MasterCard says Low Cost Carriers to Provide Impetus for a Challenging and Promising Airline Industry in Asia/Pacific

Travel News Asia 19 January 2005

MasterCard International today announced a new landmark report that examines the impact of low cost carriers (LCCs) on the airlines industry in Asia/Pacific. The report explains how LCCs may generate more traffic volumes and induce a faster growth in revenue paying passengers by enticing lower income travelers to travel in and around the region. It also discusses how, under a scenario of open skies in Asia/Pacific, the LCCs may erode the traditional position of full service carriers and result in the need for new competitive strategies, as well as potential consolidation, mergers or downsizing of some of the existing full service players.

Dr Yuwa Hedrick-Wong, economic advisor, Asia/Pacific, MasterCard, said: The growth potential of the airlines industry in Asia/Pacific is the highest in the world, with or without the LCCs. The operational environment that will unfold in the coming years will also likely to be different from that of Europe or the US. A unique situation is therefore evolving in Asia/Pacific LCCs will have to operate in a less than optimal environment, against a background of having the highest growth in the world.

Advantages of LCCs

The business model of LCCs gives them enormous advantages over full service carriers enabling them to maintain fares that entice lower income travelers to fly. The point-to-point system of the LCCs, for example, gives them a huge cost advantage over full service carriers hub-and-spoke model. It eliminates the need for a ground transfer system and a virtual computer reservations system to provide connections.

LCCs also opt to have greater use of the internet and restricted distribution channels such as their own sales outlets, or one or two selected distributors. This sales channel and the single class model effectively reduce the need for complicated inventory management.

Perhaps the real advantage that LCCs have is their focus on short range operations. In Asia, this means flights of less than three hours. This allows them to rely on a single aisle common aircraft fleet. While common airframes ensure that cockpits are the same and flight deck crew can effectively operate on any sector. The fleet also has the added advantage of having common engineers which ensure less spare part holdings of different types. Significantly, LCCs have often opted to outsource engine and airframe services so that internal cost burdens are further reduced.

The results of a simplified fleet structure, point-to-point operations, outsourcing of the technical functions and, because of the newness of the phenomenon, staff members who are younger. All these culminate to lower staffing costs.

The Impact of Budget Carriers

The fundamental core of LCCs operations is to maintain a low cost base on which is grafted high load factors achieved through low prices. In doing so, they have changed the operation structure of the airline business by using three variable, pricing, load factor and operating cost, instead of the traditional two factors, pricing and load factor that full service carriers have traditionally engaged in.

LCCs focus on achieving high load factors and lower prices to achieve good yields. At the same time, they keep operating costs down to achieve profitability. Full service carriers found this difficult to copy because of their inflexible structural costs: different fleet configurations, hub-and-spoke networks, computer reservation systems, and an older workforce.

LCCs operate most successfully in the common open skies environment in Europe and the US. In Asia/Pacific, however, there is no common open skies arrangement. The present emergence of LCCs in the region is occurring within and limited by the context of point-to-point operations permitted by the existing bilateral agreements. In the absence of a region-wide open skies agreement, the main markets of interest for a potentially explosive growth of LCCs remains China and, to a lesser extent, India. In China, for example, there are 780 routes which are short and medium haul, with around 70% of them estimated to be suitable for LCCs.

In Europe and the US, the entry of LCCs results in price compression. This means that the average prices charged by full service carriers will be forced down, in the short-term, as they begin to compete with LCCs on their respective sectors. The second is that in order to compensate for lower prices, these full service carriers will attempt to increase their load factors. In Asia/Pacific case, the situation may evolve differently. The market dynamics in the region still allows room for airlines to continue to increase their load factor without reducing prices.

If there is an Asia/Pacific open skies environment than all players will be forced to deal with price compression more aggressively as LCCs penetrate all or most of the medium and short-haul sectors, significantly impacting the competitive structure in the region. For the industry this change will mean that many of the full service carriers may be forced to choose between long and short hauls. This will result in an overall price reduction across the board. However, this resulting price competition will also force the carriers to increase their load factor in order to remain profitable. It is estimated that an increase of load factor by most carriers by 5% is needed to compensate for a 10% price reduction.

These industry effects under the open skies scenario in Asia/Pacific may therefore propel two specific ways of addressing the challenges. The first is for the major full service carriers to focus on the long haul sectors and to spin-off the short and medium haul sectors to their subsidiaries. The second is for the full service carriers to redefine their products and elect to operate in specific niches in which they have a loyal customer base.

With or without open skies, the arrival of LCCs in Asia/Pacific will likely make the airline industry more dynamic, competitive, with more refined market segmentation and customer management. Many of the developments will be challenging to the industry, but they will also bring with them new and exciting opportunities for service innovation and growth, observed Dr Hedrick-Wong.

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