Low-cost carriers: Ready for battle

By Graham Dunn

Low-cost carriers have thrived, at least in terms of proliferation, since the post 9/11 and SARS downturn struck the airline sector in the early part of this decade. Profitability though has not necessarily accompanied this growth and some weaker carriers appear at risk ofending the decade amid this more severe downturnwithout having made hay in the good times.

The latest Airline Business low-cost carrier financial survey shows clear signs of how the impact of the crisis began to hit carriers in 2008. The data, covering the financial performanc of 30 of the world's leading low-cost players, shows no let-up in revenue growth. All but one of the selected carriers enjoyed increased revenues in their latest financial year over the previous year, and all but one of those enjoyed double-digit growth. Profitability however shows a different picture. At an operating level ten of the carriers posted a loss in 2008 compared to four in 2007. And only a handful of those with financial figures ending December 2008 managed to better their 2007 operating financial performce.

This group, at least those with deep enough pockets to sustain a slump in profitability, have generally adopted a bullish approach to theeconomic slowdown, backing the resiliance of the model and believing they will come out the other side in better shape than legacy carriers and weaker rivals.

"In a downturn Ryanair grows even more than ever before as everyone gets more price sensitive," Michael O'Leary, boss of the Irish carrier, has been saying for much of the last 12 months.

"The low-cost model is most resilient during a downturn because customer sentiment is very focused on value," says JetBlue vice-president planning Marty St George.

But are low-cost carriers any better insulated than their legacy rivals from the impact of the economic downturn? At least one advantage they hold over network carriers is access to a pool of passengers from which to try and replace low income passengers who are no longer able to justify air travel. Low-cost carriers are in the market for the cost consciousbusiness passenger looking to make their travel budgets go further.

"There is certainly a trading down effect not only in Mexico but in all countries around the globe," says Mike Szucs, chief executive at Mexican budget carrier ­VivaAeroBus. "Price is now, more than ever, the largest determinant in consumer decision making. Does this help the price leaders in the industry? Of course it does. That is not to say that demand is buoyant, but the effect certainly further reinforces the competitive advantages of the low-cost carriers."

While all budget carriers stand to benefit from downgrading business class travellers in the difficult times, those that carry many of the trappings of network carriers believe they are best positioned to tap into this market.

Virgin Blue chief executive Brett Godfrey says: "Those low-cost carriers with high frequencies, serving convenient airports, offering some business essentials such as loyalty programmes, and selling through business-friendly channels are much more likely to benefit from substitution.Our 'New World Carrier' strategy was always aimed at making it easy for large businesses and government to substitute our services for higher priced competition and the economic downturn looks like being the proving ground."

Kuwaiti budget carrier Jazeera Airways' new chief executive Andrew Cowen also believes there is "significant" trading down in evidence in the market. He cites a doubling in bookings so far this year in its business focused premium cabins, plus an increase in corporate agreements.

"Companies in this region are looking to better manage their travel costs," he says. To further tap into this market it has launched a new fare product targeted at business travellers. "This fare product is fully flexible and offers various other benefits that businessmen look for but are often not usually available with low fare airlines," he says.

Cowen adds that by meeting these expectations, the carrier is well positioned to retain this traffic. "Many of these are first time Jazeera flyers, so we hope to demonstrate that when the upturn comes, there is no need to go back to paying high legacy airline fares."

Fast growing Turkish carrier Pegasus Airlines is another that has positioned itself to cater for business traffic and general manager Sertac Haybat cites both increased demand and interest from corporate agencies.

"We do see it as an opportunity [to retain traffic wins] once they try the product," says Haybat."Normally you'd expect LCCs to carry leisure and VFR traffic, but now we are seeing more and more business traffic.

"I think more people are moving from traditional legacy airlines to low-cost carriers, and they see there is no big difference [in product]. We are not 100% a low-cost carrier, we are a low-cost network carrier. They can get the same kind of network from us."

The Istanbul-based carrier is another to have focused its marketing efforts on business class in response to the crisis, notably directing a promotional campaign earlier this year in Turkey with the message of supporting your business by taking cheaper flights.

European budget carrier Germanwings believes value is the key. "Primarily it all boils down to which airline has the best deals - cost is clearly a part of this, but so is user experience," says germanwings. "Low-cost carriers need to invest in continuous innovation to make certain that they offer the best service to ­different markets."

