Flying High with Low Frills …

© Rahul Mirchandani

Case Objectives • To analyse the low cost, no frills airline industry, with specific reference to India, after making

global comparisons. • To assess the factors that have contributed to the successful growth and consistent

profitability of airline companies following this business model. • To analyse the strategies of Air Deccan, India’s first no frills carrier.

Background

Air travel is one of the world’s largest industries having generated over $300 billion in revenues in 2003 alone.

A low-cost carrier (also known as a no-frills or discount carrier) is an airline that offers low fares but eliminates all “non-essential” services. The typical low-cost carrier business model is based on:

• a single passenger class • a single type of airplane (reducing

training and servicing costs) • a simple fare scheme (typically fares

increase as the plane fills up, which rewards early reservations)

• free seating (which encourages passengers to board early)

• direct, point to point flights with no transfers

• flying to cheaper, less congested secondary airports

• short flights and fast turnaround times (allowing maximum utilization of planes)

• "Free" in-flight catering and other "complimentary" services are eliminated, and replaced by optional paid-for in-flight food and drink.

The first successful low-cost carrier is generally acknowledged to be Southwest Airlines in the United States, which pioneered the concept when founded in 1971 and has been profitable every year since 1973.

With the advent of aviation deregulation the model spread to Europe as well, the most notable success being the Irish Ryanair, founded in 1985.

As of 2004, low cost carriers are now edging into Asia, lead by operators such as Malaysia's Air Asia. August 2003 saw the launch of Air Deccan as India’s first low cost carrier.

For the past five years, low-cost airlines have been growing at more than 40 per cent a year, while the full-service airlines are yet to recover from the crisis that hit them post 9/11. Many of these low-cost airlines, be it Southwest Airlines, easyJet, Ryanair or even AirAsia, have had a great run. And the CEOs of these low-cost airlines now see themselves as a tightly-bound community of evangelists who have an avowed mission: to make air travel accessible to more and more people.

Case Brief

On August 27, 2003, the Indian traveler heaved a sigh of relief. The newspaper headlines screamed “Now every Indian can fly”. Overnight, the Indian civil aviation scene had changed radically with the launch of low cost regional services by India’s first no-frills airline, Air Deccan. However, not many in the aviation industry had taken Air Deccan seriously. Not surprising, given that Air Deccan was operating with just seven French-made, 48-seater ATRs, largely in the South, on routes that the bigger competitors wouldn't care about. Besides, not too many people in the top management of Air Deccan had any real experience in the aviation business. The CEO, Capt G R Gopinath himself would seem like a bit of a rolling stone, having dabbled in many things, including the army, multi-crop farming, sericulture, agri-consultancy and then a helicopter charter service. Not quite the combination that would inspire confidence. One year later, on August 25, 2004, the Goliaths of Indian aviation—Jet Airways, Air Sahara and Indian Airlines —got a taste of future. Air Deccan offered India an opportunity to buy an air ticket to any destination on its network, including metros, starting at mere Rs 500 + taxes! Whatever be the future for this youngest airline in India, Air Deccan’s CEO, Capt Gopinath will most certainly go down in the annals of history as the man who changed the civil aviation dynamics in India forever.

Capt G.R. Gopinath, said, “Our motto is to cut costs and pass on the advantage to the people. We want people who had never boarded a plane or dreamt of flying to fly with us.”

India’s Civil Aviation Sector

Airlines

The Indian skies presently have seven scheduled domestic carriers. These include Air-India, Indian Airlines, Alliance Air, Jet Airways, Air Sahara, Air Deccan and Blue Dart Aviation (in scheduled cargo services). Both A-I and IA also fly abroad. Pawan

Hans, Bharat Hotels, Escorts, EIH (The Oberoi group), Taj Air, Jagson, Mesco, Tata Tea, UB Air and United Helicharters are amongst 37 non-scheduled airlines in the country.

One significant policy development by the previous NDA government was allowing private domestic air carriers to operate international flights. It is now slowly taking wings. The government permitted Jet and Sahara to start operations in Sri Lanka, Nepal and Dhaka. In March 2004, the status of both Jet and Sahara changed from being domestic airlines to international airlines.

