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WHAT IS THE AIRLINE ADAPTATION CYCLE?

As evidenced globally over the past 10 years, there is a distinct cyclical nature to the adaptation of legacy and low cost airlines. This is in response to competitive market dynamics and changing consumer demands.

As shown in the following diagram, the cycle commences with existing legacy carriers offering a full service product with a high cost base for a high ticket price. This is followed by the entry of low cost carriers who offer a ‘no frills’ or ‘low frills’ product off a lower cost base for a cheaper ticket price.

As this occurs, the market grows through price stimulation during which there is a period of proliferation of low cost carriers. New entrants back themselves to compete for stimulated demand off a lower cost base. Legacy carriers respond through a combination of strategies which may include launching their own low cost off shoots and segmenting their networks and products.

As stimulated market demand begins to saturate, the low cost carriers need to find new ways of differentiating their price point to compete. They begin to de-bundle their service offering into individual components, establishing a lower base fare with a choice of ancillary product features. This may include the purchase of in-flight food and beverage, pre allocated seats, in-flight entertainment and/or a choice of two or three fare types with or without a change in fees. At this point there is a consolidation of low cost carriers.

We believe that those that can retain the low cost base, maintain a consistent level of service and loyalty, and find the right combination of de- bundling to tap into ‘value segments’ are those that will survive.

THE FUTURE OF AUSTRALIAN AVIATIONWhat does it mean for Australian airports?

DECEMBER 2014

IN THIS PAPER WE DISCUSS...

— The airline adaptation cycle – what is it?

— Where various global regions are in the cycle

— The considerations for airports based on previous lessons learnt

The airline industry adaptation cycle

Source: AMP Capital analysis

MAR BELTRAN Investment Director, Airports

ABOUT THE AUTHOR

As legacy airlines around the globe respond to the competitive market dynamics created by low cost carriers, there is a distinct cycle of adaptation for the industry. This happens to recapture lost market share and reposition carriers for financial performance. Airport operators must continuously assess elements of airport services and terminal design depending on where legacy and low cost carriers are in their respective ‘adaptation cycles’.What can we learn from the airline models adopted around the world? Is the model adopted by Australian carriers sustainable, and how will this impact Australia’s largest airports?

Mar Beltran is Investment Director of AMP Capital’s airport investments. Previously, Ms Beltran managed AMP Capital’s first social infrastructure fund, the AMP Capital Community Infrastructure Fund, as well as AMP Capital’s retail focused Core Infrastructure Fund. Prior to the Core Infrastructure Fund’s inception in October 2007, she served as a portfolio manager of AMP Life and the Future Directions Fund infrastructure portfolios, as well as the manager of AMP Capital’s investment in Australia Pacific Airports Corporation. Ms Beltran holds an Executive MBA from the Australian Graduate School of Management and has a Senior Aeronautical and Industrial Engineering Degree from Madrid Polytechnic University in Spain.

Low Cost Subsidiary

Network Adjustment

De-bundling

Consolidation

Full Service

LEGACY CARRIERS

Low Cost

ProliferationHybrid

De-bundling

LOW COST

CARRIERS

De-bundledLow Cost

Consolidation

WHERE ARE WE NOW IN THE CYCLE?

The following diagram shows the evolution of these cycles in each of the global regions. It shows the impact on market share, adjustments to airlines models and the impacts on financial performance.

Legacy carriers have been repositioning, and further segmenting their networks, as well as launching premium economy products to regain cabin yield. Within a competitive domestic environment this has not been enough and in response to getting their premium value proposition right, have also commenced their own processes of product de-bundling.

Within an unprecedented industry environment that has included deregulation, wars, SARS, the September 11 terrorist attacks and economic recession, there has been incredible pressure on performance. This has seen the legacy cycle, unable to adapt quickly enough to its high cost base, and pass through a period of consolidation.

In the European market, Air France has merged with KLM, Lufthansa with SWISS, Brussels Airlines and Austrian Airlines, and British Airways with Iberia and Vueling.

In North America, American Airlines has merged with US Airways, United Airlines with Continental Airlines and Delta Airlines with Northwest Airlines. These carriers are now managing their integration programs and are delivering substantial profits off a scaled cost base.

The low cost carrier cycle is also coming full circle, with those that remain slowly moving across into the consolidated legacy airline space. They are increasing their product and service offerings, tempted by the higher yielding corporate market sectors to create hybrid models. These models are providing an increasing level of in-cabin product and service, with attributes chosen and packaged together by consumers to create their own value products. How far these hybrid models pitch into the legacy space by offering a medium and long haul network off a competitive cost base will be an interesting dynamic to watch.

Europe and North America have passed through the legacy and low cost carrier consolidation phase. Within these regions, the industry has now evolved to the point where financial performance has improved following significantly restructured and scaled back cost bases, and where the gap between legacy, hybrid and the individual brands of low cost carriers has become blurred. Most carriers are now looking to compete with an enhanced product offer that remains de-bundled, but which can be packaged by the consumer, to determine their own value for money.

Asian low cost carriers are in infancy stage, but pace of change has accelerated. The industry has lagged behind that of North America and Europe - however it is now beginning to grow rapidly as the region continues to develop economically. It continues the process of deregulation and liberalisation and adapts its infrastructure to accommodate the low cost carrier model.

Low cost carriers are expanding and gaining market share stimulating demand with attractive fares and new routes. In 2014 AirAsia was again awarded the world’s best low cost airline for the sixth consecutive year in a row.

The Oceanic region is half way through the cycle and in ‘unstable’ territory. In this region the models of adaptation are not quite as far advanced as the European and North American markets. Legacy carriers are fully de-bundling their service offerings to turn performance around and may be on the verge of consolidation in the low cost carrier space.

