Flying High with Low Frills

Case Analysis

By

Rahul Mirchandani, Shailesh Karnik & Farida Virani

Case Objectives • To analyse the low cost, no frills airline industry, with specific reference to India, after making

global comparisons. • To assess the factors that have contributed to the successful growth and consistent

profitability of airline companies following this business model. • To analyse the strategies of Air Deccan, India’s first no frills carrier. Airline Industry In India

The entry of low-cost carriers will have several far-reaching implications for the aviation sector in India and, to a wider extent, on the mass transportation industry and domestic tourism.

In a country of a billion people, the Indian aviation industry is puny. We have 12 million people who travel by air every year against 3 million passengers who fly everyday in the US, even though its population is one-fourth that of India. The number of daily flights in India averages just about 400 a day, as against 40,000 flights a day in the US. Ryanair, among the low-cost pioneers in Europe, flies 25 million people in a year and still has less than 5 per cent market share. Closer home, in Malaysia, there are 12 million people who travel by air yearly. Look at it another way: India's 200-million middle-class population is equal to that of the whole of Europe. Even if we assumed that only one-fourth of that large middle-class could afford and would be willing to travel by air, it would call for at least a 5-6-fold increase in capacity.

The Indian skies presently have seven scheduled domestic carriers. These include Air-India, Indian Airlines, Alliance Air, Jet Airways, Air Sahara, Air Deccan (India’s first low cost carrier) and Blue Dart Aviation (in scheduled cargo services). Both A-I and IA also fly abroad. Pawan Hans, Bharat Hotels, Escorts, EIH (The Oberoi group), Taj Air, Jagson, Mesco, Tata Tea, UB Air and United Helicharters are amongst 37 non-scheduled airlines in the country.

At last count, at least four companies were in the process of starting up new no-frills airlines in India. There is Royal Airlines, the new avatar of ModiLuft, and AirOne and Visa, both of which are promoted by former Indian Airlines employees. Then there is Vijay Mallya's UB Group, which is gearing up to launch its Kingfisher Airline.

WHAT IS A LOW COST AIRLINE?

A low-cost carrier (also known as a no-frills or discount carrier) is an airline that offers low fares but eliminates all “non-essential” services. The typical low-cost carrier business model is based on:

• a single passenger class • a single type of airplane (reducing training and servicing costs) • a simple fare scheme (typically fares increase as the plane fills up, which rewards early

reservations) • free seating (which encourages passengers to board early) • direct, point to point flights with no transfers • flying to cheaper, less congested secondary airports • short flights and fast turnaround times (allowing maximum utilization of planes) • "Free" in-flight catering and other "complimentary" services are eliminated, and replaced

by optional paid-for in-flight food and drink.

Simple Product A typical low cost airline product is extremely basic. It focuses on getting passengers from point A to B, cutting out all the “extras”. This means there are no meals, drinks or snacks served free on board. In certain airlines, these may be purchased on request. The aircraft have Narrow seating to permit greater capacity. Low cost airlines offer all-economy flights, with no additional space requirements for wider business class seating. This means more passengers can be accommodated on each sector. There are no facilities for seat allocations as this “free-seating” makes passengers board the flights early to get themselves a decent seat. The pricing structures of low cost airlines allow for no additional schemes or sales promotion activities, including frequent-flyer programmes. Positioning The low cost airlines the world over are known to target Non-business passengers, leisure traffic and the price-conscious business passenger segment. The low cost model works best on short-haul point-to-point traffic with high frequencies. These airlines have aggressive

marketing strategies and compete with all transportation carriers, including the road and railway networks. Most Western low cost airlines fly to secondary airports which are cheaper to land into. However, this is not yet an option available in India. Low Operating Costs Low cost airlines have a very lean organization structure and operating costs are kept to the bare minimum with low wages (as crew/staff requirements are low and generally freshers are preferred), low airport fees, low costs for maintenance and cockpit training (as these are typically outsourced). There is no requirement for standby crews due to a homogeneous aircraft fleet. Low cost carriers aim at achieving high resource productivity. This is generally achieved due to short ground waits (as turnaround times are kept minimal due to simple boarding processes, no air freight, no hub services and short cleaning times). Selling costs are also minimized as high percentage (if not 100%) of ticket sales is generated online, eliminating the margins that would otherwise need to be passed on as commissions to travel agents.

