The Entry of Low-Cost Airlines into the Market for Long-Haul Flights

Table of contents

1. Introduction

2. Characteristics of LCCs
2.1 Route network and additional services
2.2 Distribution channels & pricing
2.3 Operational aspects
2.4 Strategic positioning

3. Characteristics of the long-haul market
3.1 General structure and incumbent players
3.2 Requirements
3.2.1 ‘Feeding’ and ‘de-feeding’
3.2.2 International code-share alliances
3.3 Entry Barriers
3.3.1 Theoretical background
3.3.2 Entry barriers to the long-haul market

4. Entering the long-haul market
4.1 The transferability of the low-cost model from short-haul to long-haul
4.1.1 Transferable characteristics of the business model
4.1.2 Required adjustments
4.1.3 Conclusion: The low-cost long-haul business model
4.2 Judo economics as an auspicious framework for entry
4.2.1 Overall Framework
4.2.2 Capacity limitations: Theoretical background and transferability to this topic
4.2.3 Quantitative model for the ‘movement step’ of the Judo strategy
4.3 Practical implications for the entry
4.3.1 Overcoming barriers of entry
4.3.2 The Judo entry

5. Empirical evidence: Norwegian Airlines

6. Conclusion

7. List of references

1. Introduction

The entry of low-cost carriers (LCCs) in the early 1990ies revolutionized the European airline industry. Before the LCCs entered the European short-haul market, incumbent full service carriers (FSCs) were able to operate relatively unhindered. Supported by many deregulations, LCCs set their focus on a cost base as low as possible, so they were able to offer fares tremendously lower than incumbent players (Button & Ison, 2008). Even though they took some market share from the FSCs, the main success was based on the ability to reach new customer segments. Passengers, previously travelling by car or long-distance busses, took advantage of newly affordable airline fares and were willing to incur limited comfort.

Now, around 20 years after the first entry of European LCCs, the short-haul market is not expected to continue growing significantly (Heymann & Vollenkemper, 2005). Hence, if the LCCs want to continue their expansion, they need a ‘new market’, and it seems just like a question of time until they add long-haul routes to their route network. Nevertheless, the longand short-haul market are comparable just to a limited amount. As we will see in the following analyses and discussions, several specific characteristics require fundamental changes in the current LCC business model, which is optimized for short-haul operations. Especially in Asia there are already long-haul operations by LCCs (e.g. AirAsiaX), but the topic of this thesis will be the long-haul market based in Europe.

The focus point of this thesis is the development of an auspicious entry mode, based on theo- retical economic frameworks (executed in chapter four). In comparison to the short-haul mar- ket, competitive interactions between incumbent FSCs and entering LCCs are expected to be much more intense on long-haul routes. This is based on the fact that LCCs will not be able to sustain their high cost advantages also on long-haul routes (Wensveen & Leick, 2009). For long-haul flights it is also not possible to reduce provided comfort and additional services in such a way the LCCs currently do on their short-haul operations. Hence, on long-haul routes, entering LCCs and incumbent FSCs will be active much more in the same market than they currently do, which implies a much higher degree of competition (Morrell, 2008). This pro- vides several points of contact for game theoretical considerations, as we will see in the fol- lowing chapters. Nevertheless, the current business model, its transferability to the long-haul market and general characteristics of the long-haul market are also essential for the key topic, since these considerations influence entry analyses significantly (Francis et al., 2007). In the last part the current long-haul entry of Norwegian Airlines will be analyzed. As the first Eu- ropean LCC, which actually enters the long-haul market (Norwegian II, 2013), Norwegian’s activities show a high degree of conformity with the entry mode suggested in this thesis. To conclude, this thesis will try to give satisfying answers to following questions:

1. How do European LCCs currently generate such significant cost advantages?
2. To which extent can the LCC business model be transferred from short-haul to long- haul? Which adjustments are required?
3. Core topic: Based on economic theory, what would be an auspicious entry mode into long-haul operations? Which implications have results of theoretical analyses on prac- tical considerations?
4. To which extent are theoretical results from previous analyses congruent to reality?

