Rationalising the
intra-European market March 2016

Although the low cost carrier is established as the most efficient model for short/medium haul travel in Europe, and the network carriers’ short haul operations generally continue to lose money, and the traditional charter carrier business is evaporating, the LCCs still represent less than one half of intra-European capacity.

The industry remains remarkably fragmented, with at least seven segments.

• The five main LCCs — Ryanair, easyJet, Wizz Air, norwegian, plus the rapidly growing Pegasus. Ryanair remains the market leader, adapting its ultra low cost strategy to higher-yielding business orientated markets with “Always Getting Better” soft product improvements, and further strengthening its finances. Meanwhile, easyJet, having led the LCC advance into business markets, is being forced to refocus on its cost base and retreat from major cities like Rome. Wizz has unit costs similar to Ryanair’s and a solid central European core, but is the most threatened of the LCCs by Brexit, the UK’s possible withdrawal from the EU, as about 30% of its traffic is between East Europe and the UK. Norwegian continues to pursue an innovative, but risky, long-haul expansion, and continues to come up against US protectionism. Pegasus is as yet a relatively unknown presence outside the rapidly growing Turkish market.
• The short haul networks of the three global network carriers, of which only one, IAG, is currently financially successful, while the other two, Lufthansa Group and Air France/KLM are struggling. The network carriers have retreated to various degrees from non-hub operations, leaving them with their core hub feeding role.

• The lower cost subsidiaries of the network carriers — Vueling, Eurowings, Transavia. Of these subsidiaries only Vueling is clearly a viable proposition largely because of its role as the de facto flag carrier of Catalonia. Transavia and Eurowings are faced with unresolved labour and network problems; their growth plans are aspirations rather than realities.
• The remaining independent or quasi-independent national carriers — SAS, LOT, TAP, SN Brussels, etc.
• A subset: Etihad-invested airlines — airberlin, Alitalia, Air Serbia, Meridiana (potentially), etc. Their future depends on the willingness of Abu Dhabi to maintain this particular aspect of its oil diversification investment strategy.
• The residual charter industry, which continues to display an element of resilience as evidenced by Monarch’s turnaround from an apparently hopeless situation.
• The niche carriers, notably Aegean (successful hybrid but exposed to Greek crisis) and Volotea (stimulating unlikely traffic flows in niche markets).

The pie charts summarise the total intra-European market in terms of capacity. It is notable how restrained total capacity growth has been over this period.

Looking at some key traffic trends, pulled together from various sources:

• The total intra-European market has grown at an average annual compound rate of 4% in the last ten years in terms of passengers carried to an estimated 650m.
• LCCs have provided substantially all the growth — a compound annual growth rate of 12% a year over the past ten years. The LCCs as a broad group account for 45% of intra-European passenger traffic up from 23% ten years ago.
• The former AEA carrier group meanwhile have seen passenger numbers virtually static with annual average growth of 1%.
• The three main network carrier groups (IAG, Air France-KLM and LHAG) have seen no growth in intra-European passenger traffic after accounting for acquisitions; but their LCC subsidiaries and affiliates have been increasing capacity at a compound annual rate of over 10% in the past five years, albeit from low bases.
• Traditional charters have seen their business decline by about a third over this period.

There is a tendency to overestimate how quickly rationalisation of this market will occur. Different airline models will continue to co-exist, but there are clear trends as to the dominant LCC model increasing its market share at the expense of the network carriers’ short haul operations, while two of their low cost subsidiaries appear to be vulnerable.

The most definite indication of the future comes from the firm order book — approximately 1,600 narrow bodies as at the end of 2015.

• The main LCCs account for 55%.
• The three network carriers, 12%.
• The LCC Subsidiaries of the network carriers, 6%.
• Charters, 6%.
• Others, 21% (of which THY accounts for nearly 11%).

