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Comment on “legacy carriers fight back”
Journal of Air Transport Management 17 (2011) 40e43
Contents lists available at ScienceDirect
Journal of Air Transport Management journal homepage: www.elsevier.com/locate/jairtraman
Comment on “legacy carriers fight back” Mike Tretheway a, b, * a b
InterVISTAS Consulting Inc., Vancouver, Canada Sauder School of Business at the University of British Columbia, Vancouver, Canada
a b s t r a c t Keywords: Traditional network airlines Airline business models Empty core problems Airline competition
The paper offers a comment on an earlier article by Hazledine that argued a business model adopted by Air Canada and Air New Zealand allows them to compete with low cost airlines. Examination of the model, however, indicates that it offers only limited protection from low cost airlines competition that has the option of replicating the model itself if it proves successful in the short-term. Ó 2010 Published by Elsevier Ltd.
1. Introduction Tim Hazledine’s paper contributes to the literature on the different pricing approaches utilised historically and presently by the legacy full service network carriers versus the low cost carriers (LCCs) that have emerged. He puts forth the propositions that: “. The legacy carrier business model is not obsolete.” “. the legacy carriers’ fixed costs can actually deliver market value, that this value can be enhanced by shrewd and innovating pricing and marketing practices .” “. and that such practices cannot easily be replicated by LCCs and so can deliver a source of competitive market advantage to the legacy carriers which can compensate for the LCCs’ lower variable cost.” He then proceeds to discuss two cases, Air New Zealand and Air Canada, and the new pricing practices they have put in place. Here I point out that while conceptually interesting, the strategies of these two carriers have not proven to have been successful strategies, and the financial viability of the business models of full service carriers is still in some doubt. In this short comment I largely focus on Air Canada, as it has faced extensive LCC competition in it domestic market on and some “transborder” routes to the US, and then comment briefly on Air New Zealand, which is only starting to face LCC competition in domestic markets. First, I discuss some conceptual issues in airline price discrimination. 2. Background on airline price discrimination As Hazeldine observes, historically, following the 1978 deregulation of US airlines, what we now call the legacy carriers introduced * Sauder School of Business at the University of British Columbia, Vancouver, Canada. E-mail address: [email protected]. 0969-6997/$ e see front matter Ó 2010 Published by Elsevier Ltd. doi:10.1016/j.jairtraman.2010.10.009
a new method of price discrimination. At the time the industry referred to it as a “capacity controlled discounting” fare strategy. The mathematical systems used to implement it have been referred to variously as airline seat management, airline revenue management and airline yield management systems. That strategy discriminated between two broadly characterised groups of air travellers. “Business” traveller demand was characterised as having a high willingness to pay, but generally required both flexibility in their travel and travel within the same week. “Leisure” traveller demand had a much lower willingness to pay but were willing to travel on less convenient air services, including a requirement that their travel extend over a weekend.1 Prior to deregulation these two consumer groups were served by separate services with separate prices: charter flights at low fares to leisure destinations and scheduled services at high fares to a wide range of destinations. After deregulation, the scheduled carriers chose to serve both consumer segments from a common source of supply, a scheduled airline flight, whose capacity was not continuously variable.2 The immediate success of this strategy revealed that there were significant economies of scope in the supply of airline services. The challenge for the airlines was one of pricing. If both consumer groups were to be serviced from the same capacity, how could the low ability to pay group be attracted to a scheduled 1 Different restrictions applied to intercontinental strategy, such as minimum stay requirements rather than Saturday stayover, but the concept of discriminating between high versus low willingness to pay passengers was the same. 2 This means that if demand today is only for 70 seats at the high fare, the airline could not tailor capacity to 70 seats. If the flight is scheduled with an aircraft of 150 seats, the airline incurs the cost of supplying the fixed capacity of 150 seats. Airline seat management systems assume a fixed capacity, In practice, the carrier may be able to substitute aircraft of different sizes or vary the number of weekly flights in the market, but for a number of reasons, such adjustments to capacity are typically planned on a quarterly basis, and are difficult to undertake in the very short-term.