Australia is at the point in both legacy and low cost cycles where product differentiation through de-bundling is the competitive edge. Within Australia, it is important to note the significant underperformance of the Qantas international flying business, and the impact this has on the industry. Unlike the other global regions, regulation through the Qantas Sales Act is preventing Qantas from doing what other global legacy carriers have done – i.e. merge with a partner to rescale its cost base, leverage operational synergies and reposition its brand. It would appear that Qantas may need more flexibility to adapt its business model and the biggest constraint is the Qantas Sale Act 1992. If freed from these regulatory restrictions it is likely the Australian aviation industry would move forward in line with other global regions to deliver better financial performance and a more certain future.

For a deeper analysis of Australian carriers, please contact our Infrastructure team via ampcapital.com

Where various regions are in the cycle

Source: AMP Capital analysis

Low Cost Subsidiary

Network Adjustment

De-bundling

Consolidation

Full Service

LEGACY CARRIERS

Low Cost

ProliferationHybrid

Consolidation De-bundling

LOW COST CARRIERS

De-bundledLow Cost

North America

North America

UK/Europe

UK/Europe

Australia

Asia

Asia

Australia

CONSIDERATIONS FOR AIRPORTS

All of these potential airline futures raise some interesting considerations for the airports with whom they interface.

Looking globally, we can see airports have and are adapting their infrastructure to meet the needs of low cost carriers. Airports are building dedicated low cost terminals, often separated from the main international terminals, with a menu of services available for use at discounted rates.

One of the lessons that airports have learnt is that there is no guarantee of low cost carrier loyalty. As the cycle of airline adaptation evolves, low cost operators are changing their models and slowly moving back into hybrid airlines. This, in turn, raises questions about the future of dedicated low cost carrier terminals and whether, in fact, airports are better to avoid exclusive arrangements and remain more flexible in their terminal designs. At the other end of the spectrum, legacy airlines are also looking to enhance their consumer’s airport experience, and extend the de-bundling and segmentation of the offer into the airport.

Discussion in the industry includes future airport designs that segment the airport infrastructure vertically, designing a full premium experience for passengers, a premium economy experience, and a different experience again for economy passengers. This design could also facilitate a low cost offering.

The benefits of such a design eliminates the need to build dedicated and isolated terminals, but allows for scale to be consolidated within a centralised terminal building that offers a streamlined and tailored passenger experience for all airlines offering a similar segmentation. A common user approach such as this cushions the airport against industry cycles - i.e. against consolidation and the shifting of carriers between models and service offerings.

Other terminal design options include the model of integrating home carrier domestic and international terminal services, as these airlines look for a competitive home advantage. In the case of Sydney and Brisbane Airports, one could readily see the benefits of integrating the Qantas domestic and international services as the terminals from which they currently operate are physically isolated from each other.

This opportunity is also available for Melbourne Airport when Jetstar relocates into a dedicated low cost carrier terminal, and frees up substantial capacity in the current Qantas Terminal 1. However, given the uncertainty around the future of Qantas, particularly with its international business, a dedicated terminal might not be sustainable in the short-term.

There might also be a future where de-bundling of the domestic product could position Jetstar and Qantas to merge their businesses. This could allow Jetstar to take over the flying network of Qantas to leverage its lower cost base but retain integration of premium services at the lounge and frequent flyer program level. In this scenario, the purpose built low cost carrier terminal would be less than ideal for a merged Jetstar and Qantas carrier.

How might various scenarios impact terminal capacity?

We analysed the potential impact on terminal capacity at Melbourne Airport for a few potential scenarios. The results of these scenarios are represented in the chart, which highlight the change in the number of years available for each terminal before it reaches capacity. The results show that from a capital management perspective, there is the potential to reshuffle supply and adjust or defer a medium-term capital program.

Terminal base case: Terminals are configured where only Qantas is operating out of Terminal 1 in 2015 and Jetstar and Tiger are operating fully out of Terminal 4. Terminal 2 continues to service the current portfolio of international airlines and Virgin Australia is operating out of Terminal 3.

Terminal 1 base case and international: Qantas domestic and international services are combined into Terminal 1.

Terminal 1 base case and international merger with Middle East carrier: Qantas mergers with Emirates - all the associated international traffic of QF and Emirates shifts into Terminal 1.

Terminal base case – slower domestic growth: Same as terminal Base Case but with a lower outlook on forecast domestic growth as a consequence of Qantas and Virgin managing for yield.

Number of years till terminal capacity is reached

Source: AMP Capital.

Note: Terminal capacities are a measure of passenger throughput not aircraft movements, and as such make no comment as to the ability to handle the corresponding number of required aircraft movements or aircraft sizes. Further, these terminal capacities do not take into account any pattern associated with peak hour handling.

Given the future uncertainty of our airlines, and the potential changes in the operating models across the next 10 years, it may be more prudent to retain as much flexibility in terminal arrangements as possible. It will also be important to avoid entering into exclusive arrangements that may prohibit a reshuffling of supply and impact a suboptimal capital program.

0 5 10 15 20 25

T1 base case +international merger

with Middle East carrier

T1 base case +international

Terminalsbase case

Impact T4 Impact T3 Impact T2 Impact T1

Terminals base case slower

domestic growth

Important notice While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. © Copyright 2014 AMP Capital Investors Limited. All rights reserved.

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In addition, airports will need to be constantly assessing the social and environmental impacts of terminal reconfigurations and construction, as these can have a major impact on the commercial, financial and reputational components of the business.

There are multiple social issues that will need to be assessed including impacts from noise, visual amenity, safety, and passenger grievances or losses.

We will continue to monitor changes in the Australian aviation landscape, in particular any further changes to the Qantas Sales Act, and look to other global markets for lessons to be learnt as it manages its investors’ interests in airports.