A forecast

We have generated a traffic forecast for the “core” intra-European market based on the explicit fleet expansion plans of the main LCCs, the three network carriers and their three LCC subsidiaries. To focus the analysis, we have only used the fleet plans of the most significant players for the period to 2022: the LCCs (Ryanair, easyJet, Wizz and norwegian); the Network carriers (IAG, Lufthansa and Air France-KLM); and the LCC subsidiaries/affiliates (Vueling, Transavia and Eurowings). Note that all the numbers quoted below refer only to the intra-European operations of this core group (estimated to account for about 80% of total intra-European traffic).

The central forecasts made by the airlines themselves have been used wherever available. Various estimates have had to made, particular in the case of Lufthansa and Air France-KLM and their subsidiaries, where fleet plans have not been quantified beyond a few years. Retirement profiles have also been factored in.

The next stage is to convert the annual fleet projections into a seat capacity forecast by multiplying the number of units by the average number of annual seats generated per aircraft (based on 2014/15 data), In turn the capacity estimates are converted into passengers by applying the latest annual average load factors. Finally, an “efficiency” factor is added to the equation reflecting a modest expected improvement in aircraft utilisation and/or load factor over the forecast period.

So we end up with a traffic forecast for the three sectors which is consistent with the fleet plans as they stand at present. An implicit assumption is that economic conditions will be benign; a major recession would cause easyJet, for example, to radically downsize its growth plans.

Overall the market continues to be driven by the LCCs whose combined growth rate 2015-2022 is estimated at 9.3% pa, back to close to the rate before retrenchment in 2009-2014. The network carriers’ growth rate is 2.1% pa, while that of the LCC affiliates is put between the other two sectors, at 5.6% pa.

The overall intra-European growth rate then works out at 6.4% pa for 2015-2022.

It should be remembered that the LCC fleets plans are firm, or at least are explicit, and two of the leading LCCs also provide base passenger forecasts for the long term (which are broadly compatible with our calculated future volume). By contrast, the network carriers, with the exception of IAG, are much vaguer with fleet projections beyond the very short term. The affiliates’ plans are even more fluid, again with the exception of IAG’s Vueling, dependent on union negotiation and setting hopeful targets, notably Lufthansa’s claim that Eurowings will somehow emerge as Europe’s third LCC.

The total market growth rate of 6.4% pa looks compatible with LCC-type expansion but is high for the total intra-European market. The historic traffic growth rate was around the 3-4% mark; and our assessed baseline assumption is 3% going forward. The Airbus intra-European traffic forecast, albeit for a longer period to 2034, predicts just 1.5% pa. There is significant difference in passenger totals derived from 3% compounding and 6.4% compounding growth rate. In fact, as the graph below illustrates the implication is for a theoretical 20% surplus by 2022.

Although there are various ways this potential surplus could be resolved — lower LCC delivery profiles, new LCC markets, total collapse of the Charter industry and/or smaller flag carriers — market trends point to the major impact being absorbed by the network carriers (and their subsidiaries), Lufthansa and Air France-KLM in the main.

The fundamental reason is the unit cost advantage the LCCs hold in a market where other factors, like claimed service quality or brand loyalty, continue to decline in importance. One can also trace the evolution of LCC traffic in three phases:

• 2002-2009 Rapid Growth: Stimulation of new markets and thinner routes, converting VFR and Charter passengers to the LCC mode, opening up in Eastern Europe, concentration on secondary points.
• 2010-2014 Consolidation: Slow-down in deliveries, initial “land grab” completed, emergence of new LCC models, more focus on primary points.
• 2015-2022? Move into network carrier core markets: Focus on higher yielding routes, LCC rebranding and product improvement, primary airports, new distribution models, interlining, new feed agreements; network carriers forced to retrench further and concentrate on long-haul.

LCC subsidiary — an unviable model?

One of the fundamental problems with low cost subsidiaries is that they are compromises. The parent airline’s aim is usually to counteract low–cost competition but it has to do this without either disturbing its own unions or undermining its core network business. Consequently, a series of conflicts arise.

