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How Low Cost Carriers evolve through 7 phases

Published on 11/01/2017
#Aviation

How Low Cost Carriers evolve through 7 phases

By Amrish Pathack

Here is just a simplification after many years of working with airlines, including those tagged as "low cost" in less than 1000 words

Genesis

LCCs will appear where there is an untapped market with strong demand potential (e.g.: recently Vietnam, El Salvador, Chile…). The barriers to entry are not as high as we may think. Indeed start-ups will rarely start with a fleet of brand new A320neo (catalogue price being of over 125m USD today). They will often start with a lease. For example, easyJet was launched (in 1995) with two wet leased Boeing 737-200 aircraft, initially operating two routes: London Luton Airport to Glasgow and Edinburgh.

Initial growth

Once operating, the airline will start its initial growth aiming to break-even within the first few years and perhaps even turn a profit. Vietjet became profitable 2 years after its first flight and Wizz Air after 6 years. There will of course be strong scrutiny on cost control, simplicity and efficiency, without yet being able to leverage economies of scale. As this initial growth takes place, the LCC will slowly add leased aircraft to its fleet and fly more people around. The lower fares will stimulate demand and steal market shares from eventual existing established rivals, both factors contributing to the initial growth.

Moment of truth

One of the first moments of truth is the Initial Public Offering (IPO), which as the name says, only happens once per company. It is the moment that the airlines, like any company, can go on the investors market and raise significant funds. At the moment of the IPO, the airline is simply worth its assets (not much since the aircraft are leased), plus the profits made up to now, minus the debts. When the IPO takes place, what we observe is that the funds raised are well beyond the current net worth of an airline (often reaching 12 to 20 times the EBITDA). Investors want 3 main things: Profits, Growth and Potential. The combination of these 3 will determine the success of the IPO. This makes the timing of the IPO absolutely key. Indeed, if done too early, the value of the LCC may still be too low and if done too late, the multiplication factor may not be as high.

The IPO is so critical that AirAsia have opted to perform one per subsidiary. The first one of the group to go through the IPO process was of course AirAsia Malaysia in view of a large order of A320 aircraft. The IPO ended-up raising USD 227m, which represents almost 17 times the earnings of that year. The latest one to hit the markets is AirAsia Philippines (2017).

Accelerated Growth

This second growth spurt will generally be fuelled by the funds raised at the IPO, unless there are some serious funds from elsewhere supporting the LCC. The LCC will at this point make a large order for a single aircraft type, based on the economics and the deal it can strike with Airbus or Boeing essentially. The orders are usually in the tens or even hundreds without knowing at the time of the purchase where they will fly. When Lufthansa ordered their 25 A350XWB aircraft, they certainly had a clearer view on the way they would be used than Lion Air when they ordered 234 A320 aircraft, and this is absolutely normal. An LCC will have a plan for the first batch of aircraft they will receive and on the current market.

As the LCC receives its new aircraft (sometimes up to 4 per month like Air Asia!) they will be assigned on given routes. Sometimes they will help in increasing frequencies on strong routes or in opening new ones but all within range of the main base. Once all profitable routes are saturated, the LCC will open a new base and allocate the next aircraft delivered to that base and so on.

End of Growth

Several factors will eventually bring the growth to an end, mainly competition, regulations or simply geography (e.g.: islands with nowhere else to grow nearby) and many others. But an LCC can only remain an LCC so long as it is in a growth phase. As soon as the growth curbs, cost will increase faster than yields and this will affect the profitability. The costs are affected by inflation and price escalations and yields are challenged by competition. For example pilot wages will go up each year as there is a deficit of pilots globally, whereas ticket fares may not, due to competition. So in order to remain a profitable LCC, it seems that there needs to be growth.

Repositioning

The most common evolutions of an LCC after growth are market repositioning through upscaling, shifting to hub-and-spoke or continuing to grow elsewhere.

The first strategy of repositioning is the one followed by Airlines such as easyJet today or JetBlue to a further extent. JetBlue even offer premium flying experience with full-flat seats, thus allowing for growth through higher yields. This repositioning also has an advantage of not relying on growth only. The second strategy is one followed by Southwest Airlines. Often referred to as one of the first LCCs, Southwest today have a hub-and-spoke model allowing for passengers to connect from one flight to another. This is incompatible with being a true LCC as connecting 2 flights calls for a synchronisation of the flight schedules, thus moving away from the highest possible asset utilisation therefore the lowest cost.

The third strategy is one followed by Jetstar Australia which was once an LCC, with subsidiaries Jetstar Asia, Jetstar Japan and Jetstar Pacific. This allows the LCC to grow beyond its geographical boundaries. Other LCCs have followed similar paths: Irelandia Aviation who is behind Ryanair is growing in South America with VivaAerobus (Mexico) and VivaColombia

Conclusion

Here you have a somewhat simplified but accurate view on how LCCs evolve. The levels of analysis required to get each phase right are not to be underestimated. Each airline is a different and represents a singular story with its own set of parameters and constraints. A possible next step could be that LCCs step on the aircraft manufacturer’s turf. Indeed easyJet have announced their ambition to build a fully electric aircraft within the next decade with Wright Electric and JetBlue have partnered with Zunum to build a hybrid-electric jet. Let us see how this unfolds.

 
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