The next transformation of the European airline industry?

The news that Ryanair is intending to interline with a number of low cost and legacy airlines before the summer of 2017 sets the timetable for what could be a significant and transformational development in the European airline industry. It is not that an airline providing connecting traffic is anything new, nor that LCC passengers self “intra” and “inter” line, rather it represents a further development in the Ryanair business model that also represents a behavioural change on the part of a number (of the still to be announced) legacy airlines receiving/providing traffic; the extent to which it is transformational of course depends upon the take up on both sides, which in part depends on where Ryanair’s network touches that of the “feed partner”. Furthermore it is also reasonable to expect that where Ryanair has led, others will follow. This news, when coupled with an acceleration in the establishment and growth of low cost long haul airlines either as standalone businesses or as airlines within an existing group; most recently evidenced by the announcements from IAG and Air France, adds a further dimension to the structural change that is occurring and where the greatest benefit is likely to accrue to the consumer through greater opportunity and still lower fares.

The economics of aviation

At the simplest level the economics of aviation are relatively straightforward. In order to satisfy a necessary, albeit not sufficient, condition for financial sustainability, in the words of the former Director General of IATA, “the need is for revenue to exceed cost”. Where the key determinants are the point at which breakeven is reached (which is the outcome of the relationship between unit cost and unit revenue) and the net contribution of traffic beyond breakeven, which to a greater rather than lesser extent is a revenue, rather than a cost issue as having reached breakeven some 90-95% of incremental revenue will flow through as free cash and profit. Whilst these are reasonably straightforward concepts (and calculations), where only point to point traffic is involved, for most airlines the reality is one where the presence of connecting traffic adds another dimension and where issues of distance based cost and revenue allocation, almost by definition, focus attention on the contribution and, hopefully, the real profit that a passenger will make at a network rather than route level not least given the distortion to the financial performance of the short haul network as a result.

The view that a number of airlines could benefit from another operator providing, in particular their feed traffic to and from short haul into long haul routes, using a “sum of sectors” approach, which in any event would be lower than they would be able to carry the traffic for, is not new either. Indeed even the most cursory glance at the distribution of cost per ASK at an airline level on a length adjusted basis highlights the extent of the potential opportunity – for the record our estimate is that in FY 2016 Ryanair’s CASK was just 3.6 € cents with a sector length of 1219 kilometres; this clearly provides an attractive opportunity when we estimate the net pro-rate on a connecting flight offered in July in economy by a legacy airline from Rome to Miami over London (and where the “in the air offer” on the short haul segment is perceived to be broadly similar) is 4.34 € cents per km. The rather more fundamental question relates to why such developments have not happened until now? Here the answers are likely to have something to do with the recognition of the need for change now, and the associated opportunity on both sides of “the equation”, as well as the acceptance by passengers of the option offered.

Some 30 years ago the view was that to connect in particular premium passengers to/from their long haul flight to the final destination on a “non-aligned” airline that offered a “product” of different quality would damage the brand and have a revenue and profit impact. Even then it may indeed have had some impact at the margin, although the reality is that the majority of transfer passengers travelled in economy or coach as they do now.

Changing times for the short haul market

Times however change and given the changes in the offer in the short haul market, it is debatable whether there is in fact a material product difference between the economy (coach) cabins of a “full(er) service” or “legacy airline” and the offer on a so-called “low cost” or “ultra-low cost” airline. Indeed from an expectations and behavioural perspective, not only is the “product” on the low cost/ultra-low cost airline now generally seen as the “norm”; in addition the actions taken by the legacy carriers have ensured that not only is there product convergence (raising some real questions of which airlines still have short haul brand value and where it arises), but that the “products” are sufficiently similar in the air to create what is perhaps best described as a “broad indifference” on the part of the majority of intending travellers.

Against this background the entry of low cost airlines (whether within or outside a group’s portfolio of airlines), into the “connecting traffic market” clearly represents an opportunity for all involved to reach a larger market. Of course the actual impacts will depend upon what new route and airline options become available and which they compete with. At an airline level, traffic will result from a combination of some growth in the market as well as from some substitution effects away from current travel options and where for the intending traveller this will inevitably result in lower fares.

At the same time the apparent “domino like”/ “me too” development of the low cost long haul segment in Europe after the perhaps inevitable and prolonged “it won’t happen here” stance by many “legacy managements”, is a further recognition of changes in what passengers want and they will accept. At one and the same time it highlights both the extent of segmentation in the market as well as equally, and more importantly, its convergence in terms of product and price in the volume segment of the market – although product convergence is evident elsewhere too. For “legacy” managers, adopting what is an increasingly necessary “portfolio” approach to access the growth that is not possible through the original core business, the issues also relate to protecting current positions as well as growing into new segments without cannibalising current flows, whilst at the same time ensuring the profitability of the original core; this is something that would appear to be particularly challenging and depends both on the starting point and, the ability to manage change and the costs and benefits associated with the change. However despite the excitement surrounding these developments, it is important to be clear that they may not provide the panacea to the problems that exist in the core business and indeed in some cases it could become an expensive and damaging diversion; an outcome that is in fact all too similar given the recognised challenges with implementation. Just as in the case of LCCs more meaningfully entering the connecting market the real beneficiaries will be the traveller and intending travellers given the further structural reduction in fares and where it seems that the race to the bottom continues, an outcome where clearly not everybody can be a winner.