Guest Lecturer, McGill University School of Business

AIRLINE MODELS
Lecture to McGill University School of Management
Pierre J Jeanniot, O.C., C.Q., FRAeS
Montreal, 1 March 2018

 

Commercial aviation started in the Western countries …. in the 1920’s and 1930’s.  … It served some elitist passenger markets … and also some cargo markets and postal services … which enabled goods and information to be transported fairly quickly … compared to the more conventional ground systems that existed at that time.

The volumes were very small … and during World War Two the demand for commercial air transport virtually disappeared … and was dominated completely by the needs of aviation military applications.

At the end of the Second World War …interest in commercial aviation transportation revived fairly quickly … and some of the technical developments which had been made for war purposes were rapidly adapted to civil aviation … mainly passenger travel.

As commercial aviation was likely to grow rapidly … the various governments decided it was necessary to develop rules to regulate … how flights would take place between countries.

This was accomplished by the Chicago Convention in December 1944 … which created ICAO … the International Civil Aviation Organization … an organization of the United Nations … which established a set of rules … or Freedom Rights.

It was followed by the creation of IATA … the International Air Transport Association …  in April 1945 to provide a framework … and rules on how to operate/manage airlines.

From the start …  air transportation was viewed as an exchange of commercial opportunities … and the regulations developed to facilitate travel between countries consisted of a number of rights … such as air rights to fly to a country … rights to pick up passengers from that country … rights to fly over a country … rights to link a country beyond the two countries in question … and so on.

The exchange of commercial operating rights between countries requesting access to markets … required equal opportunities on each side.

The exchange of access to markets … was covered by an international treaty called … an air bilateral agreement. …

This covered an exchange of rights between each country …and regulated how … flights of passengers and cargo … should take place between those countries.

Essentially … this was an international treaty … to permit the exploitation of commercial opportunities in each county.

These agreements originally dealt with a rather elitist market.

The costs of flying were very high … and only the upper class of the population could afford them.

In addition to high quality leisure traffic … there was a need for travel for business … and political reasons.

There was a need to fly between different countries … to ensure that there were adequate … and rapid connections between those countries.

With the exception of two airlines in the U.S. … namely Pan American and TWA … the airlines of every other country were government … owned … and operated according to the rights that had been negotiated by their respective countries.

Most countries wanted an airline for “political reasons” … to establish control over their airspace … and to acquire an international presence.  Hence the term … “National Flag Carrier”.
Two things essentially governed commercial aviation:

• The exchange of commercial rights to exploit the markets between two countries;
• And second … also very important …, was the need for a safe operation to the extent possible … which required increased regulation … and the enforcement of safe practices by each of the operating airlines.

In the years following the Second World War … the number of flights … the size of the airplane … the exchange of rights between countries … were growing fairly rapidly.

Every nation regulated very closely the development of aviation within its respective country and … of course … the development of civil aviation between each country … was regulated by international air bilateral agreements … under the auspices of ICAO.

IATA was to provide rules … and processes … for the actual operation and management … e.g. tariff coordination … standardized procedures for ticketing … cargo … etc.

The concept … or model of national flag carrier … still exists today …   although even those airlines … which are still owned totally … or partially … by a government … have had to become more business-like … and to be guided by commercial considerations.

Any operator within its own country … was under the jurisdiction of its own Air Regulation Bureau … and its international flights would be governed by the Air Bilateral Treaties … its government would have negotiated.

For instance … Air Canada was created to provide fast transportation from one end of the country to the other. This initial role was in many ways … similar to the creation … decades previously … of the trans continental railways.

The original name of “Trans-Canada Airlines” reflected that role … but it was changed to Air Canada when it developed an international network … originally to Britain … then France … Germany and Switzerland.

The mandate was largely to provide fast service at break-even cost.

One Minister of Transport was fond of saying “Stay away from the tax payers purse … and we will stay away from your business.”

But that was not always so!

For instance … when I was head of the company … while it was still a Crown Corporation …  I was prevented from starting a Frequent Flyer program for the best part of a year … by the government … which originally had considered that this was not part of its mandate!

As a crown corporation … Air Canada was required to appear annually …  in front of various committees … where any parliamentary elected individual could appear … and ask questions.

The following anecdote is fairly typical of the kind of cross-examination which could routinely take place.

“The quantity of Canadian wine on board of Air Canada airplanes … being pushed by the Minister representing a southern Ontario riding. – (typical anecdote)

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As one can see … sometimes … narrow political motives can become a factor … without any commercial considerations.

