming clearer: • easyJet primarily uses new aircraft; Ryanair usually has not (although has recently placed a very large order for new 737s) • easyJet aims to build frequency, Ryanair generally just to expand its network • easyJet usually flies to major airports – Ryanair airports may be 100km from the cities they serve. But easyJet faces problems of congestion (Gatwick, CDG) • easyJet’s customer service is better (eg. limited compensation for delays) • These differences are apparent in the marketing strategy of the airlines. easyJet is overtly targeting business passengers: • Business passengers help offset the fact that most leisure passengers want to travel during weekends and peak holiday periods • As a result, easyJet’s costs per passenger are about €20 higher • easyJet’s ‘intermediate’ strategy makes it more of a threat to established airlines, but also carries more risks

30. Strategies may diverge further • Ryanair says US evidence shows that the “cheapest always wins” but this is not true: • JetBlue is overtly pursuing an ‘intermediate’ strategy which distinguishes it from airlines such as Southwest - new planes, leather seats, generous legroom, live satellite TV • Very successful and profitable • Demonstrates that cost efficient and cheap are not the same • There may be a gap for a low cost but mid-service carrier: easyJet could fill this role, but it is competing with BA and others

31. What is the future for the low cost sector?

32. Low cost airlines are planning growth but there are risks • Low cost travel in Europe is still less widespread than in the US • Ryanair and easyJet are planning rapid continuing growth • easyJet grew by 21% in the year to June 2004 • Ryanair grew by 44% in the year to May 2004 • This risks leading to: • greater competition, including between the low cost airlines - Ryanair issued a profit warning last year, due to lower yields and lower load factors • capacity constraints in Southeast England • management/operational problems as low-cost carriers grow into very big airlines • direct competition with major Continental airlines • General risks to the aviation sector could hit low-cost airlines harder • Aviation fuel tax / higher airport charges

33. Traditional airlines have responded • Low cost yield management systems are being copied: • BMI has adopted an economy-class ticket structure quite similar to easyJet’s • BA has also copied elements of easyJet’s pricing system although it is much more restrictive and absurdities remain • Eurostar has also copied it, but incompletely (arguably, inadequately) • They are also trying to cut costs: • Travel agent commissions have been cut, usually to zero • Most booking now online • Wider use of e-tickets (large surcharges for paper tickets) • BA has standardised on two aircraft types at Gatwick • In America, established carriers cut costs significantly in response to low cost airlines

34. Most growth will be outside the UK • Low cost services are limited in most big Continental European cities, although bases are being developed at: • Amsterdam, Geneva, Dortmund, Berlin and Paris (easyJet) • Rome Ciampino, “Barcelona” Girona, Brussels Charleroi, Frankfurt Hahn and Stockholm Skaavsta (Ryanair) • Low-cost services at Paris, Copenhagen, Milan and Madrid are still limited Low cost market share by country, 2003

35. This is harder than expanding from the UK or Ireland • Continental European governments may do more to protect their ‘flag-carriers’ than the British or Irish government: • Ryanair has recently been prevented from advertising Dusseldorf “Weeze” airport • easyJet has found it difficult to obtain slots at Paris airports • Ryanair forced to withdraw from Strasbourg Airport after a French court ruling • Charleroi ruling may significantly impact on Ryanair (but not yet) • LCAs are also facing very strong competition, particularly in Germany - some incumbents are prioritising market share over profit • Ryanair still makes most of its profits on UK-Ireland routes

36. The air travel market is more limited • To compete for business traffic, LCCs need to build frequency, but this is difficult on routes other than from London, because there isn’t enough demand • London is a uniquely strong base market: large population and business centre, high incomes, low car ownership, on an island, bad/expensive rail services, congested roads, bad weather • More people in southern European countries take their holidays at home - so no need to fly • More dispersed origins and destinations mean more flights require interchange, but LCCs handle point-to-point traffic only; will low cost network carriers emerge? • Trains, buses and private cars in a better competitive position: the need to cross the Channel means surface travel is slower and more expensive from the UK.

37. Low cost airlines also compete with charter carriers • easyJet and Ryanair offer a number of routes to airports previously dominated by charter carriers (Malaga, Palma de Mallorca, Ibiza, Alicante) • However, charter carriers have several advantages: • operating costs equivalent to or below low-cost airlines, partly due to even higher aircraft utilisation • sales and distribution costs close to zero • load factors of 95% or higher • now selling seats to scheduled passengers • zero frills (food/drink) becomes less attractive on routes of 3+ hours • LCCs have taken significant market share from charter carriers, but as low fares were already available in these markets, less scope for growing total market size

38. The ability to offer low fares is under pressure • Ruling at Charleroi could significantly increase ticket prices, if upheld: many of Ryanair’s airport deals may be illegal, including perhaps some in the UK • Airlines now required to offer compensation, removing another of Ryanair’s cost advantages, although this is being challenged in court: • Free food, telephone calls and accommodation for cancellations/major delays - even if the airline isn’t responsible (eg. weather) • €250 cash compensation for most flight cancellations • Ryanair is now forced to pay for wheelchairs and has imposed a “wheelchair surcharge” on all passengers at Stansted and Gatwick • In the future, if airlines are required to contribute more to the environmental costs they impose, this will have a significant impact - although high speed rail travel also has significant environmental effects, over equivalent distances

39. Summary • Costs are genuinely lower - and need to be if a low cost carrier is to survive • Yield management has been transformed and the LCA approach has been copied by many other transport operators, but often inadequately • Market growth has been spurred but some passengers have transferred from established airlines and surface transport • Both full-service airlines and rail companies have to cut costs to compete; this is difficult - for railways, perhaps impossible • There are clear differences in strategy between easyJet and Ryanair. easyJet’s strategy is riskier, both for it and for the established carriers. • Charleroi ruling and other legal requirements a risk to Ryanair • Low cost airlines plan further expansion but this entails risks • Smaller low-cost carriers are likely to fail or be merged into the larger carries