2. Characteristics of LCCs

2.1 Route network and additional services

Most of the LCCs just offer the opportunity to book tickets for point-to-point connections directly from the origin to the destination airport (Francis et al., 2007). If a LCC does not of- fer a direct connection between two airports, normally it is not possible for the passenger to combine several connection flights within one booking process. In opposition to this, the typi- cal FSCs have a so called ‘hub and spoke network’. The potential passenger can combine all airports within the network of the airline to one journey (Franke, 2004). In many cases the customer has to change the aircraft at another airport, which can be interpreted as the ‘hub’. Regarding the distance of the offered flights one can say that European LCCs tend to offer just short-haul routes, whereas the route network of the FSCs includes short- and long-haul routes (Hunter, 2006). According to Francis et al. (2007), the cut between both categories is around six hours flying time, which is about the reach of an Airbus A320 airplane.

In comparison to the FSCs, a standard ticket for a flight with a LCC rarely includes additional services as free luggage, food, beverages, in-flight entertainment and so on (Button & Ison, 2008). To which extent this philosophy is applied, varies between the LCCs (Alamdari & Fa- gan, 2005). By selling additional services separately, the LCCs apply a maximization of the complementary revenues generated with those additional services (Button & Ison, 2008).

According to formal economic theory we can say that regarding the initial LCC product (the flight) there is no product differentiation. This is based on the fact that the LCCs normally just have one single class with the same amount of additional services. On the other hand, as there is the opportunity to ‘upgrade’ the flight by the purchase of additional services as transporta- tion of luggage, in-flight entertainment and so on, every passenger can create his own service bundle. Nevertheless, the initial ticket and the additional services are not sold as one product, so we can interpret both as separate products. In opposition to this, the FSCs offer different booking classes (economy, business, first etc.) connected to different levels of services (Hunter, 2006). Hence, the concept of LCCs includes no product differentiation regarding the initial ticket, whereas FSCs apply product differentiation due to different booking classes.

2.2 Distribution channels & pricing

The LCCs normally sell the huge majority of the tickets via online ticketing, whereas the FSCs also sell a big proportion via travel agents (Hunter, 2006). On the one hand, this ap- proach saves costs in terms of missing fees for travel agents (Francis et al., 2007). On the oth- er hand, LCCs keep as much control over the entire booking/ticketing process as possible.

According to Malighetti et al. (2009), the well-known special offer periods do not follow any rule regarding length and time. Regarding the development of prices, it is possible to state that the ticket prices of LCCs are (1) very unstable over time and (2) tend to increase over time by huge amounts (Piga & Bachis, 2006). In average, fares increase in a homogenous and contin- uous curve with big differences between initial price and last-minute price (Malighetti et al., 2009). To combine these empirical facts with some economic theory, LCCs apply their price discrimination mainly via the date of booking, since the quality of all seats is the same - there is just one single class. In opposition to that, the FSCs apply their price discrimination via the date of booking as well, but mainly via different booking classes (Malighetti et al., 2009), since they show a much higher stability over time. Based on those fundamental differences in pricing and distribution strategies, LCCs reach passenger load factors of around 80%, whereas FSCs remain at 70% for their inner-European flights (Francis et al., 2007).

2.3 Operational aspects

First of all, one of the most important approaches is surely the outsourcing of as many ground service activities as possible (Francis et al., 2007), such as fuel-filling, check-in staff, tech- nical checks and so on. The optimization of the ground service activities also results in very short turnaround times (Francis et al., 2007), which allows to use the aircraft as much as pos- sible to earn money with it. The short turnaround times are also supported by the fact that the LCCs normally only offer point-to-point connections, thus they do not have to ‘wait’ for con- necting passengers.

Another key cost saving approach is the maintenance of a common fleet with a possibly single type of aircraft (Klophaus et al., 2012). This simplifies all ground service activities and the complexity of scheduling. Additionally, the flexibility of staffing the crews is maximized. From a game theoretical point of view, the maintenance of a common fleet with a single aircraft type reduces the bargaining power in the negotiation with the aircraft manufacturers. If a LCC wants to enlarge its single aircraft fleet by some new aircrafts, the manufacturer can use the additional switching costs to another manufacturer to accomplish higher prices. To reduce this strategic disadvantage, the LCCs tend to order their airplanes in very big amounts and not so often as FSCs tend to do (Norwegian II, 2013).