Airport base: To leverage the benefits of a low–cost subsidiary, the optimal place to locate it would be at the main hub where yields are strongest (despite the fact that airport charges are likely to be high there). This is rarely if ever possible because of fears of brand pollution and union agreements.

Locating at a secondary airport at the incumbent airline’s main city base then seemed to be a good idea: establishing Go at Stansted, it was thought, would not only inhibit the growth of Ryanair but would also tie up slots at London’s third airport. That didn’t work for BA — Go helped stimulate the overall low-cost market and cannibalised BA’s Heathrow traffic.

The French version of Transavia is based at Orly, where it can indirectly impact AF’s CDG traffic. The Dutch version is starting a new base at Munich where it will face a typical dilemma — it will be under intense pressure from the incumbent carrier, Lufthansa, and if it does succeed in building a presence, the markets it stimulates are likely to be grabbed by efficient LCCs.

Eurowings is based at a variety of secondary airports — Düsseldorf, Hamburg, Cologne, Vienna — where it may have a certain brand loyalty but again will be the target of genuine LCCs.

Labour relations: These have been fraught; unions tend to be deeply suspicious of such ventures, regarding them, quite correctly, as a potential threat. Their response is to attempt to ring–fence the subsidiaries' activities — which frustrate the subsidiary’s employees who are denied the opportunities which come from rapid company growth; their aspirations to move to a better post in the parent company are also blocked.

Fleet growth: Although the parent airlines have ambitious fleet plans they appear to be aspirations rather than reality. The subsidiaries generally lack direct access to finance to fund major fleet growth. Eurowings has 22 units on firm order, Transavia 17 — in contrast to Vueling’s 60 let alone Ryanair’s 260. Without mega-orders the subsidiaries cannot attain major discounts, which again leaves them at serious cost disadvantage to the genuine LCCs.

In summary, Lufthansa’s and Air France-KLM’s rationale for low–cost subsidiaries is questionable. They probably do not provide a solution to loss-making short haul networks nor to the incursion of LCCs into core Legacy carrier markets.

New LCC feeder model

LCCs have greatly complicated network carriers’ feed strategies. Traditionally short haul flights to a long-haul hub relied on a high proportion of point-to-point passengers in the total traffic mix. The reason was that these passengers were higher yielding than the connecting passengers, which was partly the result of internal accounting conventions that pro-rated through ticket revenue on a distance basis. The LCCs have eroded those network economics by capturing more and more of the point-to-point traffic either at airports within the city capture zone or, increasingly, with services to the major airport hub.

In the future it would be logical to expect LCCs to play a significant role in feeding traffic to the network carriers at the intercontinental hubs.

LCC interlining/connecting models do exist — JetStar Asia interlines with several full services carriers collecting feed at its Singapore base. COPA, the high successful Panama-based LCC, has signed interline agreements with Emirates and Star Alliance airlines. But the European model, as yet a matter for speculation only, would involve, for instance, easyJet providing AF with feed at CDG or Ryanair taking over LH’s short haul service to Munich or even Frankfurt.

These are some of the issues which used to be intractable but may no longer be so:

• Distribution used to pose a major barrier but with the leading LCCs experimenting with GDS and IT systems becoming cleverer interline bookings should no longer be an issue, though there still may be yield management conflicts.
• Product: the short haul experience on LCCs and network carriers has converged to such an extent that economy passengers would have little cause for complaint, but the Legacies will always want to protect their brand.
• Primary vs secondary airports: again what used to be a major distinction, but increasingly the LCC are operating to the major hubs.
• Operating to major hubs will inevitably change an LCC’s cost structure — not just higher airport charges but also decreased aircraft utilisation because of longer turn-around times; but with no need to stimulate traffic, the higher yields should more than compensate.
• For the network carrier the significantly lower costs should be compelling, but outsourcing a vital part of the network to a LCC remains a frightening proposition, fraught with implementation risks.