Latin America: The Next Growth Market for Low-cost Air Carriers

VivaAerobus (1)

Airbus builds roughly half of the world’s jet airliners, including the largest passenger plane, the A380. It may come as a surprise, then, to hear that the biggest order for France-based Airbus aircraft ever made in Latin America comes not from stalwarts such as Brazil’s LATAM Group or Colombia’s Avianca, but by a carrier that specializes in short runs between Mexico City, Monterrey and small domestic destinations: VivaAerobus.

In late October, VivaAerobus placed an order for 52 A320s, Airbus’s signature medium-range plane, which is able to carry up to 220 passengers. It was a huge purchase for a company with only one international destination. But a look into VivaAerobus’s background provides some context: The company is a venture by one of Europe’s most prominent low-cost carriers, Ryanair, and the large Mexican transportation company IAMSA. “This decision will support our growth strategy,” said VivaAerobus CEO Juan Carlos Zuazua in a news release, “as it will allow us to further reduce our industry-leading fares and will increase the cost-per-seat advantage we currently have among our competitors.”

The cost per seat on VivaAerobus planes is key to its growth strategy because the company is trying to win business by capitalizing on the relative dearth of low-cost airline carriers in Mexico and Latin America in general. In fact, there are so few discount airlines in Mexico that VivaAerobus is not so much competing with other airlines as it is with a division of one of its parent companies, IAMSA. That company is the largest bus operator in Mexico. Bus travel has long come to symbolize domestic and regional Latin American transportation: Picture an aging bus puttering up the hills of Colombia or through Mexico’s desert, complete with luggage and goods tied to the roof. But the length of travel and relative high cost of those bus trips has created an opportunity for discount airlines, observers say.

For every publicized success story, the remnants of dozens of failed discount airlines are rusting in airport hangars.

With a population approaching 600 million, Latin America and the Caribbean are among the world’s markets that are most underserved by low-cost airlines, a category defined by various factors, including cheaper fares, few frills, one-class cabins and, in some cases, Internet-only ticket sales. Only six such homegrown companies exist in the region. That has made Latin America one of the most promising growth markets for low-cost carriers, according to analysts. Development of the industry could radically alter the region’s infrastructure system while spurring economic growth in previously isolated areas. But experts warn that building out the discount carrier market is more difficult than the companies might expect. For every publicized success story, the remnants of dozens of failed discount airlines are rusting in airport hangars.

Huge Potential

For many, the embodiment of low-cost carriers is Southwest Airlines, the U.S. company that turned profits when major carriers were losing money, and made flying on a budget, if not glamorous, at least trendy. Following U.S. airline deregulation in 1978, Texas-based Southwest began to make a market by focusing on direct flights to often underutilized airports at a fraction of the fares being charged by large, better established carriers. It was not the first low-cost carrier, but the firm’s success spurred others around the world to follow the model.

The trend, however, did not penetrate much of Latin America. Low-cost carriers are found only in Brazil, Mexico and Colombia, according to an analysis published in the journal Airline Leader in September. U.S. and European discount airlines do serve destinations in Latin America and the Caribbean, but there are a number of countries, including Chile, Peru and Panama, that have virtually zero presence of such carriers.

The Australia-based Centre for Aviation reported that Latin America “provides huge growth opportunities for low-cost carriers, given the region’s expanding middle class and minuscule [low-cost carrier] penetration outside the two largest domestic markets” of Brazil and Mexico.

According to the center, discount air travel in the region has the potential to grow much in the way it did in Southeast Asia. That region counts 22 low-cost carriers, the center says. “Demand is growing, driven by strong economies and a push to bolster regional trade and rely less on the traditional economic ties with the U.S. and Europe,” the center wrote in a report on air travel in the region earlier this year.

The growth of low-cost air travel in Latin America is already benefiting the bottom lines of aircraft manufacturers. VivaAerobus’s purchase of the Airbus aircraft was an example of the massive demand for new planes in Latin America. Airbus predicts that Latin American airlines will order 2,307 new aircraft by 2032 to meet traffic growth. The manufacturer estimates that air traffic in the region will grow at an annual rate of 5.2% over the next 20 years, faster than the worldwide average of 4.7%. It attributes that growth to the rise in the middle class and residents having more disposable income, particularly in large economies such as Mexico and Brazil.

Air vs. Bus

The middle class grew by 50% in Latin America in the past decade, according to World Bank figures. And a larger middle class — it now represents 30% of the region’s total population — means changes for the transportation market.

As a result, low-cost carriers are not just competing with existing airlines, but also against long-range bus companies. The Wall Street Journal recently compared the cost of travel for popular city-to-city routes in Brazil, Colombia and Mexico, the three countries with discount carriers. The newspaper found that low-cost carriers were significantly cheaper than large airlines (fares were less than half), and, perhaps surprisingly, cheaper than taking the bus. For example, the Mexico City to Reynosa journey cost $78.50 by bus and only $45 on a discount carrier, the Journal reported. The trip was also drastically shorter — 1.5 hours on a plane compared to 12 hours by bus.

Competing with those long-haul bus lines has helped Mexico’s low-cost airline Volaris grow rapidly since it began operations in 2006. In seven years, the carrier has grown from operating five routes to 95 routes and increased its fleet to 44 aircraft from four initially. The airline currently serves 33 Mexican cities and 13 destinations in the U.S. In October, the airline said it served 608,000 passengers, up 27.5% year-over-year.

“People in Mexico wanted to travel, but they couldn’t because of the high fares. That’s when we saw the opportunity to create a low-cost airline,” says Volaris’s head of investor relations, Andres Pliego. “When you look at per-capita air trips, Mexico is well below the world average, and that’s because of the huge local market of bus passengers. Therefore, we made a business model that would serve this market.”

