Low-Cost Air Travel Enters the Next Stage

Low-Cost Air Travel Enters the Next Stage Low-cost carriers have reshuffled the cards in short- and medium-haul service. How can established airlines maintain their advantage in long-distance routes? 1

When Herb Kelleher launched Southwest Airlines in 1971 with three Boeing 737s serving a handful of Texas cities, few bet on his success and even fewer foresaw the creation of a model that would be repeated worldwide. Forty-five years later, low-cost carriers (LCCs) have democratized air travel and are now the industry s highest-profit airlines. While LCCs challenge short- and medium-haul routes business model by carefully managing costs, increasing ancillary revenues, and choosing routes based on what s attractive to fliers and not where hubs are located, legacy carriers are still trying to figure out the best path forward imitate LCCs or hang on to their models? Now, as LCCs explore expanding into long-haul service, the threat of a new battlefield in air travel is more of a realistic possibility than legacy carriers may think. However, we believe there is a profitable path forward for legacy carriers in this environment. This paper looks at the landscape and how legacy airlines can proceed. The LCC Era Low-cost carriers have grown steadily since Southwest s beginnings, and they now account for 25 percent of all global flights. LCCs have made their biggest impact on short- and mediumhaul flights globally, with European LCCs share of 41 percent higher than Asia Pacific and North America (see figure 1). Within Europe, LCCs share of traffic varies significantly by airport, due to local regulations, slot availability, and development priorities. Some markets Spain, the United Kingdom, Portugal, and Italy, to name a few have been swept away by the LCC trend (see figure 2 on page 2). And in places such as France, Germany, and Benelux where legacy carriers still lead by a healthy amount, LCCs are expected to continue to gain in the coming years. The growth is driven by LCCs evolution from no-frills service to option-based offers that are now targeting more frequent passengers and even the small-business segment. And they re now increasingly flying from main airports even Ryanair, a mainstay in secondary airports, which now has plans for routes from major airports, including Paris Charles de Gaulle. Figure 1 Low-cost carriers share of short- and medium-haul air traffic is growing LCCs % of seats offered, short- and medium-haul flights (intra-zone) 45% 40% 35% 30% 25% Europe North America Asia Pacific 20% 15% 10% 5% 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Sources: OAG; A.T. Kearney analysis 1

Figure 2 In some countries, LCCs have captured close to half of short- and medium-haul seats offered % of seats offered, short- and medium-haul flights Legacy carriers Low-cost carriers 58% 76% 75% 52% 57% 75% 68% 53% 42% 24% 25% 48% 43% 25% 32% 47% UK Germany France Spain Italy Switzerland Benelux Portugal Note: The column width represents the numbers of seats offered in each country. The figures are for a typical summer 2016 schedule. Sources: OAG; A.T. Kearney analysis A close look reveals that mainstream LCCs have 30 percent lower costs, much of that happening behind the scenes in how they are structured (see figure 3). 1 LCCs have far more efficient value chains than legacy carriers, accounting for half of the cost difference; the other half is lower service levels (see sidebar: Three Categories of Inefficiency on page 3). Figure 3 On short- and medium-haul routes, low-cost carriers have 30 percent lower costs than legacy carriers Estimate Indexed costs, short- and medium-haul flights (Average legacy carrier=100) 30% 100 5 Lower compensation Higher productivity 3 No free catering 9 Limited passenger support 3 Higher rotation Newer fleet 4 More direct sales More online purchases Lower CRM costs 2 3 Simpler organization, processes, and systems Newer fleet 1 70 Average legacy carrier Crew Catering Ground handling Fleet and maintenance Marketing and sales IT, support, and overhead Fuel Air traffic control and navigation Average low-cost carrier Note: CRM is customer relationship management. Costs are per available seat kilometer, considering higher seat and intraday aircraft rotation, but same airports. Sources: Airlines annual reports; A.T. Kearney analysis 1 Mainstream LCCs include EasyJet, Vueling, and Norwegian, which in most cases have similar departure and arrival airports as legacy carriers. It does not include Ryanair, which for the most part flies to and from secondary airports. Ryanair has an added advantage of lower fees, or in some cases subsidies, to fly out of those airports. 2

