Around the World on $48 (or So): How High Can Discount Airlines Fly?

As two more major airlines, Delta and Northwest, file for bankruptcy protection, it’s the discount carriers that appear to be winning the battle for America’s skies. Southwest Airlines, JetBlue, AirTran and other low-fare carriers are poised to capture even more market share at the expense of troubled legacy carriers.

But it’s not only in the U.S. that discounters are giving the more established carriers a run for their money. Discounters are taking off in Mexico, India, China, Europe and points in between. What kind of competition do these discounters face, from the major airlines and from each other? And what obstacles, especially in countries like China, are governments and regulators putting in their way?

The U.S. and Points South

In the U.S., discount airlines have been flying rings around the major carriers for years, benefiting from more nimble management, lighter pension loads and the propensity of consumers to give up perks and convenience for significantly lower fares. But eventually, say Wharton faculty and airline analysts, the discounters — who now control more than 25% of the U.S. airline business — are likely to face a glut of seats. And that, the theory goes, will force them to compete without the cost advantage that has propelled them ahead of their more established rivals. The result could be a shakeout in the discount airline market.

With four of the country’s seven major, or legacy, airlines now reorganizing in bankruptcy court (US Airways and United in addition to Delta and Northwest), the time is right for low-cost airlines to strike. “The blood is in the water, but what worries me is that the track record of these new [discounters] is not all that long,” says W. Bruce Allen, Wharton professor of business and public policy.

Southwest Airlines, which has not suffered a money-losing year since 1972, remains the company to beat, according to Allen. Older than its current crop of discount competitors, Southwest has already had to cope with some of the difficulties of managing an airline over the long haul. Such difficulties — ranging from fuel price spikes to aging employees — have always hampered traditional airline companies. Southwest is “the most impressive,” says Allen. “It has personnel who are unionized, but it has kept its esprit de corps and its can-do attitude.” Moreover, Allen notes, Southwest has managed to do well even as it expands into larger markets, breaking from its tried-and-true business model of serving second-tier cities with no-frills flights.

Remembering People Express

While it is one thing to grab share from legacy carriers encumbered by union work rules and expensive pension plans, it remains to be seen if today’s discounters can continue to grow, Allen says, citing the case of People Express, which was founded in 1981 and reached annual revenues of $1 billion, but was near bankruptcy when Texas Air acquired it in 1986. “People Express was a darling of the business schools, but it expanded too fast with grandiose dreams and the big guys were able to swat it down.” Today, he says, the big operators are less able to quash the new competition. “But what happens when the newcomers are burdened with aging, high-maintenance aircraft and older, more demanding employees?”

Daniel Kasper, managing director at LECG Consulting in Cambridge, Mass., agrees that low-cost airlines will need “to watch their own labor costs. This is particularly germane for Southwest which, after Northwest and Delta, now has the highest labor costs in the industry,” he says. “They have been able to get away with that because they were always able to offset labor costs with higher productivity. As other carriers improve their costs and productivity, that could put pressure on Southwest.” America West, adds Serguei Netessine, professor of operations and information management, recently approved a 31% pay increase over the next four years for pilots. “Labor sees those airlines are much more profitable than traditional network carriers, and they believe they need some share in those profits,” Netessine says.

One scenario is that some of the large players will regroup and rise up to challenge the discounters. “If the large airlines are able to pare back expenses in bankruptcy court, that would level the playing field with the discounter on price and they would still have rich route structures,” says Allen. “What do I like about United? Not a lot,” he adds. “But it can take me to the Pacific and to Europe. If it came back with a lean and mean model, I’d be interested in flying. I’m a lot more interested in going to Paris than Lubbock.” In addition, there is still some value in the familiar brand names, like United and American. “There is a cachet” about them, Allen says. Many travelers are uncertain about the discount airlines and their young pilots: “They want to see a pilot with gray hair.”

According to Elizabeth Bailey, Wharton professor of business and public policy, the low-cost airlines got their foot in the door with airline deregulation and the availability of airport gates created by shrinking legacy carriers and airport overbuilding. The large airlines’ woes have also allowed discounters to get bargains on new and used airplanes, she says.