M. Tretheway / Journal of Air Transport Management 17 (2011) 40e43
service, while generating sufficient total revenue to cover flight costs? Price discrimination between the two groups was the answer. It was implemented by offering low fares only with accompanying restrictions. These typically limited travel flexibility e e.g., the traveller purchasing the low fare could not easily change flight plans, and required a saturday stayover or minimum travel duration that the high willingness to pay travellers generally would not abide by (Kraft et al., 1988). There was cross elasticity, of course, and some high willingness to pay travellers were able to conform to the restriction necessary for access to the low fare, but there was a sufficient number of business travellers unwilling to abide by the low fare access restrictions such that air carriers could achieve a sufficient degree of price discrimination to earn revenues for most flights that would cover flight costs and any other fixed costs of the airlines. Essentially, the low willingness to pay travellers were paying fares closer to marginal cost than the high willingness to pay travellers. Central to the legacy carriers’ ability to price discriminate was the restriction on low-fare tickets requiring purchase of a round-trip extending over a Saturday. In contrast, when what we now call low cost carriers (LCCs) entered the market, they adopted a very different pricing strategy. Originally typified by Southwest airlines, the LCCs allow purchase of low fare one-way tickets. This meant that business travellers could access low fares on travel not staying over a Saturday, by purchasing two separate one-way low-fare tickets.3 In those markets that LCCs entered, the legacy carriers immediately suffered an erosion of traffic and revenues, as the LCC one-way low fares undermined the ability of the legacy carriers to maintain their traditional price discrimination (Tretheway and Kincaid, 2005). As the LCCs entered more markets, especially in the late 1990s, legacy carriers found that the average fare they were receiving on flights was falling dramatically. For example, US Air Transport Association (annual) reported that real yield on domestic airline flights which was 6.70 cents per revenue ton-mile in 1990, fell to 5.78 cents by 1995, 5.52 cents in 2000, 4.35 cents only two years later, and to 4.10 cents in 2005. It recovered only slightly with the increase in fuel prices, reaching 4.18 cents in 2008. Since 1990, this was roughly a 40% decline in real yield, during a period when low cost carriers were rapidly, and generally profitably, penetrating US domestic markets.
3. A new price discrimination strategy for legacy carriers By the early 2000’s, the legacy carriers could no longer maintain their former round-trip price discrimination strategy as the LCC one-way low fares spread to a majority of markets in many countries. This collapse in the ability to price discriminate resulted in a major yield erosion for legacy carriers as passengers which had formerly paid high fares were now accessing low fares in sufficient numbers to cause massive losses at the full service carriers. The result was a wave of legacy carrier bankruptcies around the world from 2001 to 2005,4 including a number of carrier liquidations. Hazeldine describes the subsequent response of two legacy carriers Air Canada and Air New Zealand. In response to the threat from LCCs, these carriers essentially adopted the one-way low-fare pricing strategy. However, at least for these two carriers, they began a “new” form of price discrimination which differed from the simple pricing of the LCCs. Specifically, Hazeldine claims that these two
3 As implemented, Southwest and most other LCCs, also sell round-trip tickets that merely combine two low fare one-way tickets. 4 Legacy carrier bankruptcies and liquidations were found in Europe (e.g., Swissair, Sabena), North America (e.g., most U.S. major carriers, Air Canada), Latin America (e.g., Varig) and Austral-Asia (e.g., Air New Zealand and Ansett).