Three Categories of Inefficiency Why are legacy carriers costs so much higher than LCCs? Customers only see about half of this cost gap in service downgrades, such as less leg space, limited food and beverage services, limited airport support, and add-on fees for some services. For the most part, the major impact is behind the scenes, where LCCs have much more operational efficiency than legacy carriers. Three categories of inefficiency stand out as where legacy carriers can gain some ground back from LCCs (see figure): Crews and ground operations. Crew costs are much lower for LCCs because of the combination of both lower compensation for cockpit and cabin workers and higher productivity levels thanks to smaller cabin crew composition. Fleets and fuel consumption. LCCs aircraft cost a bit less than their legacy competitors thanks to greater intraday rotation (10 to 12 hours compared to the typical seven to nine) and better amortized maintenance, repair, and operations calendars. Their younger fleets are also more fuel efficient, and in recent years, some have gotten better one-off deals from aircraft original equipment manufacturers during some opportunistic times. Sales and support functions. A much higher share of LCCs sales occur directly (particularly online) between 50 and 80 percent, compared to 20 to 30 percent for legacy carriers which means lower commissions. And LCCs remaining support and overhead costs are designed to be lean, with simpler service and networks and less burden from decades-old IT systems and processes. The plunging cost of jet fuel has widened the gap between legacy carriers and LCCs, as lower fuel costs release pressure on the overall cost structure and allow low-cost players to differentiate. Figure Why legacy carriers costs are so much higher than LCCs on the short- and medium-haul flights Estimate Indexed costs, short- and medium-haul flights (Average legacy carrier=100) 30% 100 15 85 15 Crews and ground operations LCCs crews have higher productivity and receive lower compensation. Fleet and fuel consumption Higher aircraft rotation results in lower fleet and maintenance costs. Fuel burn is optimized through newer fleets. Sales and support functions Optimized direct sales channel mix with strong share of online sales. Simplified back-office processes and systems. Seat configuration reduces aircraft operations cost per seat. Product offering Services (such as catering, newspapers, and extra bag) are not included in ticket prices. Passenger support on the ground and in airports is reduced (online check-in; no lounge). Cabin crew composition is smaller, matching legal constraints only. 70 Average short- and medium-haul legacy carrier Operational efficiency Target short- and medium-haul legacy carrier Lower service levels Average short- and medium-haul low-cost carrier Note: Costs are per available seat kilometer, considering higher seat and intraday aircraft rotation, but the same airport. Sources: Airlines annual reports; A.T. Kearney analysis 3

Long-Haul Routes Are the Next Battlefield Long haul is the next frontier for LCCs. In Europe, Norwegian Air Shuttle already offers low-cost long-haul service to multiple destinations in the United States and a few in Asia. The impact on legacy carriers has been limited so far, because LCCs are not yet flying out of the most popular business and tourism destinations. Low-cost carriers now account for 25 percent of all global flights. However, the long-term threat is real. LCCs advantages in shorter flights also apply for long-haul service, even if the impact is lower (see figure 4). And the cost difference for LCCs versus legacy carriers is as much as 20 percent (see figure 5 on page 5). For customers, the absolute savings could prove much more attractive. While the immediate threat is still small, over the long term it will grow as LCCs enter major intercontinental routes from Europe to cities like New York, Singapore, and Shanghai. Figure 4 Many of the low-cost carriers success factors in short- and medium-haul flights would apply in long-haul flights Fleet Marketing and sales Product design Younger fleet Higher seat Online direct sales increase Low service included in price Low passenger support at airports Fully applicable Partially applicable Not applicable Factors Long-haul flight length requires higher comfort for passengers than in shorter flights, but aircraft can still be optimized (for example, less kitchen spaces, or smaller space between rows) The channel mix for LCCs will remain the same Long-haul flights require more catering service for passengers, but much of it could be remain optional Limited desk support could remain, and most operations could remain self-service, with additional support available for a fee Point-to-point liaison only Offering the most attractive destinations in long-haul would limit the need for base feeding Still possible to offer both legs without transfer service (DIY connection) Operational efficiency Higher fleet rotation Higher staff productivity Lower staff compensation It is not possible to increase fleet rotation on regular scheduled services 1 There could be an advantage in the number of days ON per year (with less magnitude than in shorter routes due to safety regulations) There would be no advantage in daily hours, due to flight structures There would be an advantage in annual compensation and cost of accommodation 1 There is a very slim possibility for some the low costs to be transposable, if LCC airlines flew at unfriendly times and proposed different flight slots to optimize rotation. However, this would be quite complex to achieve. Source: A.T. Kearney analysis 4