Another reason regional carriers were able to grow is that new airline technology created airplanes that could service smaller markets efficiently. Smaller regional jets have also proved to be a competitive advantage in an era of rising fuel prices, Bailey notes. Traditional carriers have been unable to pass along the increased cost of jet fuel — a 48% spike in the past year alone — because of tight competition on fares. Since they tend to fly larger, older planes, network carriers are again caught at a disadvantage compared to the discount airlines. Over the long-term, Bailey predicts that there will be fewer network carriers but also fewer low-fare competitors. “My sense is you are going to have two or three legacy carriers and two or three low-cost carriers,” she says.

A Focus on Costs, Not Revenues

The fundamental difference between the discounters and the well-known network carriers is that the older airlines focused on revenue, while the upstarts have focused on costs, notes Todd Sinai, Wharton real estate professor, who has studied the airline industry. For example, the legacy carriers’ hub-and-spoke system brought hordes of passengers into connecting hubs all at the same time. The system was convenient for passengers and drove up volume, but it also required airlines to hire large numbers of baggage handlers and ticket agents for peak times. Then, during off hours, the employees were idle.

The newcomers run point-to-point service to smaller markets, requiring passengers to travel at awkward times and wait for connections. “Southwest is reducing costs while not paying as much attention to revenues. A network carrier is maximizing revenues while not paying attention to costs,” says Sinai. “Now they are converging. Southwest is looking at revenues and the legacy carriers are looking at costs.”

Neither strategy is the clear winner, he says. “The Southwest type of strategy really depends on a market of people who put a lower value on their own time and therefore are willing to trade their time for a lower ticket price. Flying a network carrier is less time-costly — at least in theory — but more costly in terms of money.”

As the two models converge, low-cost airlines are attempting to cherry pick the most profitable point-to-point routes, such as JetBlue’s successful New York to Los Angeles service, Sinai points out. He notes that Southwest’s Phoenix service is beginning to look somewhat like a hub system with passengers transferring there to complete cross-country trips. “Where does Southwest go from here?” he asks. “Flying between tertiary and secondary markets is limited. At some point, Southwest has to tap the big markets in order to grow.”

Sinai says it is not clear whether there is enough demand to move the entire system to a low-cost, point-to-point model. “It’s hard to tell where the world goes from here. There could be enough cities that are large enough so that point-to-point is the wave of the future,” he says. “Or it could be that we will continue to live in a hub-and-spoke world. We don’t know what will happen.”

Another factor that is hard to gauge is how well the discount airlines will do in different economic cycles, since the current generation of discounters has expanded mostly in the post-September 11 climate of airline recession. “When demand is relatively low, the network carriers have a harder time making a go of it,” he says. “The low-cost carriers do well when demand is below the level [needed] to support the network carriers. The tricky thing in looking at these models is that they are successful in different times.”

Report Card on Low-Cost Carriers

Of the discounters, Southwest and JetBlue seem most likely to prevail, says Terry Trippler, an analyst with cheapseats.com. Privately held Sun Country, based in Minneapolis, is also doing well, he says, while Independence Air, based in Washington’s Dulles airport, is probably the weakest low-cost carrier.

AirTran, he notes, has successfully competed against JetBlue on its Atlanta to Los Angeles route, indicating it has a good chance to be among the survivors in a discount airline shakeout. Spirit Airlines has been able to fend off competition from Northwest and Southwest in Detroit.

Frontier Airlines in Denver will be heavily influenced by whether United Airlines can turn itself around, Trippler adds. Meanwhile he gives high marks to USA3000, which specializes in vacation flights to the Caribbean and Florida. The airline has been able to avoid heavy competition by using the airport in St. Petersburg, Fla., while competitors are all in nearby Tampa.

Trippler says mergers are likely among the discounters. He points to ATA Airlines and Southwest, which have entered a code-sharing agreement allowing Southwest’s passengers access to Hawaii and New York’s LaGuardia Airport, while ATA passengers can now travel easily to Southwest gates in Philadelphia and Los Angeles. “Southwest is calling the shots,” says Trippler. “It will be interesting to see if Southwest takes over.”

