Low-cost subsidiaries: compromise carriers May 2002

Air Canada is the latest of the major carriers to experiment with a new low–cost subsidiary. Air Canada ZIP will be based at Calgary initially operating six 737–200s, with plans to grow to 22. The new carrier will take on the successful and expansionist WestJet. This is despite the miserable performance of such ventures in the US where there has been a long list of failures from Continental Lite in the mid 90s to US Airways' MetroJet last December.

In Europe many of the Euro–majors, including Lufthansa, are considering whether they should set up a lower cost subsidiary. KLM is currently the leading exponent of low–cost subsidiaries, and has announced plans to expand Buzz by merging it with Basiq Air, the low–cost scheduled arm of KLM’s charter carrier Transavia.

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 might 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. BA has in effect been forced to retreat further into Fortress Heathrow, while its control of the London market has been eroded.

Heathrow is the most convenient airport for west London, but the low–cost carriers are in a stronger position in of north and east London (easyJet at Luton; Ryanair, Go and Buzz at Stansted) and now south London (easyJet at Gatwick).

Conflict between BA and Go was further intensified because the UK competition authorities insisted that the two operations be conducted completely separately. The result was Go planned its network growth independently from BA and gave its parent some nasty surprises when it announced the launch of competing services.

Rod Eddington’s assessment of Go when he arrived at BA was that it was not, as his managers claimed, a response to the low–cost threat but a way for the mainline carrier to avoid really confronting the low–cost threat. He was probably right even if the price he sold Go at, £100m, now looks distinctly cheap.

Union considerations

Frequently low–cost subsidiaries are seen as a way of tackling labour costs without confronting unions — a variation on the A/B wage scales introduced by American in the 80s. The unions themselves 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 — to impose a scope agreement like those the US Majors' pilots have negotiated with regard to the regional affiliates and the low–cost subsidiaries.

Post September 11, the US Majors largely abandoned their low–cost experiments. US Airways closed down MetroJet, United ended California–based Shuttle by United and Delta reduced Delta Express’s operation by half. In all cases the airline managements cited union undermining of their cost structures — not so much in terms of pilot salaries as in terms of productivity.

In Europe low–cost subsidiaries have been neutralised by becoming just like their parent. Alitalia Team was a brave attempt to tackle cost problems by shifting operations to a more efficient structure.

But now Alitalia is now almost 100% Alitalia Team, and most of the efficiency gains have evaporated leaving Alitalia again in a distressed financial situation.

Macedonian Airlines in Greece was an attempt to at least challenge Olympic’s all–powerful labour force by outsourcing some services to a more cost effective subsidiary, with crews flying on more flexible working practices. Inevitably, they have managed to make so many modifications to the rule book that Macedonian is now just as costly as its parent.

Mainline legacy

One of the great hopes for low–cost subsidiaries is that they will be able to combine some of the best elements of the mainline carriers with the operational efficiencies of a dedicated low–cost operator.

Unfortunately, rather than a halo effect, low–cost subsidiaries tend to cause brand confusion. For example, customers became confused and frustrated by differentiation between CAL Lite and Continental Airlines — it just seemed that service was even worse on some flights than on other. Air Canada risks further undermining its brand if ZIP is perceived as a lower quality, same fare carrier in western Canada (this is how WestJet’s management expects ZIP to impact their business).

In terms of technology transfer from the mainline to the subsidiary, there does appear to be much scope because yield management systems, internet booking engines, etc have to be specifically designed for the low–cost model.

Fleet planning in a low–cost subsidiary has frequently proved to be an exercise in expediency.

MetroJet inherited unwanted and fuel–inefficient 737–200s from US Airways; ZIP is getting a similar deal from Air Canada. Buzz’s fleet reflects its history — a mix of 100–seat BAe 146s from KLM uk plus some 737–300s. KLM is only now addressing Buzz’s fleet problems, and will probably opt for an all 737 operation.

It is a little ironic that one of the major concerns when Go was set up was that it would benefit unfairly from BA’s superior credit rating when leasing aircraft. Now the leading low–cost carriers have credit rating and stock market valuations well in excess of the mainline carriers. Airbus and Boeing are desperate for their business, and they can negotiate the best unit prices.

Rationale?

So, is there a rationale for low–cost subsidiaries in the European market? There is the hope that it is possible to improve the low–cost subsidiary model so that it does work effectively. Most of the early attempts at low–cost carriers in the deregulated European market failed, and lessons were learnt from those failures. For some of the beleaguered mainline carriers, creating a low–cost subsidiary may be an emergency fall–back strategy. They will have set up a legal entity and an embryonic airline to retreat into if competition gets really tough, and bankruptcy looms.