Dual-Strategy Airlines

Network Carriers Introduce Low-Cost Subsidiaries To Better Compete

The advent of numerous low-cost carriers and hybrids have given traditional network carriers cause to find new ways to effectively compete. As such, several airlines have introduced their own budget airlines to reach a segment not possible with their long-haul, full-service models.

Agile, flexible, dynamic, affordable … key words in today’s airline industry. Yet most people, including industry experts, airline management and even passengers, would argue that these descriptors rarely apply to the large, traditional network carriers that still dominate the market in many regions of the world.

The continued rising cost of fuel, equipment, employee wages and benefits, and airport fees, coupled with changes in consumer demand, is opening the door even wider for the development of more cost-efficient business models for airlines.

Last year, budget and hybrid carriers comprised approximately 20 percent of the Asian market and upwards of 35 percent of the airline industry in the United States and Europe. The percentages are expected to climb as an increasing number of traditional network carriers exit unprofitable markets, especially short-haul, point-to-point routes, turn these services over to low-cost partners and renew their focus on long-haul flying.

The Rise Of The Budget Carrier

Nowhere is this trend more predominant than the European airline industry. Many large traditional European carriers, including Lufthansa, Iberia and Air France, were initially conceived in the early half of the 20th century when the industry and competitive landscapes were entirely different than they are today. The majority of airlines were owned, at least in some part, by their respective governments, and the subsidies they received established these airlines as government entities. Flights, schedules, destinations and fares were tightly regulated.

During the 1990s, the European Union phased in an open-skies policy that dramatically lowered fares, bolstered commerce and tourism, encouraged competition and continues to spawn a growing number of hybrid and low-cost carriers eager to take advantage of liberalization.

At first, approximately 75 percent of passenger traffic stimulated by the short-haul budget carriers came from consumers that had rarely flown before air travel became generally affordable. A luxurious inflight experience was no longer the focus for most travelers. Air travel was now a commodity, and the destination became the objective. Consumers, for example, could choose between a nice dinner and movie or a deeply discounted flight to a weekend getaway just an hour or two away. Airlines found themselves in the unfamiliar position of competing with other leisure activities.

Eventually, the market became saturated with low fares, and inevitably budget carriers began competing with one another. Differentiation was key. Ryanair, for example, expanded its focus, flying longer sectors in a wider geographical area than most of its competition. Others grew their targeted customer segments by offering products, such as pre-assigned seats and lounge access, that appealed to high-yield business traffic — even at an additional fee. Regardless of the strategy, low-cost and hybrid carriers have successfully expanded their customer base for nearly a decade by steadily drawing consumers away from traditional network carriers, especially in short-haul, point-to-point markets.

Lufthansa’s Low-Cost Airline

As of July 1, Germanwings, Lufthansa’s wholly owned low-cost subsidiary, took over most of Lufthansa’s short-haul flights in Europe. It seeks to re-position itself as a budget airline for business travelers, with a variety of à la carte offerings. The Germanwings revamp is a major part of Lufthansa’s three-year transformation to increase group operating profit by 1.5 billion euros (US$1.95 billion) by 2015.

The Demise Of The Traditional Carrier

Last year, Europe’s 13 largest carriers — the majority of which are traditional long-haul airlines — reported an aggregate fall in net profits of 72 percent, according to CAPA Centre for Aviation. The report also noted that low-cost carriers grew faster in terms of revenues and available seat miles/kilometers (ASKs) and had higher load factors than the rest of the industry. Interestingly, traditional network carriers (those flying routes longer than 1,500 kilometers) still represent the majority of airlines, ASKs and passenger numbers in the region, but profits are driven by lowcost carriers (those flying at or below the 1,500 kilometer mark).

As competition in the short-haul, point-to-point markets continues to accelerate, traditional network carriers’ revenue losses are mounting. Their “business-as-usual” approach is no longer feasible or effective; in fact, it is detrimental. The business processes and fundamental theories upon which traditional airlines initially developed and thrived — even in short-haul markets — are becoming extinct.

However, over the decades, these processes and procedures have become so ingrained in the carriers’ operations and cultures that many have found it too challenging and costly on many levels to entirely change their strategies and operations. But fierce competition is now pressuring them to rethink outdated business models in order to survive.

The Challenge

To truly compete with low-cost/hybrid carriers in short-haul, point-to-point markets, traditional network carriers must match budget carriers’ lower fares. But fare matches are a revenue drain on traditional carriers because their equipment, distribution, employee wage and benefits, and maintenance cost bases are much higher than those of their low-cost/hybrid competitors. They were conceived and designed to function as full-service carriers, transporting passengers to long-haul destinations via a hub system.

Unfortunately, some traditional airlines have begun participating in the vicious fare-matching game with low-cost/hybrid carriers, only to pull back once the stakes become too high. By then, costs were spiraling upward at the same time revenues were plummeting downward.

An Unusual Strategy

So how do traditional network carriers keep from becoming a casualty of today’s increasingly agile, flexible and dynamic environment in which low-cost/hybrid carriers seem to thrive? The answer may be an unlikely dual strategy incorporating would-be competitors.

