Total ancillary revenue (USD): top 5 Ancillary revenue as % of total revenue: top 10 $7.3B. Allegiant. Ryanair. Spirit. Qantas. Ryanair.

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1 The Ancillary Revenue Drug Sadiq Gillani, Vice President and Head of Ancillary Revenue Practice, Seabury Group Ancillary revenues are the savior of the airline industry. These revenues now represent 12% of industry revenues for North American carriers. In an industry that is fortunate to make 10% margins in a good year, these levels of revenue represent the difference between life or death for most airlines and effectively account for the entire value of industry profitability. Airlines worldwide are estimated to have generated $13.5B in ancillary revenues in 2009, compared to $2B in 2006 a six fold increase in just 3 years, according to Ideaworks. The scale of the change is unprecedented with some airlines now charging for baggage, food, IFE, priority boarding, telephone bookings, seat selection, change fees, upgrades, lounge access and even check in. Spirit recently raised the bar by charging $45 for carry on baggage and will likely be followed by other airlines. Even premium carriers are not immune BA took the industry by surprise by becoming the first premium carrier to charge for advance seat assignments, even for business class tickets! Ancillary revenue leaders Total ancillary revenue (USD): top 5 Ancillary revenue as % of total revenue: top 10 $7.3B Qantas Allegiant Spirit 29% 24% 22% Delta easyjet 19% Tiger 19% $1.7B Aer Lingus Alaska easyjet United American United Jet2.com Aer Lingus Alaska Flybe AirAsia 18% 14% Source: IdeaWorks 1

2 How did ancillary revenues become so significant? The idea of unbundling the airline ticket first took off in the late 90s, with the emergence of a new breed of low cost carriers, pioneered by. What the European LCCs figured out is that customers were highly sensitive to the ticket price, but were far less sensitive to the price of other items that were less visible. This unbundling is something that many other high fixed cost industries have long figured out how to layer in additional services onto their core product. For example in the hotel industry, firms are able to generate significant additional revenue from food, internet and other services. These industries figured out how to unbundle a product offering to make the core product more affordable to some customers whilst creating more options for others, resulting in higher revenues than a one size fits all approach. But what the LCCs did was to re define the notion of value by re educating the customer into thinking that all they were purchasing was a seat, rather than a package of benefits in their ticket price. This best practice and creativity in identifying new revenue streams created a new platform for the industry. Some network carriers initially participated by introducing products that offered customers something for sale which they didn t already have and provide a new benefit, such as lounge access. However, it quickly spread into products that were taking away something that was previously included in the ticket price, such as food and baggage. This is a key point of debate between network carriers and their customers should they focus on charging customers for access to something new, or what they already had before. Gary Kelly, CEO of Southwest said earlier this year, we all know if we charged, we d get the bag fee, but we d lose the customer. We believe we re ahead of the game by not charging a bag fee. It is important to note that the real step change in the ancillary revenue model for the network carriers has been in the last 2 years, as an attempt to provide an immediate boost to revenues in response to the economic crisis. As much as airlines try to claim that they are offering new services for sale, we shouldn t be fooled that the real impetus behind the aggressive unbundling trend has been cost recovery rather than a strategy of providing new customer choice. Many of the new offers have payback within days and it has offered a drug to which many ailing network carriers have become hooked on. One of the first and most lucrative means that airlines discovered to derive ancillary revenues was from selling frequent miles to external companies, particularly credit card programs. It has had a true drug like effect, with distressed carriers advance selling miles in desperation at discounted rates in return for immediate cash. What is the current status of ancillary revenues? The airline industry is going through a major transition, with customers now confused as to which airlines are full service and which are no frills. In the US, Low cost carriers Southwest and jetblue continue to offer free baggage, whereas all the US legacies are charging for bags a complete paradox! As part of this transition, there has been a resetting of expectations as to what customers will get included in their ticket prices in the same way as we went from passengers wearing suits and dinner jackets in the 1970s to shorts and flip flops in the 1980s with the advent of more affordable flying the change is equally dramatic. It is now getting more difficult for customers to compare the total cost of travel between different options because of the differences in hidden fees. This is a good thing for the industry as it helps alleviate commoditization and creates opaqueness. Many airlines are taking a proactive approach to their ancillary revenue strategies, such as US Airways and United, leading the industry and happy for others to follow so that they don t stand out as being uncompetitive. Whereas other airlines, such as Cathay, Air Canada and Lufthansa have taken a more reactive late follower approach, 2