A decreasing number of national carriers still largely operate with non-commercial constraints … but generally will still require financial subsidies.

Or … have been allowed to disappear … e.g. Sabena.

*****

Later in the 1960’s … a number of technical developments increased … the productivity of operations.

Most important were the jet engine … and the jet-liner.

It was now possible to transport twice the number of passengers … at twice the speed … on any transatlantic flight.

These new airplanes increased the productivity by 4:1.

Some entrepreneurs understood … that if one could increase the seating density … and achieve a higher degree of seat occupancy … say around 90% … one could operate a flight profitably … while setting a price at less than 50% of what a regular flight was charging.

In some ways … that was the first type of “low cost model”.

They were called … Affinity charters”.

Theoretically … one had to belong to a group … which occupied the entire flight … and required that almost every seat on that flight had been sold.

Affinity charters thus made air transportation available … to less affluent people.

These charters could benefit from the higher level of seating occupation … and therefore this made it possible to operate and sell tickets at lower prices.

The requirement to belong to a group … was subsequently removed.

An airline model that emerged … at that time and featured lower prices … was Laker Airways … called “Sky Train”.

Laker was able to create a new product … which did not require most of the overheads…  of the established airlines.

The airline did not have a reservations system – it was simply walk on … walk off.

Laker Airways operated routinely between major markets … such as London/New York.

The model was dependent on little overhead … and high density seating and occupation.

A rather similar affinity charter format existed in Canada … and met the needs of the low-cost market.

That was the charter airline operated by Wardair.

Wardair operated a series of programme of seasonal frequencies.

It depended on high occupancy … and offered fares which were much cheaper … than those offered by the regular airlines.

Those successful operations encouraged the growth of consumerism …  leading to a demand … for the wide availability of lower cost air transportation.

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The Air Regulation Act was passed by the U.S.A. in 1978 to remove Federal control over routes … pricing … frequencies etc. and to allow total “domestic” competition.

All commercial constraints were to be removed … but naturally the U.S.A. maintained all regulations on safety.

Shortly after … the U.S. abolished the CAB (the Civil Authority Board) … which was a rigid …  bureaucratic mechanism … and had become redundant.

This created a climate of total … unrestricted … commercial competition within the U.S. territory.

The U.S.A. domestic air transport deregulation was sudden … and virtually instantaneous.

From that moment on … the U.S. airlines were allowed to fly anywhere they wished within the U.S. … with any flight frequency … any seating arrangements … for any price.

The only remaining regulations concerned safety … and associated air worthiness regulation.

Proving they met the safety requirements … some dozen and a half new airlines emerged fairly quickly.

These were the first U.S. low-cost airlines.

Invariably … these low costs were based on the same model … essentially

• Very low fixed costs/and overheads
• Single airplane type fleet
• Higher density seating configuration
• Single class
• High aircraft daily utilization/fast turnaround
• Focussing their operation on relatively large markets … e.g. Chicago-New York.

Pricing was designed … to significantly undercut existing airlines … on the targeted routes …

And hopefully attract new flyers … In other words … expand the market.

Employees at counters … and flight attendants … would be young … enthusiastic … and relatively low paid.

Typical of those airlines were “Peoples’ Express … the “New York Air” … the “Southwest Airlines”.

A number of traditional U.S. airlines were unable to cope … with the new degree of competition … which was being introduced.

A number of airlines disappeared … or consolidated … such as Eastern and Continental.

Of those new low-cost airlines … some 10 years later … only Southwest Airlines survived. …  The other low-costs were unable to achieve a profitable operation … in a sustainable fashion.

A good question would be …

Why were all the new low-cost airlines unable to survive … short of Southwest?

Apart from managerial know-how … the major difference lay in their choice of markets … and their aircraft scheduling strategies.

The survivor … Southwest … avoided head-on competition … and specialized in smaller markets where there was less competition.

They also decided to serve point-to-point markets … where customers were being inconvenienced … by the hub strategy being followed by the legacy/larger airlines.

Clearly … many passengers may prefer a direct flight … to a connection … if the timing is suitable.

It is also fair to say that Southwest was able to sustain enthusiasm … within its young group of flight attendants and airport employees.

The vast majority of new “low-costs” … chose to go head-to-head with established airlines on major markets.

They were unable to sustain their operation … to gain a sufficient presence … and achieve a minimum profit.

The difficult financial situation … faced by most businesses in the 1980’s … also contributed to their failures.

Given the proximity of the U.S.A. … Canada felt the need …  for progressive deregulation … of the commercial Canadian aviation market.