A number of traditional European carriers have in recent years established low-cost/hybrid subsidiary airlines with separate management teams, equipment, crews and ground personnel, employee contracts, distribution agreements, and so on. The key focus of these subsidiaries is simplicity — a single equipment-type fleet; online ticket sales primarily; and shorthaul, point-to-point flights that are not part of the traditional airlines’ hub-and-spoke networks.

Simplicity generally translates into lower costs in the aviation industry. Lower costs enable traditional airlines to offer attractive fares via their low-cost/hybrid subsidiaries and effectively compete in the current market, which is dominated by consumers searching for the best value.

Low-Cost HOP!

Air France formed low-cost HOP! from three regional airline companies (Airlinair, Brit Air and Regional). The new airline, which offers 530 daily flights with a fleet of 98 aircraft, provides interregional flights in France and Europe at affordable rates.

The Options

At first glance, the design and implementation of a dual strategy may appear too complex and costly an undertaking for most traditional network carriers. They began flying in an era quite different from today’s liberalized environment, and their business models often are no longer sustainable or preferable. Yet, few established carriers are equipped to shut down, liquidate assets, abandon previous strategies and launch “new and improved” airlines under the same name. And, in some cases, there is still a demand for the long-haul services these carriers are equipped to provide.

At the same time, establishing a budget airline from the ground up while running a large, multi-hub operation concurrently would be impossible for most traditional network carriers in terms of manpower or costs, no matter how simple the new airline’s structure.

After an evaluation of their individual assets and potential cost savings and efficiency improvements, some traditional European carriers are investing in and repurposing former regional airlines as their low-cost/hybrid partners.

Lufthansa’s budget airline partner, Germanwings, was one of the first lowcost/hybrid subsidiary entrants into the European market and has paved the way for others to follow. While Lufthansa has focused on defending its two main hubs, Frankfurt and Munich, it has utilized Germanwings to fight competitors at its more than 90 destinations in Germany and Europe.

Earlier this year, Air France invested in three regional airlines, Brit Air, Regional and Airlinair to form low-cost subsidiary HOP!.

“It’s really a renaissance of regional air transport in France and Europe, “ said Lionel Guerin, president of HOP!. “We’ve got a lot of journeys all over in different areas. The aim is to win back clients with fares that are cheaper, more accessible and more transparent.”

Other network carriers and airline parent companies are revamping the traditional alliance concept. Rather than simply placing their names on other carriers’ flights or operating flights under other carriers’ names, these airlines are expanding their reach and bolstering their competitive edge by financially investing in regional and budget carriers.

Earlier this year, the International Airlines Group, parent company of British Airways and Iberia, purchased a majority stake in Vueling, the second-largest Spanish airline with 150 medium- and short-range flights to 44 cities in Spain and Europe. Vueling’s website describes it as, “a new-generation airline that offers competitive prices while providing a wide range of value-added services and products that meet the needs of both business and leisure passengers.”

Separation Anxiety?

While it’s a bit too early to determine if the dual strategy being implemented by some traditional European carriers will reverse their fortunes, slow down losses or ultimately fail, airlines are beginning to experience both the advantages and disadvantages of this latest trend.

Lufthansa, Air France, British Airways and Iberia are well-established brands throughout Europe, as well as worldwide. While their budget subsidiaries brandish different names and logos and provide levels of service that vary from their traditional partners, name association can be a major advantage of this strategy from both an airline and consumer perspective.

Carriers employing dual strategies can also benefit from economies of scale from a purchasing standpoint and synergies in areas such as customer-loyalty programs.

Traditional network airlines seeking long-term success with dual operations must have a clear mission, definitive corporate values, precise business models and strategies, and diligence in their execution.

There is a fine line between name association and operational “contamination” — applying the strategies and objectives from one airline directly to a partner airline. Though associated, the traditional network carriers and their budget subsidiaries need to think and work as independent companies, with separate management teams, employees and resources, when possible. In effect, their operations must be insulated from each other — no subsidies, cross subsidies or financial injections.

Operational “contamination” immediately introduces additional costs and complexity into a business, and dilutes the airlines’ ability to effectively compete in their respective markets. Tightly controlling costs is vital to the survival of budget carriers.

IAG Acquires Vueling

British Airways and Iberia parent company, International Airlines Group, acquired control of Barcelona-based discount carrier Vueling earlier this year. As a result, IAG now has control of Spain’s two biggest airlines.

Flexible Technology

The travel industry, similar to other service industries, evolves based on consumer demand and preferences. Sometimes the pace seems painfully slow; at other times, the landscape appears to change overnight. The sporadic, dynamic nature of this industry requires airlines to be flexible, yet intentional, with their resources.

For example, it is simply impractical for a carrier to shelve current technology and purchase new technology each time changes are made in its strategy or operations.

As a result, the process of evaluating, selecting, implementing and calibrating technology solutions to optimally support a particular business model is an ongoing challenge for almost any airline. The process generally proceeds more smoothly when a carrier’s IT staff and management team work closely with a solutions provider to find the right “fit” for the airline’s particular operation, whether low-cost, hybrid or full-service.

Imagine, then, the challenge airlines face finding technology flexible enough to support multiple business models and operations.

Technology should not be a constraint to an airline from a strategic perspective. Rather, it should provide a flexible, dynamic platform that enables a carrier to operate seamlessly and compete effectively no matter what type or combination of business models it chooses to fly.

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