41
carriers began to sell multiple products, with different value added, at higher prices for the higher value products. As an example, Air Canada sells its cheapest “Tango” fares with lower frequent flyer benefits and higher penalties on changes to itineraries. Its “Latitude” fares offer better benefits and greater flexibility, but the price is higher. Notwithstanding that the legacy carriers had always simultaneously offered a range of different discounted round-trip products at different discount fares,5 Hazeldine presents an interesting case of a supplier moving emphasis from horizontal to vertical product differentiation. Frölich and Niemeier (forthcoming) discuss the concept of horizontal versus vertical price discrimination, based on the previous work of Lancaster (1979) and others in the “new theory of consumer demand”. As they explain, “Vertical product differentiation refers to a situation in which products differ in overall quality from other products in the market (i.e. individuals have a clear ranking over which products to choose if prices were the same for all products). Horizontal differentiation refers to a situation in which the products in the market are of same or similar overall quality, but suppliers offer slightly different attributes embodied in their products (i.e. there is no clear ranking over products if prices for all products were the same). After commenting on the “new” pricing strategy by the two legacy carriers, Hazeldine claims that a) it allows a yield premium for the legacy carriers relative to the low cost carriers, b) it creates value from the legacy carrier’s fixed costs, and c) it cannot be replicated by LCCs. The latter is questionable, and indeed some LCCs offer higher value (more flexible) products at a premium (e.g., Virgin Blue/Pacific Blue, Air Berlin), while other LCCs are currently implementing information technologies which will allow them to do so (e.g., WestJet, Southwest). Perhaps it is more accurate to characterise the advantage of legacy carriers discussed by Hazeldine as innovative and not immediately replicated by LCCs, rather than describing it as a permanent and non-replicable advantage. It appears that the LCCs will also create value from LCC fixed costs.6 4. The new legacy carrier price discrimination strategy has not resulted in financial viability A key question that needs to be asked is whether the “new” Air Canada and Air New Zealand pricing strategies have created success in achieving financial viability. I turn first to Air Canada. Fig. 1 shows revenue per revenue ton-mile and cost per revenue ton-mile for both legacy carrier Air Canada and its low cost competitor, WestJet. The drop in average revenue per ton-mile is apparent for both carriers. By 2003, it appears the two carrier’s average revenue are tracking closely together. However, not too much weight should be placed on any competitive linkage of the two carrier’s average revenues, as there are many factors not controlled for in this simple analysis including changes in average stage length and relative shares of domestic versus international services. The most important observation in Fig. 1 is the comparison of each carrier’s unit revenue to unit cost. Air Canada consistently had
5 By simultaneously, I mean that at any given point in time, the legacy carrier customer could choose from a range of airline ticket products, with different restrictions and at different prices. 6 While it is not clear, Hazeldine may be referring to an advantage of the legacy carrier fixed costs in the sense that they serve extensive route networks and can offer many connecting services. However, today’s LCCs also operate extensive route networks and some have high ratios of connecting traffic. This is the case for the LCCs competing with Air Canada and Air New Zealand. Thus if Hazeldine’s ‘nonreplicable’ fixed cost value creation by the legacy carriers is one of offering higher value connecting services, the LCCs are well on their way to replicating such an advantage.
42
M. Tretheway / Journal of Air Transport Management 17 (2011) 40e43
Air Canada vs. WestJet Operating Cost per RPM & Passenger Revenue Yield per RPM (1998 to 2008) Operating Cost per RPM and Passenger Revenue Yield per RPM (cents)
25
23
21
Air Canada 19
WestJet
17
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
15
WJ Operating Cost per RPM
WJ Passenger Revenue Yield per RPM
AC Operating Cost per RPM
AC Passenger Revenue Yield per RPM
Source: Air Canada and WestJet Annual Reports.
Fig. 1. Air Canada vs. WestJet Operating cost per RPM & passenger revenue yield per RPM (1998 to 2008).
