The European airline sector seems to be taking off. Good omens include the approval given to the merger of Holland’s KLM and Air France; the historic earnings figures of British Airways, and the line-up of services recently launched by flagship carriers for their preferred customers.
The other side of the coin involves the low-cost carriers. The foundations of their business have been shaken by the European Commission’s decision opposing the financial assistance provided by Belgium’s Charleroi airport for Ryanair, the leading low-cost carrier in Europe. That decision has become the starting signal for an entire round of measures that the Commission is expected to carry out to avoid unfair competition in the low-cost sector. Already, Michael O’Leary, chief executive of Ryanair, has warned that ticket prices will rise by about 10% because of the decision by Brussels.
On February 3, O’Leary told Bloomberg News that “throughout Europe, the price of tickets will rise. Even commissioner Loyola de Palacio says it will be between 6 and 8 euros. If she says it’s between 6 and 8 euros, then it will probably be twice as much. In Charleroi, it is going to be more than that.” The average price of a round-trip on Ryanair is about 80 euros.
“Two different things are happening in the European air market,” notes Josep Francesc Valls, a professor at the Esade business school. “On the one hand, there is a process of concentration on the part of big airlines, and their economic success. On the other hand, there is an inevitable redefinition of the low-cost model.” José Mario Alvarez Novales, a professor at the Instituto de Empresa, says, “The market is maturing, and we are going to see more mergers among flagship carriers. Meanwhile, in the low-cost sector, only the best companies will survive.”
For Bruce Allen, professor of business and public policy at Wharton, America’s Southwest Airlines provides the model low-cost airlines must follow. “[Southwest] operates outside the great operational centers of air traffic – the so-called hubs – and it provides a very profitable service. If companies can provide low-cost services, they will survive. My doubts are about the new companies. Will they be able to survive the crucial first five years?”
In recent years, the low-cost market has boomed, and this kind of company has proliferated throughout Europe. Volare, German Wings, Hapag-Lloyd Express and Air Madrid are some examples of new competitors that have entered the market. “These new companies have new airplanes and staff. But many new airlines have been unable to go beyond their first cycle of maintenance. To the extent that their airplanes get older, they require more spending on maintenance. And to the extent that the company also gets older, its staff requires higher salaries. Will they be able to survive? Southwest has shown that it can be done,” says Allen.
To maintain low fares, airlines “buy only one model of plane. It is a model that the big companies don’t want or they have not been able to buy, but which has already been ordered,” he adds. “To avoid surplus inventory, airplane manufacturers sell these models at a discount of between 25% and 30%. Moreover, since the carriers use only that model, they can put more pressure on suppliers of replacement parts than if they had a fleet divided into various models. Choosing small airports, far away from big cities, gives them another competitive advantage. To that, you can add the incentives that low-cost carriers get from regional governments who want them to start serving secondary airports.”
Lights and Shadows at Ryanair
In Europe, Ryanair is the dean of low-cost airlines. Founded 19 years ago, it is remarkable for having grown year after year and for never having lowered its profit projections. Never, that is, until last January 28 when O’Leary admitted that revenues for this year will fall by 10% to 215 million euros because of aggressive price cutting and growing competition in the sector, according to Expansión, the Spanish business publication. In the 2003 fiscal year (ending in March), Ryanair earned 239.4 million euros, up 59%. Meanwhile, its revenues shot up by 35%, to 842.5 million euros.
With its presence in 16 countries on 146 routes, Ryanair has always defended using regional airports as a formula for maintaining low costs. “It is very important for small cities that companies like Ryanair choose them, since they bring in major investments and new jobs. As a result, it’s understandable that regional authorities would try to win over the company through aid and subsidies, as Charleroi did,” notes Valls.
Brussels doesn’t share that view, and it has criticized assistance that allowed the airline to save half the cost of passenger airport fees. This came in the form of government subsidies for using connections to Europe and for lodging costs of company personnel. In contrast, Brussels has given its approval to that part of the assistance given to boost business activity in the Charleroi airport.
Experts are divided in their reactions. Novales defends the Commission’s viewpoint “because [Brussels] attacks those assistance programs that discriminate against competition.” In contrast, Valls believes that “much remains to be played out in this decision. I don’t think things will end here because public assistance programs are so widespread among low-cost airlines. In my view, they can present these subsidies as totally legitimate assistance for growth so long as the funding involved is channeled as investment to develop the economy of the region.”
The outcome of this conflict can mark the inflection point for the business model of low-cost airlines to the degree that Brussels winds up being either more — or less — strict about regulating [government] assistance programs. “In the medium term, there is going to be severe price competition, which will lead to the disappearance of low-cost companies that don’t know how to manage things effectively,” predicts Valls. Moreover, low-cost airlines will be competing increasingly against big airlines that have also entered the low-cost market either by lowering fares or by creating a second airline that offers lower prices. “The concept behind low-cost companies is extremely clear. In earlier days, traveling by plane was something very expensive but we are now undergoing the mass marketing of air travel, and we can’t turn back the clock. The market will become more stable and mature, and new entrants will have to compete harder because there will be alliances and mergers,” he adds.