The merger of America West and US Airways will also be interesting to watch, he notes. “It’s like David acquiring Goliath.” Allen says he is concerned that the two airlines are focused on either end of the country with little in common. “I don’t see a lot of synergies that they claim exist. If there were duplicative services, they could economize and get load factor up and run fewer aircraft and cut costs, but it’s like two ends of a barbell.”

Baby Boomers Flying into Retirement

Helane Becker, airline analyst at the Benchmark Company in New York, predicts problems for discount airliners. “The shakeout is coming for the industry,” says Becker. “There is too much capacity chasing too few people who want to travel, and fares are unrealistically low.”

According to Becker, not that many cities can support the low-cost, point-to-point travel; those that do exist are already spoken for by Southwest, JetBlue and what remains of the legacy carriers. “If you are new, like AirTran, there are only a few markets to fly to. You’re not going to fly Erie, Pa., to Los Angeles; you’re going to fly Chicago to Los Angeles, New York to San Francisco, or Boston to Seattle. As the new start-ups expand they are going to start running into each other.”

Another problem, says Kasper, is energy costs. “The price of jet fuel is squeezing all carriers including the low-cost carriers,” says Kasper, although he notes that Southwest has successfully hedged against rising costs for the next few years. “It’s very difficult for any airline to be profitable when oil is at $60 a barrel. If oil were $40 a barrel the industry would be very, very profitable.” If you look back, “2000 was the last year of the big airline boom,” Kaspar adds. “Traffic is now above pre-9/11 levels, costs are down and capacity is down. Yet, as a whole, airlines are losing money. If oil were $40 or $45 a barrel, they would be rolling in dough.”

On the plus side, Netessine points to future contracts for aircraft delivery as a sign that the low-cost carriers will continue to grow beyond their current 30% market share. He says Jet Blue is adding planes, Southwest has added 100 planes over the past two or three years, and AirTran has said it will add one plane a month until 2008. “It will take a few years for the network carriers to restructure and approach low-cost carriers in their costs.” Netessine agrees that “even low-cost carriers have to start thinking about differentiating themselves from one another.” He points to America West, which offers a first-class section with wide leather seats, and JetBlue’s satellite television system. European discounters, he adds, are sticking more closely to the no-frills model than their American counterparts.

According to Becker, there is one relatively untapped market where discounters can grow — the Caribbean. As baby boomers begin to retire, they may find winter homes too expensive in Florida and coastal U.S. cities. “If there is frequent and affordable air travel,” she says, “why not Mexico? Why not the Caribbean?”

So far, with the exception of Sir Richard Branson’s Virgin flights from London, discounters have not made any headway in international travel, largely because it is expensive to fly those routes, and U.S. treaties governing landing rights at foreign airports still favor the established carriers. “The big guys seem to think this is the way to go because they don’t have to compete against the discounters,” says Allen. However, according to a report in the September 20 Wall Street Journal, the discount airline skies are about to get a bit more crowded. Two new airlines are planning to offer all business-class service between New York and London. Eos Airlines will sell luxury seats at business class prices, and Maxjet Airways is expected to offer all business class seats at big discounts. If successful, the two start-ups will launch additional trans-Atlantic routes.

Meanwhile, the rest of the world is also developing discount air carriers. In Mexico this year, the government is selling the two national airlines, Aeroméxico and Mexicana, and authorizing up to five budget airlines to begin operations. The budget airlines would likely compete with long-distance buses. In Brazil, low-cost carrier Gol Linhas Aéreas Inteligentes has captured a quarter of the far-flung population’s air travel in four years of operation.

Discount carriers “are springing up in all sorts of places,” from Australia to Southeast Asia, “where the legacy airlines are just awful,” says Allen. He points to Air India, which operates old aircraft with an indifferent staff, as an airline vulnerable to emerging competition. Air Deccan (India’s first low-cost airline), Air Sahara and Jet Airways are all now lining up to take a share in the vast Indian market, he notes, although he cites poor airport infrastructure as one major limitation to discount airline expansion. “You have a billion people whose income is about to rise and ground transportation that is horrible.”