ENVIRONMENTAL SCAN

A brief analysis of the Environment in which the Indian airline industry operates is presented below: Demographic Factors India has one of the world’s youngest populations. More importantly, this population is characterized by a large, fast growing middle class, thus forming a huge section of aspirant air travelers. Growing education levels have also developed a very large network of Professionals. These form the business traveler segment of the population which is critical to the airline industry. Economic Factors Purchasing power levels are rising amongst the middle and upper sections of society consistently. With the opening up of the economy, Foreign direct investment limits in the airline sector has been increased from 40% to 49%. This has raised the interest of foreign airlines intending to invest in Indian airline companies. The government has also been striving in the development of infrastructure at all levels and in the process airports are being upgraded and capacities increased. Unused airstrips have also been pressed into service in a few areas. Such infrastructure development efforts will continue.

Political Factors The Government has actively been promoting Brand India. This long term campaign is aimed at attracting foreign investment, tourism development, etc. More specifically, the recent Union Budget has created a very favorable taxation structure for the airline industry, with a 10 year tax holiday on aircraft leasing. This is an excellent opportunity for airlines to increase their fleet size in the medium term.

Socio-Cultural Factors The growing interest of an educated population in visiting various famed parts of the Indian subcontinent on family vacation is a growing trend. The government is very actively promoting domestic tourism that has increased Population mobility. It is a characteristic of every Indian, rich or poor, to demand value for money. This is a factor that works in favour of the low frills carriers. Safety and Security concerns with the rail network are increasing with a steady increase in rail accidents. Correspondingly, airline travel in India has had very few accidents, too few and far between to act as a deterrent.

Technological Factors Aircraft manufacturers continue to build and deliver new aircraft, adding new capacity. The fast changing fly by wire aircraft technology is changing the way people fly, with a much wider choice available for new airplane models and variants. However, in India, a severe constraint is the lack of an effective and efficient airport infrastructure.

INDUSTRY ANALYSIS

Michael Porter’s five forces model has been used as a framework to analyze the Indian airline industry and its attractiveness to new and existing players. Threat of New Entrants At last count there are 7 new entrants waiting to enter the airline industry in India, all in low cost avatars. This threat of new entrants causing intense competition in the short run is imminent. However, a shake-out is also almost certain with the possibility of only a few strong players surviving. Entry barriers are a major deterrent for new players entering this industry. These barriers include government licensing and approvals, huge initial capital investments in fixed assets and equally high running costs.

Power of Buyers The general Indian traveler is extremely value conscious. Growing awareness has also increased expectations for punctuality, safety and service. However, with supply of seats being miniscule in line with the demand, especially in peak periods, the bargaining power of the buyers is not too high. However, transparent Web based comparisons in fare structures are now possible which increases the power of the customer to choose the best deal. Earlier, travel agents were the only source of information and travelers were dependent completely on this intermediary. These Travel agents are fast losing their edge. Another trend is the availability of easy consumer/personal loans for travel purposes from almost all banks. These holiday now-pay later schemes have increased the buyers’ purchasing power manifold.

Power of Suppliers The airline industry has two major critical suppliers, both of whom have tremendous influence over the industry. Fuel suppliers have a significant impact, more so in India, where aviation turbine fuel supply is government controlled. The world’s aircraft suppliers enjoy in a duopoly and fiercely control their market shares. However, at this point, Airbus and Boeing have two radically diverse views on the future needs of civil aviation and this is reflected in their new product developments. Boeing has focused on medium capacity long haul aircraft (expecting that demand will grow for smaller aircraft that can fly more frequently offering a wide choice of departures in flight schedules). Airbus has made huge investments in the A380 which is its new large capacity-long range super jumbo (expecting that demand will grow for larger more fuel efficient and luxurious aircraft that can accommodate more people per flight) Power of Substitutes Trains and Luxury Buses are a substitute for air travel that can have impact on very short sectors, where travel time by road/rail is around 3 to 4 hours. This is especially because of the time spent traveling to/from the airport, one hour prior reporting, baggage claim, etc. Attractive Package Tours are also a substitute because they offer a convenient one-stop shop option whereas an airline ticket is just one part of the travel arrangements. Power of Competitors There is Intense Competition amongst low cost airlines and the full service airlines. Apex fares and promotional schemes offered by all the full service carriers, offering prices at lower or

similar to the low cost ticket fares are a tremendous competitive force. With the entry of additional players within the low cost segment itself, this competition will most certainly intensify further. Maintaining the KEY COST DIFFERENTIATORS in comparison with the full service airlines is crucial to maintain competitive advantage in the long term. The competitive pressures can be effectively managed if the flexibility is available with regard to pricing the inventory of tickets. This flexibility is possible only because of the 2:1 cost gap that exists in favour of the low cost airlines.