In comparison with the FSCs, the LCCs tend to operate their flights between smaller airports, which are also known as ‘secondary airports’ (Alamdari & Fagan, 2005). Since these airports are much smaller than well-known and famous airports, the competition for aircrafts slots is much lower, which results in significantly lower fees for the airline (Francis et al., 2007). This directly implies a significant higher bargaining power regarding the fees for the aircraft slots (Gillen & Lall, 2004). With the focus on short turn-around times, the LCCs also tend to not offer cargo services (Alamdari & Fagan, 2005).

In line with Hunter (2006), payment conditions at LCCs are 5%-40% lower than the conditions for employees of FSCs. Regarding the job design, the employees of LCCs show a bigger amount of flexibility regarding their tasks and also many pilots are employed as contractors. Hence, Jetblue and Southwest as examples for typical LCCs end up at labor costs 30-40% lower than typical FSCs (Karivate, 2004).

2.4 Strategic positioning

According to Michael Porter, there are three main strategies for a company or organization to create a competitive advantage within its industry (Porter, 2004). A firm should either focus on a cost leadership strategy, a differentiation strategy or a focus strategy. If the firm focuses on achieving the cost leadership, it is able to offer a specific product to the lowest price in the market. If we transfer this to the airline industry, LCCs tend to act in line with this generic strategy based on Porter’s research (Alamdari & Fagan, 2005). How the LCCs achieve signif- icantly lower costs in comparison to the FSCs, has been analyzed in the previous chapters adequately. There are different estimations of how big the cost advantage is, but most of the authors end up at around 50% (Wensveen & Leick, 2009).

In the same way as the strategic positioning of the LCCs towards the FSCs can be analyzed in line with Porter’s thoughts, also the positioning of the LCCs among themselves can be exam- ined. The differentiation strategy describes a firm’s behavior in a way that the firm tries to add or change some attributes of the product it offers. Due to the changed product, the firm is able to differentiate itself from its rivals acting in the same or a connected market (Porter, 2004). The added/changed attributes either allow a premium price, an increasing market share or both. Recent economic literature states that the LCCs started to add some additional services to their initial product in the last years (Klophaus et al., 2012). Coming back to Porter’s theo- ry, this can be interpreted as the LCCs’ approach to apply the differentiation strategy. Even though the LCCs start to offer some more additional services, they are still not comparable with the FSCs. Combining this with the results presented above, we can say that the LCCs apply both the cost leadership strategy for the competition with the FSCs and the differentia- tion strategy for the competition with other LCCs.

In the public perception the main strategy of the LCCs seems to be the goal to ‘steal’ market share from the FSCs, but there are several empirical facts which stand in opposition to this. The main source for the tremendous success of the LCCs in recent years seems to be that the LCCs first enlarged the ‘pie’, before they cut off their piece. Due to significantly lower ticket prices, the LCCs were able to attract new customer segments. Customers, who were not able to afford flight tickets before due to high prices offered by the FSCs, became able to afford cheap LCC tickets. This statement is supported by Mason’s (2008) analysis of the number of passengers travelling between Barcelona and London between 1997 and 2005. The number of passengers flying with British Airways and Iberia as the incumbent FSCs remains on a rela- tively stable level, whereas the total number of passengers increases tremendously after the entry of the LCCs Easyjet and Ryanair (from 310,000 in 1997 to 1,250,000 in 2005).

According to Morrell (2008), especially the group of passengers who visit friends and rela- tives and low-budget tourists are the most important customers for the LCCs. Even a relative- ly cheap LCC ticket means a high proportion in the overall expenditures of the trip. In many cases, those customers do not choose between a LCC flight and a FSC flight, but they choose between ‘doing the trip’ and ‘not doing the trip’. Flying with a FSC has rarely been an option. Based on this, the well-known phrase that LCCs and FSCs are acting in a highly competitive relationship, does not fully meet reality. In line with this argumentation, the main competitors of the LCCs (on short-haul trips) seem to be long-distance busses, train connections or travel- ling by car. The ‘enlargement of the pie’ also gets supported by the fact that for example UK residents increased the proportion of their personal income spent for air travel by 250% between 1996 and 2006 (Mason, 2008).