Airports

The findings of the Naresh Chandra Committee report, A Roadmap for the Civil Aviation Sector, paints a dismal picture of airport infrastructure. In all, there are 122 airports which are managed by the Airport Authority of India (AAI). Of these 94 are civil airports (including 11 international) and 28 are civil enclaves at defence airfields.

Out of the 400-odd airstrips and airfields in the country, only 62 are in use. Dispersal of traffic simply hasn't happened, with over 40 per cent of traffic being between Mumbai and Delhi. The four gateway airports account for 42 per cent of revenue. Only 10 airports made a profit in 2001. Finally, airport charges are almost 78 per cent higher than the international average. Says the report: "Barring a few airports, available infrastructure is under-utilised. There are a large number of airports where full infrastructure is available, but only operate one to two flights a day."

More Airlines

At last count, at least four companies were in the process of starting up new no-frills airlines in India. There is Royal Airlines, the new avatar of ModiLuft, and AirOne and Visa, both of which are promoted by former Indian Airlines employees. Then there is Vijay Mallya's UB Group, which is gearing up to launch its Kingfisher Airline.

Air Deccan - Reshaping an Industry Inside Out

Air Deccan has turned conventional wisdom on its head. Explaining the business model of Air Deccan, its managing director G R Gopinath says: “Our business model helps us cut operation costs by about 50 per cent compared to regular airlines.”

Key elements of this unique business model are summarized below.

Lean Product

Air Deccan’s product is basic – minus hot meals, frequent flyer programmes, decent legroom, and a full complement of air-hostesses.

No meals on board means Air Deccan does not need the extra space for storage. Instead, Air Deccan has added seats.

In the typical Jet and Indian Airlines layouts, one could increase the seat factor by as much as 20 per cent by pulling out the business class, reducing the seat pitch (how far the seat can incline), and throwing out a couple of galleys. "Now, if you can put in three extra rows, then you get (6x3) 18 seats more. In a 120-seater aircraft, if you get 18 seats more, you are up by 15 per cent," says Cyrus Guzder, CEO, Airfreight Ltd, and a well-known aviation expert.

Besides, there's no time wasted on cleaning the aircraft. The result: quicker turnarounds at the airports. Also, there's no need for a crew of more than six, or even four, members. While most full-service airlines like Jet take at least an hour to leave an airport after landing there, Deccan does it in 15-20 minutes for ATRs (and about 30 minutes for its new A320 service.) So, if Deccan does six sectors a day, it can fly one additional sector a day. This allows it to fly 20-30 per cent more than a full-service airline. On an average, the conventional airlines fly their aircraft for 8-9 hours a day, while a low-cost carrier is able to keep its planes airborne for 11 hours a day. "It is only by more hours of flying that you can give a lower price," says Gopinath. In fact, it is

able to make the same revenue with fewer aircraft.

Now, squeezing out more from the capital asset simply lowers the fixed costs. Even other costs, like costs of the crew, hangerage or even finance costs are somewhat lower. All this tots up to close to 40-45 per cent less depending, of course, on how much extra the airline can fly.

Unique Pricing

Air Deccan has already pitched its fares slightly higher than AC II-class fares, but lower than AC I-class fares. In the past few years, rail fares, especially in the higher classes, have gone up. Despite that, a quarter of a million passengers travel on AC trains every day. So if the differential isn't much, there's a possibility that a large number of them could well upgrade to air travel.

Air Deccan uses a simple yield management model while pricing its inventory of seats on each sector.

Ms Vijaya Menon, Air Deccan’s Manager Corporate Communication, explains : “The broad rule of the thumb for the pricing is 25 per cent of the inventory will be available at Rs 500 to Rs 4500, 50 per cent at Rs 4500 and the balance at Rs 4500 to Rs 6250. 3 seats will be sold at Rs 500 per flight. This is an instance of the Delhi-Guwahati flight where other carriers charge around Rs 9000 for regular one-way fare.”

Economies of Scale

Air Deccan uses the same type of aircraft in its fleet. This way it can move pilots and cabin crews around, and won't have to worry about carrying spares for three different kinds of aircraft. That generates economies of scale.