Figure 5 Low-cost carriers could have a 20 percent cost advantage over legacy carriers on long-haul routes Estimate Indexed costs, long-haul routes (Average legacy carrier=100) 20% 100 7 93 13 Operational efficiency LCCs crews would have higher productivity and receive lower compensation. Fuel consumption Fuel burn would be optimized through newer fleets. Sales and support functions Optimized direct sales channel mix with strong share of online sales Simplified back-office processes and systems Seat configuration reduces aircraft operations costs per seat. Product offering Services (such as catering, newspapers, extra bag, and in-flight entertainment) are not included in ticket prices. Passenger support on the ground and in airports is reduced (online check-in; no lounge). 80 Average long-haul legacy carrier Operational efficiency Target long-haul legacy carrier Lower service levels Average long-haul low-cost carrier Sources: Airlines annual reports; A.T. Kearney analysis Four Ways Europe s Legacy Carriers Win the Long Haul With busy long-haul routes an essential part of legacy carriers profit and network attractiveness, competition from LCCs is a clear hazard. So how can legacy carriers keep their advantage in long-haul service? With these four moves: Enrich and emphasize product differentiation and the customer experience. The temptation is to try to beat LCCs at their own game, but in fact, legacy carriers can gain a competitive edge by standing their ground. Investing in what makes them stand out including service, coverage, and customer experience offers greater opportunity for success than trying to keep pace with LCCs. Legacy carriers can use the same unbundling methods not to lower service levels but to increase their differentiation by offering innovative services that customers will value. Service is where legacy carriers can truly shine. The customer is still king, and taking care of, understanding, and surprising him or her with favored services or innovations is one way to build the legacy brand value, keep customers happy, and outshine LCCs. Airlines massive troves of data from frequent flyer and credit card programs can help them better customize services. Challenge long-haul economics with cost and revenue analyses. When seeking the most profitable routes and seat classes, floor space usage and costs by cabin are particularly important to understand. If necessary, legacy airlines can reconfigure cabins to adapt them for various routes. In the end, analytics can redefine route economics and help legacy airlines move closer to optimal cost levels than simpler analyses based on available seat kilometer (ASK) analyses. 5

For example, while premium classes are long thought of as subsidizing lower seat classes on long-haul flights, the benefits are often overstated, considering that those sections have fewer seats and cost more to serve (see sidebar: Premium Classes Are Not a Prerequisite in Long-Haul Economics). Transform the operating model. As we noted above, at least half of LCCs advantage comes from operational efficiency. Three steps are important for legacy airlines to close this gap: Enhance and deploy lean processes across the value chain. Use advanced benchmarking approaches to identify and size competitive gaps versus peers and engage transformation programs in relevant domains. Empower procurement organizations. Improve practices, tools, and organization from procurement to payment. Implement innovative sourcing approaches to change the rules of the game and capture untapped potential (for example, collaborative optimization in ground handling or catering, which could deliver savings of up to 15 percent). Create new deals with employees. Change must start at the base. The transformation described above will benefit from strong support from operational teams, both in timing and magnitude of closing the competitive gap. Develop dedicated low-cost units. The long-haul battle may actually be won in the short and medium haul, as traffic bundling in hubs remains a crucial differentiator for long-haul economics. Instead of downgrading core legacy operations to match LCCs value proposition which will only hurt brand image legacy airlines creating dedicated low-cost arms alongside their main operations is preferable, as some large European airlines are already doing with Vueling, Transavia, and Eurowings. The key is that the model be built from the start as a LCC, rather than a transformed version of a legacy carrier. These new LCCs must also have the freedom to use favorable flight networks, even if they compete with main airline service. Premium Classes Are Not a Prerequisite in Long-Haul Economics The conventional wisdom is that first class and business class subsidize economy classes in long haul, and it s not entirely false premium passengers bring in much more revenue (two to 10 times greater, depending on class), are typically more frequent fliers (increasing average revenue per user), and, with most costs fixed, bring higher revenue per seat, meaning higher profits. But in reality, the benefits are lower than many realize. Even though revenues on a perpassenger basis are usually higher, revenues related to airplane floor space are often similar for premium seating and sometimes even lower. Business class occupies two to three times more space per flier than standard classes; when looking at load factors by class, business class usually reaches only 50 to 75 percent, compared to 85 to 90 percent for economy. And it simply costs more to serve premium classes. On-the-ground amenities like lounges, special desks, and special assistance are expensive to maintain. On board, catering costs are between three and five times more expensive, and there is typically one cabin crew member per four to 12 seats, compared to 1 per 30 or 40 in economy. Ultimately, comparing premium class revenues and costs with economy classes on an applesto-apples basis, the results are surprising for some legacy airlines, raising questions about their strategies for different classes and the aircraft space devoted to premium classes. Hence, the premium classes are not essential in long-haul flight economics, even if for some airlines with outstanding yield management capabilities, it can boost route profitability. 6