“When you look at per-capita air trips, Mexico is well below the world average, and that’s because of the huge local market of bus passengers. [We] made a business model that would serve this market.” –Andres Pliego

Today, Volaris has captured 25% of the Mexican market, Pliego notes. “A key factor for our success is that along with our low-cost strategy, we were the first to implement the point-to-point model in our country, connecting destinations directly without the need to go through a central or hub airport.” Pliego adds that the company hopes to use that approach, similar to the one employed by Southwest, to expand domestic and international offerings, eventually adding flights to the Caribbean, Central America and Canada.

Volaris’s success pushed IAMSA, the bus line operator, to launch VivaAerobus in 2006. Together, Volaris and VivaAerobus are seen as a major reason why Mexicana, one of Mexico’s two major carriers along with Aeromexico, went out of business in 2010. The growth of Volaris, which successfully launched an initial public offering on stock exchanges in Mexico City and New York (NYSE) in September, is an example of the demand for low cost carriers in Latin America, Pliego says.

“Traditionally, there were only big legacy companies that offered high fares. That generated a dynamic where there was a constant flow of passengers that didn’t grow,” he notes. “Now, what I think is changing [that] is the proven success of business models like ours. Low-cost carriers like Volaris provide people the opportunity to travel to their destinations for the same price as a bus. This clearly stimulates the aviation market and the passenger flow.”

A ‘GOL’ in Brazil

The hands-down leader of the six Latin America-based low-cost carriers is Brazil-based GOL Air Transport, which began commercial operations only a decade ago. It now has capacity to shuttle just over one million passengers per week. The airline was launched by Grupo Aurea, which also runs one of Brazil’s largest intercity bus companies.

The company opened for business just as major changes were being put in place in the Brazilian aviation industry. Regulators in 2002 moved to deregulate fares, which had previously been set by the government. GOL took advantage of this change by competing on a cost basis. Its first flight was between the capital, Brasilia, and Sao Paulo. Since then, GOL has captured a significant share of the domestic market by offering discounted fares between major Brazilian cities.

Today, GOL is the second-largest Brazilian airline behind TAM, one of the carriers that makes up Latin American leader LATAM Airlines. GOL represents 47% of all low-cost carrier capacity in Latin America, according to the Airline Leader study.

The effect of GOL’s growth has been to increase the total market while cutting the fare price, creating a more competitive sector in the country and setting it on a track for growth. Since 2002, the average fare on major routes in Brazil has been cut in half, according to Brazilian Association of Airlines president Eduardo Sanovicz.

“As you look into these success stories, what you see is a very small number of carriers, such as Southwest, Spirit and others, that have been successful.” W. Bruce Allen

“As the average ticket [price] goes down — and there was a period that we have been living through since 2003 with social inclusion and an increase in the average income of the Brazilian people — there was an enormous difference in the Brazilian aviation threshold,” he notes. “We went from 30 million air tickets sold in the country in 2002 to something like 100 million air tickets sold here in 2012, including domestic and international. This transformed [Brazil] into the third-largest domestic market” in the world, behind the United States and China.

Sanovicz predicts that the country is on track for even more growth. By 2020, he adds, the Brazilian market will have more than 200 million active passengers, and the airline industry will add as much as 2% to future gross domestic product.

Felipe Monteiro, senior fellow at Wharton’s Mack Institute for Innovation Management and a professor of strategy at INSEAD in France, says the growth in air travel is directly linked to the economic strides made in Brazil. “The role of the emerging low-middle class in Brazil — and we are talking about approximately 40 million people in 10 years [entering the middle class] — was critical to increase the demand for regional travel,” notes Monteiro, a former senior analyst at Banco do Brasil. “When you take regional flights in Brazil, it is common to see many first-time travelers.”

Yet, for all the opportunity there appears to be in Brazil, the domestic market is dominated by a handful of companies. In 2012, just four airlines, including GOL, accounted for 99% of all air ticket sales made in the country.

And GOL’s success hasn’t caused discount carriers to rush into Brazil. The one company that followed, Azul, has grown steadily. Launching commercial operations in 2008, Azul has moved quickly, capturing 17% of the domestic market in the first seven months of 2013, according to the Brazil Association of Airlines. Azul moved in May to expand its fleet and destinations by offering an initial public offering to raise cash. However, the company withdrew the offering in August as a result of the slowing Brazilian economy, saying that it would reintroduce the IPO when the economy improves, possibly next year.

Potential Hurdles

Issues such as raising capital and fighting with larger carriers are serious potential obstacles for incoming low-cost carriers in Latin America, says W. Bruce Allen, a professor emeritus of business economics and public policy at Wharton. “As you look into these success stories, what you see is a very small number of carriers, such as Southwest, Spirit and others, that have been successful,” he notes. “Compare them to the hundreds that have gone out of business because they couldn’t provide the service, burned through the cash and, basically, couldn’t compete with the big guys.”

Allen adds that the barriers to entry in the low-cost market are lower than ever. “You can lease planes, you can lease your space at the airports, you have the passengers paying the fees for air traffic control; the costs can be very low.”

Allen, however, points to the Asian market, particularly India, as an example of a region where low-cost carriers flooded a once-promising market. “Certainly in Latin American countries, the middle class is growing, and that’s what happened in India, where you have 1.2 billion people, many of whom became middle class fairly quickly,” he notes. “All these new carriers came in, and all of a sudden you could go to all these places in India very cheaply.”

But not long after commencing operations, several of the splashy entries to India’s low-cost market shut down, including Kingfisher Airlines, which had the backing of one of the country’s largest conglomerates. In India’s experience lies a lesson for Latin America, Allen says. “Once you begin operating, the reality is that it’s hard to make it work.”

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