E-distribution

Air Deccan tries to save on distribution costs, which can be 11-15 per cent in a conventional airline. They do this by not going through the travel agents and the existing central reservation systems like Amadeus and Galileo. Instead, they sell

through the Internet and call centres. Air Deccan does not issue a ticket, as it costs to print, mail and process tickets. What passengers get instead is a booking number when they make a reservation. Passengers have to quote this number at airport check-ins, and present their photograph ID to collect their boarding pass.

Funding

The high mortality rates and wafer-thin margins in the airlines business make it hard for entrepreneurs to raise money. So far, Air Deccan has been funded through contribution by directors and cash accruals. Gopinath and his close aide and executive director K.J. Samuel hold 26 per cent each, while Vishnu Rawal, an old Hong Kong-based friend of Gopinath, owns 8 per cent. Golden Ventures, promoted by an NRI Group, holds another 20 per cent. Then, Bangalore-based Brindavan Beverages has taken up an 18 per cent stake. Deccan has raised funds from investors (equity: Rs 30 crore) and taken a debt of Rs 70 crore from Bank of Baroda. That adds up to Rs 100 crore. Captain Gopinath has mandated N.M. Rothschilds & Sons to raise $60 million-70 million to fund expansion. He has been jetting around the globe, presenting a business case to private equity funds like Warburg Pincus and CDC, which have shown an interest in funding Air Deccan. If Gopinath is able to get funding, it will be the first instance of private equity in an airline in India.

Global Ambitions

Air Deccan is also keen on introducing international flights, but they can do so only after having three years experience as scheduled domestic airlines. The Battle for Indian Skies Airline Current

Market Share

+/- from previous

year Air Deccan 1% Nil Indian Airlines 41.8% 39.3% Jet Airways 46.7% 48.4% Air Sahara 13% 13% Total domestic passengers flown during August 2004 estimated at 14.78 million.

The Indian skies are witnessing a bloody battle for market shares. A much anticipated farewar has broken out. A little before Rono Dutta announced the Air Sahara 'surprice' package, Indian Airlines (IA) extended a host of promotional fares and Air Deccan came up with its most fantastic offer: the Rs 500 Mumbai-Delhi ticket. The Air Sahara surprice is a 30-day advance return fare that's 36 per cent less than the 30-day advance apex fare. IA's 'metro non-metro Scheme' lets travellers pay Rs 1,000 for the non-metro leg of a flight, if it includes a metro leg. Air Deccan will shift to dynamic pricing next week where, the earlier you book a ticket, the cheaper the fare (Rs 500- 8,000 for a Bangalore-Delhi ticket). In fact, in the last few months, IA has quietly introduced discounts under various heads: round-trip fares, weekend fares, special fares, etc. And though, after the recent 10 per cent fare hike in June, its one-way Mumbai-Delhi fare is up from Rs 6,575 to Rs 7,215, it has a promotional fare of Rs 6,445 till 30 September. (Jet has a similar offer.) All domestic full service airlines continue to offer Advance Purchase (Apex) fares that reward passengers for booking tickets 30/15/7 days in advance, with fare levels increasing as the date of travel approaches. These fares are significantly cheaper than economy class fares. Though apex fares form a small percentage of the overall seating capacity — at 10% or even less — they have ushered in an era of cheap travel, which consumers find within their reach. What is most significant is that at their lowest level (Super Apex 30 days advance purchase) these fares are lower than AC class train fares and even lower than the full fares of Air Deccan. Some experts say the price cuts are a reaction to a normal, seasonal fall in passenger traffic (schools reopening, monsoons, etc.). In fact, demand can drop by 15 per cent in July and August. "Even if we sell 8-10 seats for Rs 1,000, it adds straight to our bottomline,'' says an IA director. But others say the fall is due to competitive pressure. The battle has just begun.

Constraints in India Government Controls Around 35-40 per cent airline costs in India at present are government imposed. Internationally, this figure is around 15-20 per cent. Take the recent tax on leasing. Depending on where you lease from, this will hike costs by 15-40 per cent. If the government forces Indian carriers to go to certain countries, leasing costs will go up. Suddenly, that country will be deluged with requests from Indian airlines to lease planes. Moreover, airport charges, aviation turbine fuel (ATF) cost and other operational costs (all government controlled) are the same for all airlines, whether it is a low cost airline or not. Poor Airport Infrastructure The problem wth airports was clearly summarized by Rono Dutta, CEO, Air Sahara, in an interview. He said: “We can buy more airplanes and put them in the air. How do you take all these people through the terminals? Not enough gates, not enough counter space, not enough parking bays.” Lack of secondary airport infrastructure In Europe as well as the US, low-cost airlines have one more way to shave off costs - but one that