Scot Hornick, partner at leading aviation consultancy Oliver Wyman, says with many businesses looking to reduce travel costs, the challenge for low-cost carriers is to figure out how to tap the premium market without giving up on their principles of simplicity and alienating their loyal customer base.

"The key is to find where to selectively add commercial complexity and to do so in a manner that pays for itself," says Hornick. "The opportunities may lie in areas like codesharing, baggage transfer or frequent flyer programmes. While several carriers are seeking this opportunity, many lack the technology platforms to take it for now."

While a low-cost carriercan benefit from temptingcost-cutting business travellers, it has to hope the recession doesn't stop too many from travelling. JetBlue's St George says: "The biggest concern is on the revenue side - what will be the customer propensity to travel going forward? The impact [of the recession] on air travel is what we're watching closest."

"In the US, the booking curve has moved very close in," says St George, but adds: "People still want to go, they just don't want to book six months out in case they no longer have a job."

Other low-cost carrierexecutives reportsimilar trends. "More and more consumers are delaying purchasing decisions until the last minute, as you would expect they might when there is general uncertainty in the economy," says Szucs. "The booking pattern is becoming shorter and it's about managing this effect. We've had great success in lengthening the cycle, but that is shortening now."

Szucs also believes airlines face increased seasonality effects and will have to work to fill aircraft in off-peak periods. "The challenge for airlines is to have a profit in every quarter. Very few break the cycle," he says. "What I see happening is the peaks will continue to book well, but consumers might not take other trips. The peaks will undoubtedly hold up well, but it needs more stimulation to get people into the off-peak."

Price then, the chief weapon in the armoury of low-cost players, remains as key as ever in stimulating demand. "Price is everything," says Szucs. "Price remains the principle driver of purchasing decisions for short- haul travel. It is effectively a commodity after all, so lowest price will win. With fuel much lower than before we are able to offer lower prices than ever before and these are stimulating the demand levels we need."

Godfrey adds: "Travellers will always respond to price, even in a severe economic downturn, as we have found out in launching several new leisure routes. In established markets it seems that the discount has to be larger than before to get the same uptake, but by launching new routes that have not previously enjoyed low prices we seem to be able to maintain better stimulation bang for the discount buck."

Szucs adds: "The [true] LCCs are incredibly well placed. We can put a low price out there with our cost base and sustain it."

A low cost base has always been critical to low-cost upstarts and despite work by network carriers to reduce their own cost base, the indications are that their lower cost rivalsare more than retaining this edge. A recent study of US carriers performed by Oliver Wyman shows that the unit cost gap between the network and low-cost players has in fact widened, rather than getting narrower as might have been expected as the network carriers hack at their own cost bases.

Hornick says: "The study shows low-cost carriers have been just as much, and often even more aggressive than network carriers in their cost cutting. The study shows that for these low-cost and hybrid carriers the constant drive to reduce costs is second nature."

These cost bases were in part helped by sourcing aircraft at low prices from the manufacturers during the post 9/11 downturn. This, together with moving in on the ground surrended by retrenching network carriers, are the opportunities carriers benefited from during the last downturn.

ButGodfrey suggests the opportunities for low-cost carriersspecifically should not be overstated. "I'm always suspicious of low-cost carrier CEOs who saywhat a wonderful opportunity a recession is because the fact is most low-cost carriers were born during the most recent boom and have no experience of a recession in their particular market and certainly not in a recession of this scale," he says. "I don't think there are many opportunities that are unique to low-cost carriers that are not also available to better managed legacy carriers - why would only they presently be in a position to secure good deals with manufacturers for example?"

As happened in previous downturns, airlines have been scaling back growth plans and withdrawing capacity, prompting a softening in the aircraft market. Ryanair, among the carriers to benefit from striking alarge order deal in the last downturn, has already indicated its interest in doing so again.

"There are opportunities in the aircraft market," says Pegasus' Haybat. "More and more aircraft are available from manufacturers and lessors. We do see this as quite a big opportunity for growth."

But a key difference in this downturn is the crisis in the financial markets. Aircraft maybe readily available, financing is not.

"As a country Turkey is entitled to Ex-Im financing, so we don't see any problems on this part of the financing as long as you have the export agencies behind you. The more difficult part is the pre delivery paymentand unguaranteed portion. So you have to havegood cash flow to support PDP payments as the PDP financing market is dead."

Szucs adds: "Certainly it is a good time for anyone to acquire aircraft, lease rates have fallen and the OEMs will have capacity." But he notes: "18 months ago banks were lining up before you, now there is no finance. Part of the issue is availability of aircraft. That availability is now there, the issue is accessing it. Either you've got your own cash or you've got to create your own means of getting the funding. The manufacturers have a key role to play in trying to provide forms of funding to enable the carriers with successful models to grow into the space."