The Canadian government introduced …  a Domestic Commercial Aviation Deregulation Act … which progressively provided total domestic freedom.

The 1984 “Freedom to Move” Act permitted … progressively …

• Any airline to fly anywhere in Canada
• Total freedom on frequency and pricing

But … of course … the Act maintained all safety-related regulations.

Air Canada … was government-controlled and was faced with the choice of becoming a private enterprise … or eventually disappearing …. since it would not be able to compete on the open market … as a number of important decisions needed government approval.

The new Act forced Air Canada to privatise … encouraged new low costs to emerge … and caused some of the existing airlines to merge … particularly PWA acquiring CPAir … then Wardair.

A new low-cost was successfully launched … “WestJet” … which wisely followed the same successful model … as Southwest Airlines … e.g. one airplane type … high seat density and one class.

WestJet originally …  avoided head to head competition … and also recruited some young and enthusiastic employees.

A number of regional airlines merged … or disappeared … and some of the more traditional charters … survived … generally as a component or holiday/destination package … example Air Transat.

The U.S. Domestic Deregulation Act … had allowed full freedom to the airlines to alter their schedules.

To increase their efficiency in serving the market … the surviving traditional airlines decided to build around a major hub … sometimes called “Fortress Hubs”.

For example … Atlanta became the major hub of Delta …. Dallas for American Airlines … and Chicago for United Airlines.

This enabled each major airline to concentrate traffic … increase the efficiency of airplane utilization … as well as ground services.

The hub strategy provided for more frequent services to the “spoke” cities … but required passengers to transit through the hubs.

This “fortress hub” strategy …  enabled the major airlines to dominate the market of their major hubs.

The passengers had a joke …

“With this system … when I die and I wish to go to heaven … I will have to go through Atlanta … Dallas … or Chicago.”

Hubs were also developed for air freight.

The strategy of the domestic cargo hub in Memphis … enabled FedEx to offer an efficient package delivery service … throughout North America … daily.

On the international side … KLM … was probably the first airline to build an international hub in Schiphol (Amsterdam).

Exploiting its strategic geographic position in Europe … and the proximity of relatively underserved markets … KLM was quite successful at growing its traffic … well beyond its own base.

KLM became a 6^th Freedom specialist … handling traffic flows from other countries … to other countries through Amsterdam.

With a relatively small “home market” … Singapore … an island state … exploited the same strategy … driving traffic flows from Southeast Asia to Europe … through Changi Airport.

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During the 1990’s … the European Community decided to deregulate progressively the air travel market.

The creation of a European Common Air Market enabled:

“Any current regular European airline to have unlimited freedom to operate within the Common Market … any location … frequency … price …etc.

The emergence of new carriers … essentially low-costs … with the ability to operate anywhere within the Common Market.”

The model of the new European low-costs … was similar …  to the original group of low-cost airlines in the U.S. … with the following differences:

The new European low-costs:

• Avoided head to head competition
• Operated from secondary/low cost airports
• Attempted to avoid unions
• Emphasises ancillary revenues
• Located their corporate H.Q. … in countries with the lowest corporate tax (e.g. Ireland).

These features enabled a number of new low-costs to grow rapidly … e.g. Ryanair … EasyJet etc.

As expected … the European deregulation forced regular … or legacy … airlines to attempt to adjust … to the increased competition.

Some were allowed to fail … e.g. Sabena … and many consolidated.

Eventually … three major groups emerged … one led by British Airways … the International Airline Group … (IAG) … which included BA … Iberia … and Vueling … a low-cost airline.

The second group was led by Lufthansa … which acquired Swiss … (formerly Swissair) … Austrian Airlines … Brussels Airline … (replaced Sabena) … and low-cost airlines Eurowings … and German Wings.

The third group … of Air France/KLM … operating Transavia … originally created by KLM … Air France is also starting another low-cost … Joon.

The acquisition … or development … of a low-cost airline by the three major European groups … is a recognition of the significant success of the new European low-cost … and an attempt to participate in this expanding market.

The strategy followed by these three major groups … is to concentrate their traditional operations … on the long-haul markets … and to expect their low -cost subsidiaries … to regain a reasonable market presence … on the short to medium routes in Europe.

This assumes … that the long-haul market … will not be seriously threatened … by new low-cost airlines attempting to achieve a profitable operation on the long-haul market.

Long haul/low cost airlines … first began operating in Asia.

“Long-haul” market is defined here … as any operation of more than 4,500 kms.