Deccan or its followers will not have in India for some time to come. These airlines avoid flying into mainland airports and, therefore, don't incur high parking and landing fees. So, instead of Heathrow in London, a low-fare airline would use Luton or Stansted. India doesn't have too many secondary airports, and this is considered a major constraint. The Naresh Chandra Committee, however, has suggested a compromise - lower landing and parking charges for low-cost airlines. Lessons from the West The world over, low-cost airlines have begun to radically change the rules of the business. In market after market - be it in the US, Europe and, now, Australia and South-east Asia - the low-cost model has expanded the market, and gained significant share. Full-service airlines have responded in one of three ways: restructure their operations, launch their own low-cost airline, or simply get crippled. Part of the industry’s problem is the very nature of the product it offers. An airline seat is a fixed-cost perishable product. The incentive to fill empty seats and fly underutilized aircraft is tremendous. Idle capacity inevitably comes back on the market as start-ups buy the aircraft or established airlines

increase the utilization of expensive assets. Meanwhile, manufacturers continue to build and deliver new aircraft, adding new capacity. Pricing and overcapacity pressures, however, pale in comparison to the impending impact of the cost gap that exists in the airline industry. By cost gap, we refer to the 2:1 differential that exists between traditional full-service airlines’ unit

costs and that of low-cost carriers for a given stage length (route distance in miles). Low cost carriers, such as Southwest and Ryanair, don’t operate on the low end of the airline cost curve; they occupy an entirely different cost curve. (see exhibit below)

The table below provides a snapshot of the global trends related to low cost carriers :

Europe Here, the gravy train is turning into a graveyard. After a decade of phenomenal growth, Europe's low-cost airlines are struggling. There are too many seats available on too many aircraft for rock-bottom prices which are simply too low to be profitable. The following table makes a comparison of European Low-Cost Airlines based on the degree to which the low-cost concept has been implemented can be shown using the predefined strategic success factors.

However LCCs (like Ryanair) with their superior business design for inexpensive direct flights, will expand their European market share from the present 5 percent to 25 percent by 2010, thereby establishing themselves on a long-term basis. Given the attractiveness of this market, new airlines are bound to be founded. However, only purely “low-cost” business designs will be successful. In the long run, only two to three low-cost airlines will survive as major players on the intra-European market. The aviation market in Europe has split in two major customer segments. Customers will choose different airlines for different

purposes: flexible holiday and private travelers and price-conscious business passengers prefer low-cost airlines for short routes (upto a maximum of 4 hours), while the big network carriers focus on intra-European and inter-continental business passengers. Low-cost airlines also compete with European railways, especially on the lucrative, heavily used long-distance routes (roughly 400 to 700 km). Some airports, especially regional airports and former military bases (e.g. Frankfurt-Hahn), offer low-cost airlines remarkable opportunities for growth.

United States of America A generation after deregulation of America's airlines in 1978, low-cost carriers have seized control of the US domestic market.

Low-cost airlines may now be mature as a concept in America, but the market remains in flux. Since September 11th 2001, the six largest network carriers have slashed costs and reduced capacity by one-fifth as they have struggled to stay financially solvent. Even before the terrorist attacks, however, budget airlines were on a roll. Since 2000 they have expanded capacity by 44%. Low-cost carriers currently have 400 orders out for new planes, whereas the old network carriers have only 150 planes on order.

Most of the expansion has come from JetBlue, Frontier and AirTran; Southwest, which accounts for nearly half the sector, has been obliged by the wider air-travel recession to check its expansion, although it is now returning to its former growth path of 10% a year. Southwest is the fourth-largest American airline by passenger numbers.

Behind the current recovery there lies a bitter truth for network carriers. Though their passenger numbers are rising, revenues remain flat because they cannot raise prices. As the cost of jet fuel soared in the spring, some network carriers tried to compensate by raising ticket prices, only to give up within days. Budget airlines control pricing in the market.