Opportunities and Obstacles in Europe

According to Josep Francesc Valls, a professor at the ESADE Business School in Barcelona, low-cost European airlines are not very different from their counterparts around the world, except in one major respect: The borders in Europe are more restrictive than the borders within the United States, and as a result, “low-cost European airlines have a very national feel.” Otherwise, however, they rely on the same business model as the U.S., one “based on reducing their costs and using the Internet as a sales channel. This enables them to acquire a significant flow of qualified travelers who are attracted by the discounted price offers available at any given moment.”

Low-cost airlines were initially established in the United States and Europe after the deregulation of the old national flagship carriers. In Europe, this happened during the late 1990s; in the U.S. deregulation took place in 1978. “A series of companies emerged that took advantage of the opportunity to meet the needs of major segments of the market as well as niches that traditional airlines had not addressed,” says Valls, an expert on tourism. “They did this by providing lower prices.” These new airlines “are moving into the open space within the middle and lower range. They compete on the basis of low prices against both conventional airlines and charter carriers.”

The low-cost skies of Europe are dominated by three companies: Ryanair, the pioneer, which transported 24.6 million passengers last year; easyJet, which carried 24.3 million passengers, and Air Berlin, which carried 12.037 million. Valls adds a fourth player to the list — Germany’s Hapag-Lloyd Express. The three largest low-priced carriers share a bit more than half of the low-cost market in Europe. Overall, some four dozen airlines are involved in the competition. According to Valls, the low-cost market has already started to undergo a cleansing process, as shown by the 2004 bankruptcy of Volare, the Italian airline.

The big companies are “consolidating their positions while the small ones are disappearing because they don’t have what it takes to compete,” Valls says, adding that it is not easy for new players to navigate the market because of major barriers to entry. Vueling, the low-cost carrier based in Barcelona, is one of the latest companies to arrive, and it did so “thanks to the extraordinary amount of funding” behind it.

In the future, we may see at least one corporate takeover. However, notes Valls, “It is more likely that the conventional airlines that are repositioning themselves in the market will either buy out low-cost airlines or create other low-cost ones. They could position themselves as conventional airlines while also penetrating the low-cost market with a separate brand.” It now appears that Iberia, the traditional Spanish flagship carrier, could pursue such a strategy.

Valls believes that there will be changes in pricing, both in the short and medium term. “The low-cost companies, which have made a very strong effort to enter the market, must raise their prices to some degree within four or five years, much the same way that the conventional airlines lowered their prices.” The result will be a market that continues to offer a full range of prices — high, middle and low. “Some companies will address all of those segments, using different brands [for different segments]. Or they will specialize in just one,” he adds.

A “Black List” in the E.U.

In Valls’ opinion, traditional legacy carriers should not compete exclusively on the basis of price. “That’s what the low-cost airlines do, and it is very hard to take market share away from them,” he says. “Conventional carriers should focus more on providing services over the Internet, and on trying to attract those web users who buy low-cost tickets online from airlines.” Beyond that, he suggests, conventional carriers “should consolidate their strengths by using strategies of differentiation and specialization.” They should take advantage of their long experience providing customers with high-quality service. For example, they should look for ways to reduce waiting times at airports and shorten the time spent at baggage claims. “Airlines are losing their ability to provide value,” he says, referring to the low quality of in-flight service.

Airlines should also face up to clouds on the horizon for the entire aviation sector. Beyond rising concerns about fuel prices, there is widespread angst about a list of accidents that have occurred in recent months, including several involving airplanes operated by low-price carriers. For example, a Boeing 737 operated by Cyprus-based Helios Airways exploded near Athens, causing the deaths of 121 passengers, and a plane operated by Jakarta-based Mandala Airlines crashed in Indonesia, killing 130 people. This series of events has alarmed travelers and officials of the European Union, which will publish a “black list” of dangerous airlines toward the end of 2005 or early next year. Carriers whose names appear on this list will be prohibited from flying over the territory of the 25 member E.U. states.

Europe’s low-cost airlines have defended themselves during this crisis of confidence, arguing that not all low-cost carriers are alike. “Low-cost airlines in Europe are not the same thing as in other countries,” Cristina Bernabé, easyJet’s marketing director for Spain and Portugal, told Expansión, the Spanish business daily. For Valls, in matters of security, there is no reason to differentiate either by airline or country of origin. “When it comes to security, everything is strictly regulated,” he says. Low-cost companies have cut the time they need for baggage handling in half compared with conventional airlines, which spend some 40 minutes on the ground. But that achievement “does not damage their ability to handle security requirements.”