revenue below cost, even after adopting the “new” pricing strategy described by Hazeldine. The carrier entered bankruptcy protection in 2003, liquidating shareholder value, and emerged from it in 2004. This restructuring, even when combined with its new pricing strategy, did not bring unit revenue above unit cost. In 2009, it experienced another major financial crisis, and has survived only by further major cost cutting and deferral of required pension plan contributions. To its credit, it did achieve some important reductions in unit cost that helped offset the plunge in its yields,7 but the story at Air Canada seems to be one of cost reductions to offset yield declines (and balance sheet restructuring), rather than one of yield increases offsetting higher unit costs. In direct contrast, the LCC in the market, WestJet, has always enjoyed unit revenues above its unit costs. It did not require financial restructuring in the early 2000s, nor did it experience losses and a financial crisis in the recession of 2007e2009. It has not liquidating its shareholder value. One also observes from Fig. 1 that while Air Canada achieved real yield improvement following 2004, that was at virtually the same rate of increase achieved by its rival. This evidence is not supportive of a hypothesis that the legacy carrier has gained a yield advantage from vertical product differentiation and a corresponding pricing strategy, and certainly is not evidence that the new strategy is allowing the legacy carrier to fight back, at least at with a financially sustainable business model. In 2009, Air Canada’s board selected a new CEO, who has been addressing issues of cost and financial structure in an effort to find a basis for the business to achieve long-term financial viability. Air New Zealand has a different record. In 2001 the carrier was placed under administration and survived only due to a NZ$800 million investment by the federal government. This was an enormous investment by the taxpayers of $200 per capita, or $800 for every family of four. Since then, Air New Zealand has achieved profitability. However, in its domestic market, until just recently, it faced competition only from another legacy carrier, Qantas’ New Zealand operation. Further, as Hazeldine himself observes, a key to
Hazeldine’s paper provides valuable insight into the dynamics of airline pricing strategy, including a possible shift in emphasis from horizontal to vertical product differentiation and a differential pricing strategy by the legacy carriers. But this has not halted the increasing market share of the LCCs, except temporarily in 2009, when the LCCs were more adept in withdrawing capacity in the face of a rapidly weakening market8. Globally these carriers accounted for all of the global growth in air passenger volumes since 2001. These carriers have substantial numbers of aircraft on order, representing incremental capacity, while their legacy carriers have fewer narrow body aircraft on order, with much of that capacity being earmarked for replacing of aging capital. It appears that the LCCs will continue to gain global market share in the coming years. In at least one of Hazeldine’s two exemplars of legacy carriers fighting back, financial success has not been achieved, with the carrier being restructured by bankruptcy in 2003 and just barely averting bankruptcy or liquidation in 2009. This carrier’s story seems to be more one of cost cutting and drastic balance sheet
7 The increase in unit cost in 2008, at both carriers, is largely linked to the enormous increase in fuel prices.
8 The Centre for Asia Pacific Aviation (2009) reports that 22% of global airline seats are now accounted for by LCC.
Air New Zealand’s success was a major reduction in costs by simplifying its product. It will be interesting to observe how Air New Zealand responds to penetration of its small, but important domestic market by low cost carriers. As observed by the Centre for Asia Pacific Aviation, “The remodelling has been brave and surprisingly durable in fact. But the recent invasion of the carrier’s domestic market by both Virgin (Pacific) Blue and Jetstar is shredding yields on the only three main domestic trunk routes and all major city pair routes to Australia.” (Centre for Asia Pacific Aviation, 2009). It may be too early to pass judgement on Air New Zealand’s pricing strategy against LCCs, although cost reduction and product simplification appear to have assisted the carrier. 5. Concluding comment
M. Tretheway / Journal of Air Transport Management 17 (2011) 40e43
restructuring, than one of achieving a new yield premium. If this legacy carriers is fighting back with a new product differentiation and price discrimination strategy, the success of this strategy has yet to be evidenced. The other exemplar required a massive government bailout/ investment, and is only now facing the realities of LCC competition in its home market. The problem of an empty core for legacy carriers appears to still remain. The “new” product differentiation and price discrimination strategy by these two legacy carriers, is neither non-replicable by LCCs nor closing the gap with the financial viability of the LCC business model (Button, 2003).
43
References Button, K.J., 2003. Does the theory of the ‘core’ explain why airlines fail to cover their long-run costs of capital? Journal of Air Transport Management 9, 5e14. Centre for Asia Pacific Aviation, 2009. Global LCC Outlook Report Sydney. Frölich, F., Niemeier, H., The importance of spatial economics for assessing airport competition. Journal of Air Transport Management forthcoming. Kraft, D.H.J., Oum, T.H., Tretheway, M.W., 1988. Airline seat management. Logistics and Transportation Review 22, 115e130. Lancaster, K., 1979. Variety, Equity and Efficiency. Columbia University Press, New York. Tretheway, M.W., Kincaid, I.S., 2005. The effect of market structure on airline prices: a review of empirical results. Journal of Air Law and Commerce 70, 467e498. US Air Transport Association (annual). Airlines passenger yields: US airlines. available at. http://www.airlines.org/economics/finance/PaPricesYield.htm.