The financial performance of U.S. airlines since 2000 has followed two very different paths. Despite significant cost-saving initiatives and industry-wide traffic volumes approaching pre-September 11th levels, legacy airlines continue to lose money. Legacy airlines’ unit costs (cost to fly one seat 1 mile) have increased since 2000 while fares have declined; as a result, these airlines have yet to regain profitability. Meanwhile, low-cost airlines continue to expand market share, enjoy a greater unit cost advantage over legacy airlines than they did in 2000, and in all but one quarter have collectively earned a profit. The weak performance of the legacy airlines over the last 3 years has significantly diminished their financial condition; as a result, some of these airlines are vulnerable to bankruptcy, especially if there are additional shocks to the industry. Unit cost competitiveness is the key to profitability of airlines because airlines have found it extremely difficult to increase their revenues in the current environment. While legacy carriers reduced their overall operating expenses over the last three years, these cuts largely paralleled legacy airlines’ capacity reductions. Conversely, low-cost airlines have been able to reduce their unit costs through expansion. Low-cost airlines’ ability to maintain lower labor costs and lower asset-related costs accounts for the majority of the unit cost differences between low-cost airlines and legacy airlines. The cost advantages enjoyed by low-cost carriers are striking.

A look at the comparisons made in the table that follows highlight the wide differences in operational costs:

Parameter Low cost US carrier

Full service US Legacy carrier

No. of employees per aircraft 84.6 (Southwest) 116 (United) Ticket Sales through travel agents 2% (JetBlue) 61.2% (USAirways) Passengers guaranteed connections 10% (Southwest) 40% (American

Airlines) No. of US cities serviced 23 (JetBlue) 109 (United) No.of foreign countries serviced 0 23 (United) Average Pilot salary $ 135,000 (AirTran) $ 215,000 (Delta) Seniority of captains < 10 years (AirTran) 5 to 35 years (Delta) No. of downtown ticket offices 0 (SouthWest) 13 (USAirways) Types of planes operated 1 (JetBlue) 16 (Delta)

Parameter Low cost US carrier

Full service US Legacy carrier

Employee Benefits No defined-benefit traditional plans

Avg. $ 9.99 an hour (Delta)

Average Base pay $ 8.25 an hour (JetBlue)

$ 21 an hour (USAirways)

Weeks of training required before moving pilots to different aircraft categories

NA 8 weeks (Delta)

The following diagram illustrates the overall impact of the widening unit cost differential gap between the low cost and legacy carriers in the USA over the years:

Wall Street analysts suggest that one of the best measures for examining airline unit cost performance is to relate airlines’ unit costs to the stage length (distance) flown. The gap between legacy and low-cost airline unit costs has widened across all route distances. For example, in 2000, at a 1,000-mile Route distance, legacy airlines’ unit costs were 45 percent higher than low cost airlines; by 2003, legacy airlines’ unit costs were 67 percent higher. The cost advantages in the low cost airline business model have ensured that the no-frills segment has never faced operating losses in the USA.

Overall, industry-wide demand in the USA has nearly returned to pre-September 11th levels, but fares have not. Although nearly as many passengers are flying as before September 11th, they are paying less to do so. In addition, legacy airlines are losing market share to the low-cost airlines. Demand, as measured in the number of miles paying passengers were transported, is down over 10 percent for the legacy airlines since 2000; demand for low-cost airlines has risen nearly 40 percent. Not only are legacy airlines collecting less fare revenue from the passengers they fly, they are also flying fewer passengers than they used to. Low-cost airlines are flying more passengers at lower prices.

External Challenges A series of significant changes and unforeseen events during the last several years has presented the global airline industry with its most significant challenges since it was deregulated. These challenges have come from within the industry as well as from external factors affecting the demand for air travel. Demand for air travel began weakening in 2000, well before the September 11th terrorist attacks. An economic downturn that began in 2000 depressed airline revenues, and the terrorist attacks of September 11th, the Iraq war, and the outbreak of Severe Acute Respiratory Syndrome (SARS) have compounded this trend. These events have contributed to a change in the demand for air travel that is likely to suppress revenues for the foreseeable future, including the inability of airlines to charge premium business fares. Although it is impossible to isolate the effect of various events, demand as measured by revenue passenger miles (RPMs), was down 6.5 percent and 11.4 percent for 2001 and 2002, respectively, from the US Federal Aviation Administration’s (FAA) June of 2001 forecasts.

