This article was written by Robert Boyle and sponsored by our Aviation & Aerospace Practice.
Has the time finally come for low-cost long-haul?
The low-cost business model has been extremely successful in short-haul. The only real challenge to it in the minds of investors is the ultra low-cost model, which builds on the strengths of the low-cost model and "turns it up to 11".
But for some reason, when the journey time reaches 4-5 hours, the sentiment shifts. "Low-cost long-haul doesn't work", has become almost as universally accepted by analysts as "lowest cost always wins in short-haul". Why is this?
It is true that there have been high profile failures, notably Norwegian, but do these cases just represent poor execution? Or are there more fundamental reasons why the model does not seem to have translated well? And could the pandemic have shifted the balance in favour of low-cost as a model for long-haul going forward?
In trying to answer these questions, I’d like to begin by looking at what makes the low-cost model so successful in short-haul. That starts of course with much lower unit costs, but where does this advantage come from?
Unit cost advantage #1: Seating density
The single most important factor in reducing unit costs is seat density. Get 10% more seats on the same aircraft and you’ve pretty much cut unit costs by the same amount. Nothing else can give you the same scale of advantage. If easyJet had the same 144 seat count as the two class aircraft that British Airways operates on flights to Europe, it would have to eliminate 100% of its employee costs to offset the unit cost impact.
Of course, British Airways would rightly argue that it gets a revenue premium from its business class cabin. But for markets where there is little or no business class demand, the aircraft configuration decision that BA has taken has made it impossible for them to compete for the 85% of the market that is basing its purchase decisions essentially on price.
Unit cost advantage #2: Airport costs
EasyJet’s largest cost category is airport and ground handling, making up 31% of total operating costs in 2019. A 25% increase in these costs would wipe out their profits.
Simplified airport processes and outsourced ground handling give them significant cost advantages that network airlines cannot match, at least from their main hub airports. But equally important is their ability to get better deals from airports. Their “USP” to customers (price) is less dependent on which airport they operate from. People will drive quite a distance to get a bargain. Outsourced airport operations give them cost variability. These factors leave them better able to play airports off against each other, as they can easily downsize and upsize their operations in response to airport incentives.
Unit cost advantage #3: Labour costs
Source: CAA 2015
The above chart shows the significant cost advantage on basic cost per employee that easyJet has compared to long-established airlines like BA. Unfortunately, the most recent public data that I have is from 2015. But in the following four years, the average cost per employee went up 9% at BA and only 8% at easyJet, so I don’t think the relative positions have changed that much. You can see now why BA has been pushing so hard to tackle these cost issues and why cabin crew is where the most noise is coming from.
There are of course other sources of cost advantage, like aircraft utilisation from fast turnarounds and extended operating days. There is also a big gap in overhead costs, with the simpler business model of low-cost carriers needing less complex IT and other infrastructure to support it. But given limited space, I will turn to the other big advantage of the low-cost model: revenue.
You might think it strange that I am picking revenue as an area of advantage for the low-cost airline model. In terms of average fares, the network airlines enjoy a significant premium, of course. But that is mainly driven by business passengers, which, as we have seen, also drive significant costs. For leisure passengers, the low headline prices and massive ancillary revenue sales associated with the highly unbundled pricing model of the low-cost airlines actually drives a higher realised total revenue per seat in many instances.
Why have the network carriers not copied this, if it is a superior revenue model? Well they have tried and with some success. However, they are always constrained by worries about diluting business passenger yields and by their legacy IT systems, which are simply not optimised for a commercial model which prioritises ancillary sales.
Another constraint is the brand positioning of the big network carriers. Their premium positioning designed for long-haul and for business class passengers becomes a constraint when trying to sell £50 tickets to people looking for a cheap flight to Malaga. Quite simply, if you were trying to run a discount store, you would not put “Harrods” on the outside of the shop and expect to sell very much.
So, what about low-cost long-haul?
Which of these advantages transfer well to long-haul and which do not? And how has the pandemic changed things?
Seating density works just as well. IAG’s low-cost long-haul airline LEVEL has 314 seats on its A330-200 aircraft, compared to the 288 that Iberia fit on the same aircraft, a 9% increase. I don’t have a like-for-like comparison with BA, but that would be an even bigger gap given the premium-rich configurations that BA typically flies. Of course, business class has always been a much more important source of revenue for long-haul travel and this is one of the reasons why the network airlines have been able to beat the low-cost operators on most long-haul markets. However, for routes where there is little business class demand, the low-cost model will have the advantage. COVID has hit business demand harder than leisure, increasing the number of markets where low-cost will work well.
Airport costs are much less important for long-haul than they are for short-haul, for obvious reasons. But they are still important and provide a source of advantage. Over the next few years, airports will be desperately trying to maintain their prices for perceived “captive” airlines operating hubs, whilst finding ways to entice new airlines to bring much needed passenger volume.
Labour costs make up a slightly smaller proportion of total costs for long-haul than for short-haul, but they are still important. Long-haul specialist Virgin Atlantic’s labour costs represented 14.5% of total operating costs in 2018 (the latest accounts we have), almost exactly the same proportion as easyJet’s. With the pandemic having created a huge pool of out-of-work and experienced pilots, cabin crew and other airline professionals, this is an opportune time for a new low-cost airline to hire people at rock bottom rates.
What about the revenue advantages of the low-cost model, do they translate into long-haul? Fundamentally the answer is yes. A low headline price is even more useful for attracting passengers when the sticker price is higher to start with. You might think that nobody will travel with hand baggage only and bring their own food and drink when taking a ten-hour flight, but there are plenty who will for the right price. And ten hours gives a much longer window to sell people stuff on board. People who are now “on holiday” are less price sensitive than they were when booking their trip. Another beer? Why not.
Finally, a word about aircraft. This is typically one of the areas of challenge for low-cost long-haul. The aircraft which have intrinsically good unit costs tend to be big, especially when configured at high seating densities. Network airlines fill these aircraft with connecting traffic or business class seats. The emergence of smaller but equally efficient aircraft like the 787 is a game changer, but these aircraft have been expensive to buy or lease. With a minimum efficient fleet size of at least ten aircraft, the capital commitment to set up a low-cost long-haul airline using modern efficient aircraft has been quite a barrier. High capital requirements was one of the issues that ultimately sank Norwegian’s efforts. However, the pandemic has transformed aircraft availability and this may be a once in a lifetime opportunity to secure cheap, fuel-efficient wide-body aircraft. Something that really matters in long-haul.
What remains unclear is whether airlines or investors will think this is good moment to be launching a new long-haul airline with an unproven business model. It will certainly take some guts and vision.
But I’d bet there will be at least one brave management team and one set of investors out there who are prepared to give it a go.