If European LCCs enter the long-haul market now, it will be interesting to see to which extent they will be able to ‘enlarge’ this market as well. However, even though their fares will be relatively low in comparison with the incumbent FSCs, the fare will still be too high in order to motivate many additional passengers. This is also supported by the fact that many experts estimate the LCC cost advantages to be much lower for long-haul operations (e.g. Wensveen & Leick, 2009). This issue will be discussed in detail in the chapter regarding the transferability of the business model to long-haul routes (chapter 4.1).

Even though LCCs are acting mostly in their own customer segment, there is no doubt that they also took market shares from the FSCs, of course. In the last years, media coverage was high regarding the crisis of nearly all of the European FSCs. The entry of the LCCs into the inner-European short-/medium-haul market surely supported the crisis, but authors tend to see the main reasons more in the increasing competition due to deregulations, increasing costs for input factors as fuel, exogenous economic crises and the expansion of Asian airlines into the European market (Franke & John, 2011, Mason & Alamdari, 2007, or Grimme, 2011). A fur- ther analysis of the crisis of European FSCs would be beyond the scope of this thesis.

3. Characteristics of the long-haul market

3.1 General structure and incumbent players

Even though the airline industry was deregulated in many ways, the general market structure especially in Europe is still influenced by regulative issues (Chan, 2000). Based on the gen- eral history of the European airline industry, most of the countries founded their own national ‘flag carrier’ after World War II. It is obvious that the governments had the incentive to not allow other airlines to operate flights touching the ground of the own country. The first im- portant deregulation was applied in 1992, when the European Council of Ministers decided to remove several constraints regarding pricing and geographic distribution (Chan, 2000). From 1998 on it was possible for all EU airlines to operate flights independently from the origin of the airline. Prior to this change it was not fully legal to offer flights which do not touch the ‘home country’ of the airline (Chan, 2000). Without these deregulations it would not have been possible to (1) found a new airline as competitor to the flag carriers (usually FSCs) and to (2) have the opportunity to choose routes and the general operating model autonomous. Besides several inner-European short-haul low-cost airlines (such as Ryanair, EasyJet etc.), the long-haul market is still dominated by current or former flag carriers with a clear FSC business model (Dennis, 2005), such as British Airways, Lufthansa or Air France KLM. Be- sides Norwegian Airlines (see chapter five) none of the important European LCCs currently offers trans-continental long-haul flights. The biggest FSCs (given previously) are also mem- bers of international code-share alliances, which will be defined in detail in chapter 3.2.2. The airlines within one of such alliances tend to show collusive behavior regarding offered routes, prices and ticket distribution (Gayle, 2007 & 2008). However, this partial collusion is accept- ed by regulating authorities, otherwise it would not exist. Thus, an airline entering the long- haul-market should rather see itself in competition with entire alliances than with single play- ers. An application of this statement will follow in the chapter regarding Norwegian’s entry to the long-haul market.

Besides the ‘big players’ given above, there are also smaller European airlines which offer long-haul flights. Based on the historical evolution of the European airline market, nearly eve- ry country still has its own flag carrier (which might by privatized), even though many of them are owned by one of the big FSCs. For example, Lufthansa owns Austrian Airlines and Swiss, whereas Air France bought Dutch KLM and British Airways is owned by the same holding company as Iberia from Spain (see ‘investor relations’ section of the respective homepages of the mentioned airlines). Hence, the concentration especially in the European long-haul market is relatively high.

The hub-airport of the mentioned FSCs is usually located in the home country. Based on this, one might think that two airlines with their hubs (starting point for long-haul flights) located in different countries do not really act in the same market. Nevertheless, due to hub-and-spoke networks the FSCs normally apply, passengers have to change the flight anyways on their long-haul journey in most of the cases (Alamdari & Fagan, 2005). A passenger travelling from Berlin to New York does not care whether he is transferring in Frankfurt (using Luft- hansa) or London (using British Airways) to get his connecting long-haul flight to the US. Hence, the location of the hub-airport does not significantly affect the competition between FSCs due to existing network structures. If we transfer this to the topic of this thesis, an Euro- pean LCC entering the long-haul market must not consider just the ‘local’ FSC (and its code- share partners) as competitor, but all FSCs covering respective areas.