One of the contenders … in the long-haul low-cost market is Air Asia X … which was originally targeting long-haul markets from Kuala Lumpur in Malaysia … to Sydney Australia … and from Kuala Lumpur … to London England.

The key features of the Air Asia X Business Plan are:

• Single aircraft type operation … (wide-body) A-330 …

B-767-300 etc.

• Daily aircraft hours utilization of 16 hours/day +
• High density seating … and assigned seating

[to help boarding]

• Discretionary income generated by all frills … (food … drinks … entertainment … baggage … certain seats etc.)
• Connections offered … for a fee … but no hub and spoke.
• The L.C.C. terminal at Kuala Lumpur Airport … and Gatwick in London.

Air Asia X has set as an objective … to achieve operating costs of 50% less than the competition … which is a very challenging objective.

The other major low-cost … long-haul contender … is Norwegian International … which is hoping to use more narrow-body aircraft on Atlantic routes … such as Boeing 737 Max … to connect Ireland and Scotland … with secondary airports in the U.S.

But adopting the European model to a long-haul operation has been challenging … and Norwegian’s long-haul operation is running lean. … [difficult to replace aircraft if mechanical] … (poor on-time performance)

While it was able to register its aircraft in Ireland … to benefit from lower corporate tax … Norwegian was not able to circumvent labour law by hiring Thai crew.

Ryanair had been able to sign up its flying personnel … to an individual contract … in Singapore  (now threatened).

In spite of all these efforts … in both Asia and Europe … long-haul low-cost operation has yet to demonstrate clearly … that this model … ensures sustained financial viability.

The growth of low-cost carriers … particularly Ryanair and EasyJet … has been nothing short of spectacular.

Today … Ryanair is the largest European airline … in terms of passengers carried annually.

Perhaps feeling that the low-cost market is becoming saturated … some low-costs have now decided … to attract a portion of the business traveller … by offering a “modest” business product and thus enjoying better yields.

This has given rise to a “hybrid” model for some low-costs.

Their “Business Plus” product includes:

• Travel flexibility (ability to change flights)
• Reserved seat priority
• Booking priority
• Baggage allowance, and
• Dedicated Business check-in at airports

Typical of those are WestJet and Southwest in North America … and EasyJet as well as Ryanair on some European routes.

Some of those low-costs are also offering connection services … which had not been available previously.

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In the extreme case of the Ultra-low-costs … every possible feature … such as choice of seats … baggage … any food or entertainment etc. … is the subject of additional price.

A number of ultra low-cost airlines … in the U.S.A. … are leading the way.

Typical of those are “Spirit Airlines” and “Frontier”.

The traditional Ryanair is still the true low-cost … and “no frills” champion … but for these ultra low-cost airlines … ancillary revenues account for an increasing part of their profits.

Internet … and fare search engines … have strongly increased the transparency of pricing … and the face value of tickets … has become the main driver … for customer purchasing behaviour.

Promoting the idea that customers will only be charged … for the services they chose.

For the airlines … ancillary fees represent a high revenue potential … with a large profit margin.

At the centre of the strategy … of those ultra low-cost airlines … lies the need to be a low fare leader in the market.

They aim at operating at fares … at least 25% lower than charged by the competition.

These airlines are planning average daily utilization … of more than 12 hours/day

… and an average load factor of over 85% or more.

New flights to small airports … is also a component of their strategy.

Finally … ancillary revenues have the advantage of being less seasonal … for example … fares move up and down … but baggage fees stay the same.

Three new ultra low-cost airlines are presently being planned in Canada.

“SWOOP” … the new WestJet airline’s … ultra low-cost … will begin domestic flights …. In June … with flights between Abbotsford in B.C. … and Hamilton and Halifax.

While fares will be at rock-bottom levels … SWOOP passengers … will similarly pay for everything beyond the seat itself.

In some cases … ancillary fees may exceed the cost of the fare.

Jetlines … and FlyToo … are still hoping to start operating in the next timeframe … hopefully in 2018.

Required financing is said to be mostly in place … and their plan is said to follow the same successful ultra low-cost model.

We wish them the best.

*****

There are several important topics … which given time constraints … we have not been able to explore … such as:

• The nature and impact of airline alliances
• The “Open Sky” air bilateral … originally promoted by the U.S.A. … to guide aviation rights bilateral negotiations … which increased international competition.
• and the controversy surrounding the definition of “fairness” in the implementation … of Open Sky Air Bilaterals between Gulf Airlines … and the European and U.S. legacy airlines.

Those subjects … and others … have an impact on the evolution of airline markets … and would require further discussion.