Contents lists available at ScienceDirect
Journal of Air Transport Management journal homepage: www.elsevier.com/locate/jairtraman
Comment on “legacy carriers fight back” Mike Tretheway a, b, * a b
InterVISTAS Consulting Inc., Vancouver, Canada Sauder School of Business at the University of British Columbia, Vancouver, Canada
a b s t r a c t Keywords: Traditional network airlines Airline business models Empty core problems Airline competition
The paper offers a comment on an earlier article by Hazledine that argued a business model adopted by Air Canada and Air New Zealand allows them to compete with low cost airlines. Examination of the model, however, indicates that it offers only limited protection from low cost airlines competition that has the option of replicating the model itself if it proves successful in the short-term. Ó 2010 Published by Elsevier Ltd.
1. Introduction Tim Hazledine’s paper contributes to the literature on the different pricing approaches utilised historically and presently by the legacy full service network carriers versus the low cost carriers (LCCs) that have emerged. He puts forth the propositions that: “. The legacy carrier business model is not obsolete.” “. the legacy carriers’ fixed costs can actually deliver market value, that this value can be enhanced by shrewd and innovating pricing and marketing practices .” “. and that such practices cannot easily be replicated by LCCs and so can deliver a source of competitive market advantage to the legacy carriers which can compensate for the LCCs’ lower variable cost.” He then proceeds to discuss two cases, Air New Zealand and Air Canada, and the new pricing practices they have put in place. Here I point out that while conceptually interesting, the strategies of these two carriers have not proven to have been successful strategies, and the financial viability of the business models of full service carriers is still in some doubt. In this short comment I largely focus on Air Canada, as it has faced extensive LCC competition in it domestic market on and some “transborder” routes to the US, and then comment briefly on Air New Zealand, which is only starting to face LCC competition in domestic markets. First, I discuss some conceptual issues in airline price discrimination. 2. Background on airline price discrimination As Hazeldine observes, historically, following the 1978 deregulation of US airlines, what we now call the legacy carriers introduced * Sauder School of Business at the University of British Columbia, Vancouver, Canada. E-mail address: [email protected]. 0969-6997/$ e see front matter Ó 2010 Published by Elsevier Ltd. doi:10.1016/j.jairtraman.2010.10.009
a new method of price discrimination. At the time the industry referred to it as a “capacity controlled discounting” fare strategy. The mathematical systems used to implement it have been referred to variously as airline seat management, airline revenue management and airline yield management systems. That strategy discriminated between two broadly characterised groups of air travellers. “Business” traveller demand was characterised as having a high willingness to pay, but generally required both flexibility in their travel and travel within the same week. “Leisure” traveller demand had a much lower willingness to pay but were willing to travel on less convenient air services, including a requirement that their travel extend over a weekend.1 Prior to deregulation these two consumer groups were served by separate services with separate prices: charter flights at low fares to leisure destinations and scheduled services at high fares to a wide range of destinations. After deregulation, the scheduled carriers chose to serve both consumer segments from a common source of supply, a scheduled airline flight, whose capacity was not continuously variable.2 The immediate success of this strategy revealed that there were significant economies of scope in the supply of airline services. The challenge for the airlines was one of pricing. If both consumer groups were to be serviced from the same capacity, how could the low ability to pay group be attracted to a scheduled 1 Different restrictions applied to intercontinental strategy, such as minimum stay requirements rather than Saturday stayover, but the concept of discriminating between high versus low willingness to pay passengers was the same. 2 This means that if demand today is only for 70 seats at the high fare, the airline could not tailor capacity to 70 seats. If the flight is scheduled with an aircraft of 150 seats, the airline incurs the cost of supplying the fixed capacity of 150 seats. Airline seat management systems assume a fixed capacity, In practice, the carrier may be able to substitute aircraft of different sizes or vary the number of weekly flights in the market, but for a number of reasons, such adjustments to capacity are typically planned on a quarterly basis, and are difficult to undertake in the very short-term.