Flying into the Future As the industry s highest-profit airlines, LCCs are forcing legacy carriers to reexamine their traditional business models. With the battle shifting from short- and medium-haul routes to the longer routes, the legacy carriers can still succeed by revamping how they operate and standing out from the crowd with an outstanding customer experience. Authors Hugo Azerad, principal, Paris hugo.azerad@atkearney.com Eugenio Prieto Ibanez, global head of Transportation, Travel, and Infrastructure Practice, Madrid eugenio.prieto@atkearney.com Key contributors and local contacts Marco Andreassi, partner, Rome marco.andreassi@atkearney.com Pablo Escutia, partner, Madrid pablo.escutia@atkearney.com Christian Hassel, partner, Copenhagen christian.hassel@atkearney.com Mark Page, partner, London mark.page@atkearney.com Pedro Rezende, partner, Lisbon pedro.rezende@atkearney.com Rene Steinhaus, principal, Berlin rene.steinhaus@atkearney.com Robert Tasiaux, partner, Brussels robert.tasiaux@atkearney.com Salvatore Zarate, partner, Middle East salvatore.zarate@atkearney.com 7

A.T. Kearney is a leading global management consulting firm with offices in more than 40 countries. Since 1926, we have been trusted advisors to the world's foremost organizations. A.T. Kearney is a partner-owned firm, committed to helping clients achieve immediate impact and growing advantage on their most mission-critical issues. For more information, visit www.atkearney.com. Americas Atlanta Bogotá Boston Calgary Chicago Dallas Detroit Houston Mexico City New York Palo Alto San Francisco São Paulo Toronto Washington, D.C. Asia Pacific Bangkok Beijing Hong Kong Jakarta Kuala Lumpur Melbourne Mumbai New Delhi Seoul Shanghai Singapore Sydney Taipei Tokyo Europe Amsterdam Berlin Brussels Bucharest Budapest Copenhagen Düsseldorf Frankfurt Helsinki Istanbul Kiev Lisbon Ljubljana London Madrid Milan Moscow Munich Oslo Paris Prague Rome Stockholm Stuttgart Vienna Warsaw Zurich Middle East and Africa Abu Dhabi Doha Dubai Johannesburg Manama Riyadh For more information, permission to reprint or translate this work, and all other correspondence, please email: insight@atkearney.com. The signature of our namesake and founder, Andrew Thomas Kearney, on the cover of this document represents our pledge to live the values he instilled in our firm and uphold his commitment to ensuring essential rightness in all that we do. A.T. Kearney Korea LLC is a separate and independent legal entity operating under the A.T. Kearney name in Korea. A.T. Kearney operates in India as A.T. Kearney Limited (Branch Office), a branch office of A.T. Kearney Limited, a company organized under the laws of England and Wales. 2016, A.T. Kearney, Inc. All rights reserved.