Growth prospects for low-cost airlines remain very promising. These days, 40% of all European passengers fly on low-cost carriers. Valls disagrees with the notion that the only people who go this route are travelers who have less money to spend. People choose an airline depending on the flight schedule and destination. It has nothing to do with how much money they will be spending when they get there, he says. In fact, many executives opt for low-cost airlines.

Low-cost Carriers in China: A Hard Game to Play

Over the last six months, China’s airline industry, which for a decade hadn’t registered any new members, showed sudden signs of growth. Three private airlines — Okay Airlines, Spring Airlines and United Eagle Airlines — made their debut. Even more notably, Shanghai’s Spring Airlines became the first carrier in China to offer low-cost airfares. On July 18, the opening day of the carrier, a flight from Shanghai to Yantai cost 199 yuan (about $24). The move by Spring Airlines — which is owned by Shanghai Spring Travel Agency, the largest privately-owned travel agency in China — stirred discussions in the media about low-cost airfares. In April, Thailand’s Asia Airline opened its China flights and charged 99 yuan ($12) for a ticket from Xiamen to Bangkok. The move marked the first step by foreign air carriers to launch low-cost services.

The flight run by Spring Airlines has 180 seats, none of them first class. Passengers are offered bottled water, but they don’t get free meals (although meals are available for purchase). Carry-on luggage can weigh no more than 15 kilograms. The ticketing system is not linked to China’s air information system, but developed by the company itself, and the airline plans to use only one type of airplane, which makes pilot training and maintenance easier — a strategy also followed by America’s Southwest Airlines. Indeed, Spring airlines has adopted a number of measures used by Southwest. Spring chief executive Ge Xuejing estimates that such measures can save the carrier 20% in total costs. At the same time, he says, “If we maintain a capacity rate of 85% and the airfare remains at a discount rate of 50%, we are able to break even.”

In addition, according to press reports during the World Economic Forum in Beijing in September 2004, CEOs from some of the world’s well-known low-cost carriers — including Asia Airline, Britain’s Easy Group and Australia’s Qantas — all said they believed that it’s time for them to enter the Chinese market, noting that in developed countries, an air ticket on average represents 0.5% of a passenger’s annual income, while in China the ratio is as high as 10% to 15%. This suggests a huge demand from Chinese consumers for low-cost air services.

Suddenly, low-cost air service is a hot topic. But can the concept fly in China?

“We are determined to be a low-cost carrier…” Wang Zhenghua, president of Spring Travel, told reporters at the time of the launch. But Zhu Kai, formerly with America’s Northwest Airlines and now president of Eagle Airlines, holds the opposite view. “Low-cost air is a flawed concept,” she said. The phrase should be “cost control, as every airline has the need to minimize cost.”

A substantial number of airline costs are subject to changes in the international markets. For example, aircraft are imported from the U.S. or Europe, and fuel prices fluctuate with world oil prices. Rising oil prices have already heavily burdened airlines all over the world. Southern Airlines, one of the three largest state-owned carriers in China, recently said in its semi-annual report that rising oil prices have caused a jump in its operating costs. The airline posted a loss of 843 million yuan for the first half of 2005. Citing the same reason, Eastern Airlines recorded a loss of 410 million yuan.

At the same time, tight government controls limit Chinese airlines’ ability to reduce costs. For example, because China Aviation Oil Holding Co. corners the aviation oil supply, Chinese airlines have to pay more for aviation oil than they would in the international market. In the Asia Pacific region, the fees charged by China’s domestic airports are higher than every other country except Japan. And the government’s control of routes also makes it very difficult for airlines to reduce costs by offering more flights. In addition, the General Administration of Civil Aviation of China has specific restrictions on the hiring and firing of pilots.

The costs over which airlines have control represent about 30% of the total. Given the limited amount of flexibility and the highly restricted operational environment, it’s anything but easy for low-cost carriers to compete with their more traditional counterparts and differentiate their services, industry insiders say.