It is also important to note that with every flight to a trans-continental destination, there is also a local airline offering the same connection in many cases. An airline offering the route London-Peking is not just competing with other European airlines, but also with Chinese airlines. This additional competitor is differing with changing destinations, so the corresponding local airline is a competitor only for a limited number of routes.

3.2 Requirements

3.2.1 ‘Feeding’ and ‘de-feeding’

According to the current state of aircraft technology, the most efficient aircrafts for long-haul flights have a much higher passenger capacity than efficient short-haul aircrafts (Francis et al., 2007). To reach sufficient high passenger load factors, the long-haul operating airline needs more passengers per flight than on short-haul routes. Without feeding, only at airports in areas with a high density of population the demand is high enough to reach sufficient passenger load factors. Francis et al. (2007) show that even the FSCs, which are known for their rela- tively bad capacity utilization, reach values of around 80%. As soon as the local demand is not high enough, the airline has to find a way to bring passengers from more distant areas to the starting airport of the long-haul flight, and this approach is called ‘feeding’.

In the same way, as there likely is not enough local demand to start the flight at a specific airport, the demand for the specific destination airport might be too low. In the case that a significant number of passengers is continuing the journey after the arrival of the long-haul flight, the airline has to find a way how to transport the passengers to their final destination. This approach is called ‘de-feeding’. According to Francis et al. (2007), 85% passengers of the American Airlines flight from Manchester to Chicago connect to another flight in Chicago, which illustrates this issue adequately.

In the chapter regarding the network of the offered routes it was mentioned that the LCC cur- rently offer mainly point-to-point connections, whereas as the FSCs installed a so called hub- and-spoke network. The FSCs use their networks as a feeding system for the long-haul (inter- continental) flights which are departing at the hubs. Passengers, who want to start their jour- ney at an airport where the FSC does not offer a direct connection to the destination, are sup- posed to first take a flight to the next hub airport of the FSC where the long-haul flight depar- tures. If the final destination of the journey is not the destination of the long-haul flight, there is the requirement for ‘de-feeding’. In most cases, the de-feeding flight is operated by a code- share partner airline of the initial FSC, since the destination of the long-haul flight is not a hub of the initial FSC, but a hub of another airline. The importance of these code-share alliances will be discussed in the following chapter.

3.2.2 International code-share alliances

The requirement for an airline operating long-haul flights to be member of a code-share alli- ance is closely connected to the previous analysis. As soon as there is the requirement for feeding or de-feeding at an airport which is not the ‘home-airport’ of an airline, there is the opportunity to still offer those flights, but operated by another airline (Gayle, 2007). Well- known examples for such alliances are the Star Alliance (e.g. Lufthansa, SAS, United), SkyTeam (e.g. KLM, Delta) or oneworld (e.g. airberlin, British Airways). Usually the airlines within one code-share alliance automatically integrate fitting connecting flights into their booking system. Sometimes the flight operated by a partner airline even gets a flight number from the initial airline. If a passenger is involved in a code-share flight, in most cases the ‘de- feeding flight’ is operated by a partner from the code-share-alliance (Gayle, 2008).

Another important advantage of these alliances is the compatibility of the frequent flyer programs (FFP) between the airlines within one alliance. A member of Lufthansa’s ‘Miles and More’ program can earn bonus points by flying with any other airline which is member of the Star Alliance. In terms of entry barriers (see chapter 3.3), switching costs between airlines within one code-share alliance are more or less equal to zero.

In the case an airline faces technical problems with one of its aircrafts, partner airlines within the same code-share alliance can help out by transporting some of the ‘stuck’ passengers in other aircrafts with available seats. This issue is important especially on long-haul routes, since other transport services are not available and fitting flights are rare. The opportunity to get assistance by other airlines in such cases prevents negative news and passenger complaints (Aftenposten I, 2013).

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