M. Tretheway / Journal of Air Transport Management 17 (2011) 40e43
service, while generating sufficient total revenue to cover flight costs? Price discrimination between the two groups was the answer. It was implemented by offering low fares only with accompanying restrictions. These typically limited travel flexibility e e.g., the traveller purchasing the low fare could not easily change flight plans, and required a saturday stayover or minimum travel duration that the high willingness to pay travellers generally would not abide by (Kraft et al., 1988). There was cross elasticity, of course, and some high willingness to pay travellers were able to conform to the restriction necessary for access to the low fare, but there was a sufficient number of business travellers unwilling to abide by the low fare access restrictions such that air carriers could achieve a sufficient degree of price discrimination to earn revenues for most flights that would cover flight costs and any other fixed costs of the airlines. Essentially, the low willingness to pay travellers were paying fares closer to marginal cost than the high willingness to pay travellers. Central to the legacy carriers’ ability to price discriminate was the restriction on low-fare tickets requiring purchase of a round-trip extending over a Saturday. In contrast, when what we now call low cost carriers (LCCs) entered the market, they adopted a very different pricing strategy. Originally typified by Southwest airlines, the LCCs allow purchase of low fare one-way tickets. This meant that business travellers could access low fares on travel not staying over a Saturday, by purchasing two separate one-way low-fare tickets.3 In those markets that LCCs entered, the legacy carriers immediately suffered an erosion of traffic and revenues, as the LCC one-way low fares undermined the ability of the legacy carriers to maintain their traditional price discrimination (Tretheway and Kincaid, 2005). As the LCCs entered more markets, especially in the late 1990s, legacy carriers found that the average fare they were receiving on flights was falling dramatically. For example, US Air Transport Association (annual) reported that real yield on domestic airline flights which was 6.70 cents per revenue ton-mile in 1990, fell to 5.78 cents by 1995, 5.52 cents in 2000, 4.35 cents only two years later, and to 4.10 cents in 2005. It recovered only slightly with the increase in fuel prices, reaching 4.18 cents in 2008. Since 1990, this was roughly a 40% decline in real yield, during a period when low cost carriers were rapidly, and generally profitably, penetrating US domestic markets.
3. A new price discrimination strategy for legacy carriers By the early 2000’s, the legacy carriers could no longer maintain their former round-trip price discrimination strategy as the LCC one-way low fares spread to a majority of markets in many countries. This collapse in the ability to price discriminate resulted in a major yield erosion for legacy carriers as passengers which had formerly paid high fares were now accessing low fares in sufficient numbers to cause massive losses at the full service carriers. The result was a wave of legacy carrier bankruptcies around the world from 2001 to 2005,4 including a number of carrier liquidations. Hazeldine describes the subsequent response of two legacy carriers Air Canada and Air New Zealand. In response to the threat from LCCs, these carriers essentially adopted the one-way low-fare pricing strategy. However, at least for these two carriers, they began a “new” form of price discrimination which differed from the simple pricing of the LCCs. Specifically, Hazeldine claims that these two
3 As implemented, Southwest and most other LCCs, also sell round-trip tickets that merely combine two low fare one-way tickets. 4 Legacy carrier bankruptcies and liquidations were found in Europe (e.g., Swissair, Sabena), North America (e.g., most U.S. major carriers, Air Canada), Latin America (e.g., Varig) and Austral-Asia (e.g., Air New Zealand and Ansett).