Deep pockets and strong funding are not only key to exploit opportunities in a downturn, but also for survival itself. A number of low-cost carriers[see box story]were among the airlines that collapsed last year amid the pressure of high fuel prices and the financial crisis. Others quietly moved out of the sector.

But while consolidation among network carriers grew apace last year, there appears little appetite for consolidation in the low-cost sector. For most the complexity of merging different carriers and organisations outweigh the benefits of merging. The mergers there have been in the sector have largely been strategic - primarily based around gaining access to slots at key airports or, notably in Asia, to gain access to markets restricted under bilateral air service agreements.

One high profile merger that is going through at present is the tie-up of Spanish carriers Vueling and Clickair. Here though the process is eased as both operate from ­Barcelona - which has recently seen a flood in capacity- and Airbus narrowbodies fleets.

"If you look in the EU, I can't see any advantage for big low-cost carriers swallowing the small carriers, as they can base aircraft where they want [because of traffic rights]," says Haybat.Pegasus' parent ESAS has itself just acquired a minority stake in Germany's Air Berlin. But he describes it as a strategic move for the investors and notes there are no co-operation plans between the two carriers.

Most see mergers unlikely to drive growth, instead sector consolidation is more likely through airline casualties. Godfrey says: "In the present environment it is probably better to simply let some failing capacity come out of the market to relieve pressure on revenues than go through the expense and distraction of a takeover/integration unless there is some strategic objective that existed before the global financial crisis and economic downturn."

Budget carrier Norwegian, which had experience of merging a carrier through its purchase of FlyNordic, ruled out a move for Sterling before its collapse, instead preferring to launch its own operation at Copenhagen.

In the longer term Godfrey expects fewer low-cost players, but those remaining to take larger shares. "I suspect if the present conditions continue through 2009, there are a good many carriers in both Europe and in the US, that don't have pockets deep enough to get them through and they'll be steamrolled."

Neither are carriers immune to market conditions which has seen carrierscurb recent growth. Across the globe low-cost carriershave been among those cutting capacity or curtailing planned growth - even if only on a temporary or seasonal basis. This has seen established low-cost playerssuch as European carriers Ryanair and easyJet slow growth plans over the winter, Virgin Blue cut capacity in the Australian market, and US carriers AirTran, JetBlue and Southwest Airlines all trimmed capacity for this year.

"The airline industry has been retroactive at adjusting its size," says St George. "JetBlue will be shrinking, but we've been a growth company from day one. Low-cost carriers are now talking about shrinkage because of a duty to shareholders. The industry is more attuned than it has been historically."

Low-cost failures

A number of low-cost carriers were among the many airline casualties during 2008, as high fuel prices, the financial crisis and ultimately falling demand took its toll. Collapses came across regions and business models, though in many cases other carriers have moved fast to fill the void.

In Europe the highest profile casualty was Scandinavian budget carrier Sterling. The Copenhagen-based carrier, which generated revenues of $719 million and carried 4.3million passengers in 2007, was already struggling when its Icelandic parent was caught up in the financial crisis last autumn.

The void left at its Copenhagen base was swiftly filled as first Norwegian and Dutch leisure carrier Transavia, moved to fill the gap, before Denmark's Cimber Group which had acquired some of Sterling's assets relaunched it at Copenhagen under the Cimber Sterling brand.

In the US market high profile casualties last year included budget operators ATA Airlines and Ohio-based Skybus Airines in the spring of 2008. ATA, which carried 2.7million passengers in 2007, was forced to halt operations and file for bankruptcy protection in April after losing a key military charter business contract. Southwest Airlines, which formerly codeshared with ATA, later acquired ATA's slots at LaGuardia Airport to launch its entry into the New York City market.Southwest has just announced it will use the slots to provide five daily flights from LaGuardia to Chicago Midway and three daily flights to Baltimore Washington from the end ofJune.

Other casualties last year saw two of the fledgling long-haul low-cost ventures fall. Early in the spring of 2008, Boeing 747-400operator Oasis Hong Kong suspended flights after just 18 months of operations. In August transatlantic low-cost carrierZoom -which had operations in Canada and the UK -was forced to suspend operations after its refinancing efforts failed.

Other casualties in the budget airline sector last year included Mexico's Avolar.

---