New Horizon for Flagship Airlines
For the airline sector, the past two fiscal years have been marked by the attacks of September 11, the war in Iraq, and the slowdown of the global economy. The last three years have also been notable for increased fears about flying, lower levels of consumer spending, and cost-savings efforts on the part of companies in this sector. But the shoe is now on the other foot. As Allen notes, “British Airways has announced record results.” Between October and December 2003, BA earned 83 million pounds sterling, compared with 13 million pounds for the same period during the previous year. This spectacular increase stemmed from renewed demand for its trans-Atlantic flights, as well as lower personnel costs. “If the flagship companies bounce back with energy and renewed resources, they can still make up for lost ground.”
Allen recalls that at the end of the 1970s, “many new American companies failed right after they got into the airline sector. They overestimated demand and they underestimated costs. They didn’t have enough capital, and they entered segments where they did not have a competitive advantage. Meanwhile, flagship carriers knew how to respond. Ultimately, the big groups were stronger than their adversaries, and knew how to attack them with renewed resources.”
Now history could repeat itself. For leading airlines, prospects are about to soar, given the recovery in demand and significant investments carriers have been making. A key area is in business class and first-class service, the most expensive and profitable travel. At the recent International Tourism Fair, which takes places each year in Madrid (Spain), firms such as British Airways, Spain’s Iberia, and Germany’s Lufthansa presented their new offerings in the competition to provide the most exclusive, most comfortable seating. The goal is to attract the most elite segment of the traveling public.
Clearly, British Airways is counting on the only armchair that converts into a totally horizontal position. Iberia is appealing to travelers on the basis of the additional six centimeters of width in its new seating. Lufthansa is putting its focus on technology built into its new luxury armchairs, which provide massaging effect to passengers who pay up to 1,300 euros for each ticket. To bring their luxury classes up to date, each of these flagship carriers has invested between 100 million and 300 million euros. The indispensable requirements of their new fleets include telephones, Internet access, and larger television screens.
To pay for these costly upgrades, airlines are cutting back on the benefits they provide in tourist class. Air Europa, a Spanish firm, has eliminated all meal service, much the same way as low-cost airlines have dropped it. Iberia will do likewise beginning in March. In addition, Iberia will cut one stewardess from the flight crew of each plane. As a result, 400 staff members will be relocated in other aircraft where the airline will augment its menu of services – 13% of its international flights, 9% of its European flights, and 3% of its domestic flights.
“Betting on business class is the right thing to do,” emphasizes Novales. “In my view, the low end of the market is still going to be dominated by low-cost airlines, because the big companies cannot sustain a general policy of cost-cutting. In their case, the battle involves differentiating themselves by quality and brand segmentation; and by using the cheapest planes for short trips.”
Adds Allen: “If each company finds its competitive advantage in the market, there is no reason why the two business models cannot coexist. In general, all goods and services involve some consumers who are looking for higher quality and are ready to pay higher prices, and other consumers who demand lower prices and lower quality. Markets support this divergence, and there is no reason for the airline sector to be any different.”
Threatened by a Storm of Mergers
Experts agree that the future of this sector will depend on this model of coexistence. Flagship carriers must find ways to differentiate themselves in terms of quality and compete for the high end of the market, which requires more investment but is also more profitable. Meanwhile, low-cost companies will continue to maintain their dominance in the low end, which will be increasingly competitive and harder for new players to enter.
A third variable – airline mergers – is also going to play a role. Now that the skies have been opened wide, the big carriers must deal with infrastructure, staffing and maintenance expenses that are too high to sustain. “Until now, they have maintained this way of doing things because they were based on unilateral agreements. Flagship airlines enjoyed the best flight schedules as well as exclusivity [to routes]. But this model has been broken by the European Union and by free-trade agreements. To survive, the old monopolies have had to make their international flights more expensive, and they have lowered fares on their domestic flights,” explains Novales.
The recently approved union of KLM and Air France has created a European giant with an annual turnover of 20 billion euros and 62 million passengers. The new entity is the largest airline in the world in terms of revenues, and the third-largest in terms of passenger traffic. Alitalia, the Italian carrier, also enjoys a commercial alliance with Air France, and it could join in this agreement. On the opposite side of the aisle, Iberia and BA are looking at this new entity with a magnifying glass, aware that they might have to take the next steps. Although the analysts believe that the merging of the two companies will take place, the president of Iberia, Fernando Count, gave assurances on February 24th, during the annual presentation of results, that “we are not considering a fusion with BA”. In his opinion, the commercial alliance that is already in place with BA “is better than a merge”. Also, profit at Iberia has fallen 8,7% in 2003, to 145,8 million euros, this was caused by “the low fares offered by the low fare airline competition and by the excess of capacity/seats that has transformed the situation into a price war”, said Count.
Already Brussels has given the go-ahead for creating that grand alliance [of Iberia and BA]. It would be similar to a merger but without any exchange of shares, even though BA already controls 9% of Iberia. The merger of KLM and Air France serves as an example, allowing the companies to take notes and draw up an arrangement that might work out better. Above all, the changes could involve the kinds of limitations placed on Air France and KLM by the (EU) Commission. These included 94 scheduled takeoffs and landings that Air France and KLM were forced to hand over [to other carriers] in such locations as the Netherlands, France, the United States and Italy.
“All sorts of similar arrangements are going to be created over the next few years because Europe is moving towards an open-skies policy where there won’t be economies of scale that allow companies to cut the cost of buying equipment, maintaining airplanes, deploying information systems and so forth,” emphasizes Novales. Nevertheless, Allen warns, “problems can crop up when they try to integrate different corporate cultures.” As a result, “I am not sure if mergers are the answer for the big companies.”
For the time being, the answer to that question remains up in the air.