In addition, they add, another important characteristic of China’s airline industry is that 70% of the business comes from 30% of the market, which includes Beijing, Shanghai, Guangzhou and a dozen mid-sized cities. It’s very difficult for new airlines to compete in those markets, yet opening other markets depends not only on an individual airline’s strategy but also on government policies and the economy.

Air Travel as a Luxury

Because each Chinese on average has less than $800 in disposable income, many still look at air travel as a luxury. Given these figures, some economists in China believe that high airfares are the key reason for a lack of passengers. But for those who do fly, is price an issue? And how low do airfares have to go in order to spur demand? In addition, is airfare the key driver for China’s airline industry?

Li Yi, an editor at China Civil Aviation, told China Knowledge@Wharton that in 1997, when airfares dropped across the board, the average ticket price was 40% lower than in 1996, but the passenger volume only increased 1% to 2% in that period. The industry broke even in 1996, while in 1997 it lost more than 20 billion yuan.

Three possible conclusions, say industry observers, can be drawn from those statistics: The first is that at least in 1997, Chinese consumers were not sensitive to price changes. Second, lowering fares is not enough to spur the market. Third, a 40% decline in price is not enough to attract passengers.

Chinese airlines started to break even in 2001, with profits of 200 million yuan. According to Li, “The development of China’s aviation industry is in direct proportion to the development of the overall economy. The overall economy entered a phase of rapid development in 2001. Since 2002, Chinese airlines have seen their passenger volume grow more than 10% each year. In 2004, the airlines were profitable. In the first half of this year, the industry incurred a loss, which was partly because of government policies and partly because of rising fuel prices.”

Li suggests that the ratio of airfare to per capita income limits air travel in China. From that perspective, she says, even though airlines try their best to lower costs and airfares, there still won’t be a jump in the number of passengers if the income level stays the same.

The year 2004 saw a record for China’s aviation industry in terms of transportation volume, which jumped 35.3% over 2003. A total of 121 million people — or one in every 10 Chinese — traveled by air, up 38.1% from a year earlier. Like the rest of China’s economy, the air transportation industry has become one of the fastest-growing industries and has attracted attention from carriers throughout the world.

At the end of July, the General Administration of Civil Aviation of China issued rules on investments in private airlines that aim to encourage private capital to flow into the air transportation industry and break the monopoly held by China Aviation Oil Holding Co. At the same time, industry participants and academic experts are calling for more improvements in other areas such as fuel prices, materials, air routes and flight schedules.

Some industry experts see the establishment of a new wave of domestic airlines. Travel agencies now invest in airlines, and there are foreign carriers eager to compete in the Chinese market. Different sources of capital will bring in different business models, leading to a more vibrant aviation market in China, the theory goes.

Yu Jianjun, an aviation industry analyst at Central China Securities, told China Knowledge@Wharton that low-cost carriers may adopt their own strategies — such as doing business in the markets shunned by traditional airlines — in order to differentiate themselves. Meanwhile, he says, China’s population and economic development both point to a bright future for low-cost carriers.

Citing Knowledge@Wharton

Close


For Personal use:

Please use the following citations to quote for personal use:

MLA

"Around the World on $48 (or So): How High Can Discount Airlines Fly?." Knowledge@Wharton. The Wharton School, University of Pennsylvania, 05 October, 2005. Web. 19 November, 2017 <http://knowledge.wharton.upenn.edu/article/around-the-world-on-48-or-so-how-high-can-discount-airlines-fly/>

APA

Around the World on $48 (or So): How High Can Discount Airlines Fly?. Knowledge@Wharton (2005, October 05). Retrieved from http://knowledge.wharton.upenn.edu/article/around-the-world-on-48-or-so-how-high-can-discount-airlines-fly/

Chicago

"Around the World on $48 (or So): How High Can Discount Airlines Fly?" Knowledge@Wharton, October 05, 2005,
accessed November 19, 2017. http://knowledge.wharton.upenn.edu/article/around-the-world-on-48-or-so-how-high-can-discount-airlines-fly/


For Educational/Business use:

Please contact us for repurposing articles, podcasts, or videos using our content licensing contact form.