SWOT ANALYSIS FOR AIR DECCAN

STRENGTHS

Cost differentiation First mover advantage

Brand Equity

WEAKNESSES

A fixed-cost perishable product Limited sectors

Questionable on-time performance Promoters having lack of financial muscle

No previous industry experience

OPPORTUNITIES

Un-serviced Hinterland Air Charters

Product differentiation Tax holiday on aircraft leasing

THREATS

Killer competition Overcapacity

Diminishing yields per passenger Indian Railways

Growing road networks Open skies policy

Oil price fluctuations Government Controls

Lack of airport infrastructure Absence of secondary airports

STRENGTHS Cost Differentiation : Unit cost competitiveness is key to profitability for airlines because airlines have found it extremely difficult to increase their revenues in the current environment. THE COST GAP IS THE SOURCE OF SUSTAINABLE COMPETITIVE ADVANTAGE FOR LOW COST CARRIERS … A 2:1 differential exists between traditional full-service airlines’ unit costs and that of low-cost carriers for a given stage length (route distance in miles). Air Deccan has the following sources of cost savings in comparison with the full service airlines :

Lean Product - Air Deccan’s product is basic – minus hot meals, frequent flyer programmes, decent legroom, and a full complement of air-hostesses.

More Seats per aircraft - No meal on board means you don't need the extra space for storage. Instead, Air Deccan has added seats. Air Deccan has increased the seat factor by as much as 20 per cent by pulling out the business class, reducing the seat pitch (how far the seat can incline), and throwing out a couple of galleys.

Reduced staff numbers – There is no need to clean the aircraft due to the absence of food services. Also, there's no need for a crew of more than six, or even four, members. All Air Deccan ATRs operate with 1 crew member and Airbuses with 2.

Quicker turnaround times - While most full-service airlines like Jet take at least an hour to leave an airport after landing there, Deccan does it in 15-20 minutes for ATRs (and about 30 minutes for its new A320 service.) So, if Deccan does six sectors a day, it can fly one additional sector a day. This allows it to fly 20-30 per cent more than a full-service airline. On an average, the conventional airlines fly their aircraft for 8-9 hours a day, while a low-cost carrier is able to keep its planes airborne for 11 hours a day. This allows Air Deccan to make the same revenue with fewer aircraft. Squeezing out more from the capital asset (aircraft) simply lowers the fixed costs.

Low incidental costs - Even other costs, like costs of the crew, hangerage or even finance costs are somewhat lower, in these airlines.

Economies of Scale - Air Deccan uses limited types of aircraft in its fleet. This way it can move pilots and cabin crews around, reduce training costs, and won't have to worry about carrying spares for several different kinds of aircraft. This generates economies of scale.

E-distribution - Air Deccan saves on distribution costs, which can be 11-15 per cent in a conventional airline by not going through the travel agents and the existing central reservation systems like Amadeus and Galileo. Instead, they sell through the Internet and call centres. Air Deccan does not issue a ticket, as it costs to print, mail and process tickets. What passengers get instead is an electronic ticket (a booking number) when they make a reservation.

All this tots up to a saving of close to 40-45 per cent compared to full service airlines.

To take the examples from the West, leading low cost carriers, such as Southwest and Ryanair, don’t operate on the low end of the airline cost curve; they occupy an entirely different cost curve.

First Mover Advantage :

Air Deccan has the advantage of being the first low cost airline in India. This allows it to establish itself before competition increases in this low cost segment, apart from competition that already exists across segments (low cost vs full service carriers).

This is a major strength as Air Deccan will be laying down the rules and frameworks for the industry in a manner that suits its business and operational model. However competition is waiting in the wings. At last count, at least four companies were in the process of starting up new no-frills airlines in India. There is Royal Airlines, the new avatar of ModiLuft, and AirOne and Visa, both of which are promoted by former Indian Airlines employees. Then there is Vijay Mallya's UB Group, which is gearing up to launch its Kingfisher Airline.