Looking ahead The entry of these low-cost carriers will have several far-reaching implications for the aviation sector in India and, to a wider extent, on the mass transportation industry and domestic tourism. In a country of a billion people, the Indian aviation industry is puny. We have 12 million people who travel by air every year against 3 million passengers who fly everyday in the US, even though its population is one-fourth that of India. The number of daily flights in India averages just about 400 a day, as against 40,000 flights a day in the US. Ryanair, among the low-cost pioneers in Europe, flies 25 million people in a year and still has less than 5 per cent market share. Closer home, in Malaysia, there are 12 million people who travel by air yearly. Look at it another way: India's 200-million middle-class population is equal to that of the whole of Europe. Even if we assumed that only one-fourth of that large middle-class could afford and would be willing to travel by air, it would call for at least a 5-6-fold increase in capacity. Aviation experts are betting that Jet and Sahara could start a debilitating price war to push the fledgling no frills airlines off the tarmac - permanently. Almost as a precursor to the impending battle, intense lobbying with the civil aviation ministry has

begun. Last week, Praful Patel, the new minister of civil aviation, met the heads of all the domestic airlines in the capital. At that meeting, the representatives from Jet and Sahara sprung a surprise by arguing for a new level-playing field. They wanted the government to increase the minimum equity needed to start an airline from Rs 30 crore to Rs 250 crore-300 crore. Also, fleet sizes ought to be at least 7-10 planes, not five, they argued. While both Jet and Sahara were unwilling to comment on this, aviation experts say the two operators of what the industry calls full-service airlines, are trying to erect entry barriers. After all, it could well be a matter of their survival. So, what are the possible future scenarios? Over the next few years, one can expect to see a complex system of low-cost airlines. Depending on the amount of capital they are able to raise and the business plan they formulate, some will ply on the trunk routes, others on the Class A and B towns and then, some will operate purely as air taxis. As for Deccan, Gopinath is committed to being a serious player in the high sweepstakes game. "We don't want to be a regional airline. We want to be a known as a national airline, going to the regions. If you want to be a major player, you have to be a national player," he says. For the moment though, Deccan remains a small player, flying just about 1,600-1,700 passengers a day and expects to achieve a turnover of Rs 450 crore by end of March 2005. Jet, on the other hand, had an operating revenue of Rs 2,876 crore in 2002-03 with a fleet size of 41. So the critical question is: does Deccan have the deep pockets needed to withstand a price war? Much will depend on how the competition will react. Fortunately, a low-cost airline has the advantage of being a model that throws up cash much faster than its full-service counterparts. So, if Deccan can survive the price war for the first year or so and scale up, it will soon reach a size where Jet and the rest cannot undercut without losing massively in the bargain. "It is always simpler to drop prices if you are trying to take on a company with just three planes. If, Air Deccan, however, scales up fast to

100 planes or so, the others cannot undercut it without maiming themselves," says Kaul. Even if it does scale up, there's another possibility: success will soon attract imitators. The pending applications in the Civil Aviation Ministry for new start-ups, all of whom want to be low cost carriers, is a clear signal that a massive influx of new entrants is on the cards. In Europe, the original pioneers, Ryanair and easyJet, are suddenly faced with too many new competitors in the same low-price segment, sparking off an intense price war. "To attract customers, they are cutting prices to unreasonable levels, impacting the profitability of the entire sector," says Nirmalya Kumar, professor of marketing and director of the Aditya Birla India Centre at the London Business School. Kumar, who wrote a prize-winning paper on easyJet, says some low-cost airlines also lose their bearing and begin adding frills like assigned seatings, hot meals and in-flight entertainment to attract some of the more comfort-seeking customers. But that leaves them exposed to being undercut by a new competitor who focusses exclusively on price. "Anything (like frills) that adds costs and reduces price competitiveness is a bad trade-off. After all, if you get them on price, you could lose them on price too," says Kumar. In the low-price sector, only those with the lowest costs survive in the long run, and scale does matter in delivering the lower costs. "In the short run, all sorts of dislocations happen until the newcomers start running out of money," says Kumar. Captain Gopinath will be hoping that he can steer his company through the turbulence - and stay on course to be India's first successful low-cost airline.

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