41
carriers began to sell multiple products, with different value added, at higher prices for the higher value products. As an example, Air Canada sells its cheapest “Tango” fares with lower frequent flyer benefits and higher penalties on changes to itineraries. Its “Latitude” fares offer better benefits and greater flexibility, but the price is higher. Notwithstanding that the legacy carriers had always simultaneously offered a range of different discounted round-trip products at different discount fares,5 Hazeldine presents an interesting case of a supplier moving emphasis from horizontal to vertical product differentiation. Frölich and Niemeier (forthcoming) discuss the concept of horizontal versus vertical price discrimination, based on the previous work of Lancaster (1979) and others in the “new theory of consumer demand”. As they explain, “Vertical product differentiation refers to a situation in which products differ in overall quality from other products in the market (i.e. individuals have a clear ranking over which products to choose if prices were the same for all products). Horizontal differentiation refers to a situation in which the products in the market are of same or similar overall quality, but suppliers offer slightly different attributes embodied in their products (i.e. there is no clear ranking over products if prices for all products were the same). After commenting on the “new” pricing strategy by the two legacy carriers, Hazeldine claims that a) it allows a yield premium for the legacy carriers relative to the low cost carriers, b) it creates value from the legacy carrier’s fixed costs, and c) it cannot be replicated by LCCs. The latter is questionable, and indeed some LCCs offer higher value (more flexible) products at a premium (e.g., Virgin Blue/Pacific Blue, Air Berlin), while other LCCs are currently implementing information technologies which will allow them to do so (e.g., WestJet, Southwest). Perhaps it is more accurate to characterise the advantage of legacy carriers discussed by Hazeldine as innovative and not immediately replicated by LCCs, rather than describing it as a permanent and non-replicable advantage. It appears that the LCCs will also create value from LCC fixed costs.6 4. The new legacy carrier price discrimination strategy has not resulted in financial viability A key question that needs to be asked is whether the “new” Air Canada and Air New Zealand pricing strategies have created success in achieving financial viability. I turn first to Air Canada. Fig. 1 shows revenue per revenue ton-mile and cost per revenue ton-mile for both legacy carrier Air Canada and its low cost competitor, WestJet. The drop in average revenue per ton-mile is apparent for both carriers. By 2003, it appears the two carrier’s average revenue are tracking closely together. However, not too much weight should be placed on any competitive linkage of the two carrier’s average revenues, as there are many factors not controlled for in this simple analysis including changes in average stage length and relative shares of domestic versus international services. The most important observation in Fig. 1 is the comparison of each carrier’s unit revenue to unit cost. Air Canada consistently had
5 By simultaneously, I mean that at any given point in time, the legacy carrier customer could choose from a range of airline ticket products, with different restrictions and at different prices. 6 While it is not clear, Hazeldine may be referring to an advantage of the legacy carrier fixed costs in the sense that they serve extensive route networks and can offer many connecting services. However, today’s LCCs also operate extensive route networks and some have high ratios of connecting traffic. This is the case for the LCCs competing with Air Canada and Air New Zealand. Thus if Hazeldine’s ‘nonreplicable’ fixed cost value creation by the legacy carriers is one of offering higher value connecting services, the LCCs are well on their way to replicating such an advantage.
42
M. Tretheway / Journal of Air Transport Management 17 (2011) 40e43
Air Canada vs. WestJet Operating Cost per RPM & Passenger Revenue Yield per RPM (1998 to 2008) Operating Cost per RPM and Passenger Revenue Yield per RPM (cents)
25
23
21
Air Canada 19
WestJet
17
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
15
WJ Operating Cost per RPM
WJ Passenger Revenue Yield per RPM
AC Operating Cost per RPM
AC Passenger Revenue Yield per RPM
Source: Air Canada and WestJet Annual Reports.
Fig. 1. Air Canada vs. WestJet Operating cost per RPM & passenger revenue yield per RPM (1998 to 2008).