3 taking advantage of changes in the competitive landscape when they are presented, but not wanting to be seen by customers as taking the lead. We ve seen a few premium national carriers as the last ones continuing to hold the line on offering a traditional package of benefits, including Emirates and Singapore. But how long will they hold out? The network carriers are in a difficult situation as they have traditionally been able to generate a yield premium, partly through the attractiveness of their loyalty programs. However, the drive for ancillary revenues is in direct conflict to this. This focus on short term ancillary revenues runs counter to the strategy of building long term revenues through customer loyalty. A loyalty strategy is centered on providing reward and recognition in return for customer loyalty offering extra benefits for free, compared to selling those benefits for a fee. We see airlines like United selling many elite benefits such as premium check in, boarding and upgrades with a real risk of annoying their best customers. The question many network carriers are grappling with is it possible to do maximize loyalty AND ancillary revenues? Airlines can attempt to turn unbundling from a loyalty detractor into a reinforcer. By assigning a price to elite benefits, elite customers may further appreciate the value of the items they are given for free. In addition, by waiving charges for elites for certain items, such as checked baggage or preferred seating, the value of holding elite status can be reinforced. Network carriers must carefully manage the tension between pursuing the lifetime value of a customer and the short term value of an individual transaction. A coordinated ancillary plus loyalty strategy is required to ensure success. In particular, a well thought out communication strategy is necessary to clearly articulate the new ancillary services to elite members and how they are being affected, given the risks involved in playing around with their benefits. However, many airlines are however taking a piecemeal approach, adding incremental products rather than being strategic. It s a time of great confusion for customers as to what they are getting included and what they have the option to buy. Elite members are starting to question the value they are getting from their loyalty program and concerned about benefit devaluation. And it s a time of great debate for the network carriers of which direction to head in and how to develop new revenue streams without damaging loyalty. One thing is certain the industry is going through a major transition and there s no turning back. Where are airlines going next with ancillary revenues? There are broadly four stages that network carriers go through in developing their ancillary revenue strategies. The first stage is simple add ons, like insurance, hotels and frequent flyer miles to partners. The second stage is unbundling of previously included items for items such as food and baggage. This is where most network carriers find themselves today, trying to implement new additional charges. The third stage is enrichment selling additional high margin services that the customer did not have access to previously, such as lounge access and priority check in. The problem here is that the customer can become overwhelmed by the number of options and when new products are added they cannibalise existing revenue streams. Consumer studies show that the more options a customer has, the less likely they are to purchase. The fourth stage, which many carriers are now entering in response to customer confusion, is repackaging putting together various customized ancillary products and offering them for sale at discount, making it easier to purchase. This is something which United is leading the industry on offering a package of benefits such as Premium Line which includes priority check in, boarding and security. This has the advantage of simplifying the options presented and tailoring an offer to different customer segments. 3

4 It is important to note that there is a limit as to how far the network carriers will be able take their ancillary revenues and this varies by market. For example, for US Airways it was charging for drinks the customer backlash was finally too much and they reversed this decision. For Qantas, it has been offering meals it has long been acknowledged in the Australian market it is a last differentiator to Virgin Blue and a defining characteristic of a premium airline. In Canada, it has been charging for domestic baggage. It is much harder for national icons like Air Canada and Qantas to take things away, as the customer backlash and media scrutiny can be too damaging. The US market doesn t have this issue as there is no national icon and customer expectations have now been set so low. The COO of said this year that there is a limit to where ancillary revenues can go. He said: ancillaries are maxing out. We are already deriving ~22% of revenue (from ancillaries) and this is getting close to the natural limit. Although it is structurally challenging for the network carriers to get close to the levels, the industry as a whole still has room to grow ancillary revenues further. As well as charging for new (and formerly free) services, there is significant potential for airlines to monetize their websites and sell more travel related services alongside the air ticket. In driving up ancillary revenues they must continue to overcome the challenges presented from operating legacy technologies and motivating a workforce not accustomed to selling. However, regulators are increasing their scrutiny of ancillary fees which could put a dampener on the party. In the U.S., the Government Accountability Office has issued a report recommending that airlines disclose all fees across all ticket distribution channels, including those used by travel agents. It has also recommended that Congress explore taxing the ancillary fees that airlines are making, which are currently tax exempt. In addition, there was a backlash in Congress on Spirit s recent new policy of charging for carry on baggage, which was viewed by many as one step too far. Any regulatory changes could significantly diminish the profitability of ancillary revenue streams. How have ancillary revenues redefined the airline business model? Ancillary revenues are the drug keeping network carriers alive. The airline industry exhibits many of the characteristics of what economists call perfect competition with the transparency of internet shopping driving down prices and profitability. However, unbundling offers some relief from the devastating effects of this and the opportunity for network carriers to target customers for additional money at multiple touch points. Ancillary revenues have allowed the network carrier model to survive albeit in a new form. Until now, we have seen less unbundling taking place on international long haul flights due to limited LCC competition. However, if the long haul low cost carrier model continues to prove successful, we could see further pressures on the network carriers to charge for more services in order to compete. If this model continues to expand in the next decade, we could see further unbundling and degradation internationally, expanding domestic charges for things like food and baggage into long haul markets. Regardless of this potential long term change, any revenue increases for the network carriers over the next few years are much more likely to come through ancillary revenues internet based fare comparison shopping has become too strong to allow airlines to raise fares substantially unless there is a major upturn in demand. This further highlights the importance of developing a coherent ancillary revenue strategy. The European LCC model is based on an unbundled approach and maximizing these ancillary revenue streams whilst maintain low ticket prices has enabled the model to be successful. The traditional LCCs are likely to continue leading the charge with innovative new revenue streams and products. We have seen demonstrate that nothing is sacred by charge for checking in. However, there is not much else for these carriers to go after. It 4

5 remains to be seen whether other LCCs such as Southwest and jetblue will succumb to the ancillary revenue drug as well, or move further towards an all inclusive model. In summary, ancillary revenues have become key to the survival and evolution of the network carrier model and are likely to remain a top priority for some time. In the same way as ancillary revenues have enabled the growth of LCCs, they are increasing in importance to the network carriers. The ancillary revenue drug has allowed the network carrier model to survive albeit in a new form. 5