revenue below cost, even after adopting the “new” pricing strategy described by Hazeldine. The carrier entered bankruptcy protection in 2003, liquidating shareholder value, and emerged from it in 2004. This restructuring, even when combined with its new pricing strategy, did not bring unit revenue above unit cost. In 2009, it experienced another major financial crisis, and has survived only by further major cost cutting and deferral of required pension plan contributions. To its credit, it did achieve some important reductions in unit cost that helped offset the plunge in its yields,7 but the story at Air Canada seems to be one of cost reductions to offset yield declines (and balance sheet restructuring), rather than one of yield increases offsetting higher unit costs. In direct contrast, the LCC in the market, WestJet, has always enjoyed unit revenues above its unit costs. It did not require financial restructuring in the early 2000s, nor did it experience losses and a financial crisis in the recession of 2007e2009. It has not liquidating its shareholder value. One also observes from Fig. 1 that while Air Canada achieved real yield improvement following 2004, that was at virtually the same rate of increase achieved by its rival. This evidence is not supportive of a hypothesis that the legacy carrier has gained a yield advantage from vertical product differentiation and a corresponding pricing strategy, and certainly is not evidence that the new strategy is allowing the legacy carrier to fight back, at least at with a financially sustainable business model. In 2009, Air Canada’s board selected a new CEO, who has been addressing issues of cost and financial structure in an effort to find a basis for the business to achieve long-term financial viability. Air New Zealand has a different record. In 2001 the carrier was placed under administration and survived only due to a NZ$800 million investment by the federal government. This was an enormous investment by the taxpayers of $200 per capita, or $800 for every family of four. Since then, Air New Zealand has achieved profitability. However, in its domestic market, until just recently, it faced competition only from another legacy carrier, Qantas’ New Zealand operation. Further, as Hazeldine himself observes, a key to
Hazeldine’s paper provides valuable insight into the dynamics of airline pricing strategy, including a possible shift in emphasis from horizontal to vertical product differentiation and a differential pricing strategy by the legacy carriers. But this has not halted the increasing market share of the LCCs, except temporarily in 2009, when the LCCs were more adept in withdrawing capacity in the face of a rapidly weakening market8. Globally these carriers accounted for all of the global growth in air passenger volumes since 2001. These carriers have substantial numbers of aircraft on order, representing incremental capacity, while their legacy carriers have fewer narrow body aircraft on order, with much of that capacity being earmarked for replacing of aging capital. It appears that the LCCs will continue to gain global market share in the coming years. In at least one of Hazeldine’s two exemplars of legacy carriers fighting back, financial success has not been achieved, with the carrier being restructured by bankruptcy in 2003 and just barely averting bankruptcy or liquidation in 2009. This carrier’s story seems to be more one of cost cutting and drastic balance sheet
7 The increase in unit cost in 2008, at both carriers, is largely linked to the enormous increase in fuel prices.
8 The Centre for Asia Pacific Aviation (2009) reports that 22% of global airline seats are now accounted for by LCC.
Air New Zealand’s success was a major reduction in costs by simplifying its product. It will be interesting to observe how Air New Zealand responds to penetration of its small, but important domestic market by low cost carriers. As observed by the Centre for Asia Pacific Aviation, “The remodelling has been brave and surprisingly durable in fact. But the recent invasion of the carrier’s domestic market by both Virgin (Pacific) Blue and Jetstar is shredding yields on the only three main domestic trunk routes and all major city pair routes to Australia.” (Centre for Asia Pacific Aviation, 2009). It may be too early to pass judgement on Air New Zealand’s pricing strategy against LCCs, although cost reduction and product simplification appear to have assisted the carrier. 5. Concluding comment
M. Tretheway / Journal of Air Transport Management 17 (2011) 40e43
restructuring, than one of achieving a new yield premium. If this legacy carriers is fighting back with a new product differentiation and price discrimination strategy, the success of this strategy has yet to be evidenced. The other exemplar required a massive government bailout/ investment, and is only now facing the realities of LCC competition in its home market. The problem of an empty core for legacy carriers appears to still remain. The “new” product differentiation and price discrimination strategy by these two legacy carriers, is neither non-replicable by LCCs nor closing the gap with the financial viability of the LCC business model (Button, 2003).
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References Button, K.J., 2003. Does the theory of the ‘core’ explain why airlines fail to cover their long-run costs of capital? Journal of Air Transport Management 9, 5e14. Centre for Asia Pacific Aviation, 2009. Global LCC Outlook Report Sydney. Frölich, F., Niemeier, H., The importance of spatial economics for assessing airport competition. Journal of Air Transport Management forthcoming. Kraft, D.H.J., Oum, T.H., Tretheway, M.W., 1988. Airline seat management. Logistics and Transportation Review 22, 115e130. Lancaster, K., 1979. Variety, Equity and Efficiency. Columbia University Press, New York. Tretheway, M.W., Kincaid, I.S., 2005. The effect of market structure on airline prices: a review of empirical results. Journal of Air Law and Commerce 70, 467e498. US Air Transport Association (annual). Airlines passenger yields: US airlines. available at. http://www.airlines.org/economics/finance/PaPricesYield.htm.