Brand Equity :

Air Deccan will most certainly have a sustained mind share in the Indian consumer’s psyche. They will always be remembered as the airline that took the initiative (and the risk) to reshape an industry inside out. Air Deccan’s CEO, Capt Gopinath will most certainly go down in the annals of history as the man who changed the civil aviation dynamics in India forever. Air Deccan was the first airline that made air travel affordable to all Indians. This brand equity is a major strength that Air Deccan must successfully capitalize.

WEAKNESSES A fixed-cost perishable product – The major weakness of any airline is the very nature of the product it offers. An airline seat is a fixed-cost perishable product. The incentive to fill empty seats and fly underutilized aircraft is tremendous. This leads to price wars, with airlines resorting to slashing fares in an attempt to fill seats, as it is better to fill seats at lower prices rather than fly half empty planes. Limited sectors – At present, Air Deccan flies to very limited sectors. This makes it easier for the competition to unleash killer price cuts in these few sectors. It is always simpler to drop prices if you are trying to take on a company with just three planes. So, if Deccan can survive the price war for the first year or so and scale up, it will soon reach a size where Jet and the rest cannot undercut without losing massively in the bargain. Questionable on-time performance – Limited aircraft also means unavailability of standby planes in the event of operational problems. At present, Air Deccan is not known for maintaining a good on-time performance. This will over time, erode brand equity and alienate the time-conscious business traveler. Shaping up on-time performance records by eliminating sources of teething troubles is critical. This is more important as carriers like Jet Airways have received awards for their flight dispatch reliability and on time records, which they use as a USP. Promoters having lack of financial muscle - Air Deccan has been funded through contribution by directors and cash accruals. Gopinath and his close aide and executive director K.J. Samuel hold 26 per cent each, while Vishnu Rawal, an old Hong Kong-based friend of Gopinath, owns 8 per cent. Golden Ventures, promoted by an NRI Group, holds another 20 per cent. Then, Bangalore-based Brindavan Beverages has taken up an 18 per cent stake. Deccan has raised funds from investors (equity: Rs 30 crore) and taken a debt of Rs 70 crore from Bank of Baroda. That adds up to Rs 100 crore. The limited resources of the promoters is a major constraint if external funding is not streamlined for future expansion. Captain Gopinath has mandated N.M. Rothschilds & Sons to raise $60 million-70 million to fund expansion. He has been jetting around the globe, presenting a business case to private equity funds like Warburg Pincus and CDC, which have shown an interest in funding Air

Deccan. If Gopinath is able to get funding, it will be the first instance of private equity in an airline in India and overcome this major weakness of Air Deccan. No previous industry experience - Not too many people in the top management of Air Deccan have any real experience in the aviation business. The CEO, Capt G R Gopinath himself would seem like a bit of a rolling stone, having dabbled in many things, including the army, multi-crop farming, sericulture, agri-consultancy and then a helicopter charter service. Not quite the combination that would inspire confidence.

OPPORTUNITIES

Un-serviced Hinterland - Out of the 400-odd airstrips and airfields in the country, only 62 are in use. Dispersal of traffic simply hasn't happened, with over 40 per cent of traffic being between Mumbai and Delhi. Barring a few airports, available infrastructure is under-utilized. There are a large number of airports where full infrastructure is available, but only operate one to two flights a day. Aviation has reached only a fraction of India. There are large areas of trade and commerce in the rural hinterland that are pockets of prosperity which are yet un-serviced. These are areas with price-conscious consumers having purchasing power – an ideal untapped market for Air Deccan, untapped by full service carriers, making it a huge opportunity.

Huge Market Potential - In a country of a billion people, the Indian aviation industry is puny. We have 12 million people who travel by air every year against 3 million passengers who fly everyday in the US, even though its population is one-fourth that of India. The number of daily flights in India averages just about 400 a day, as against 40,000 flights a day in the US. India's 200-million middle-class population is equal to that of the whole of Europe. Even if we assumed that only one-fourth of that large middle-class could afford and would be willing to travel by air, it would call for at least a 5-6-fold increase in capacity. This points to a huge opportunity for Air Deccan and the aviation industry in general. However, this large market is recognized by all and is the reason why new players are waiting to enter the Industry to exploit this potential. It is pertinent to note that the number of air travelers in India has grown 34% during the first 9 months of 2004-05 as compared to the same period last year, as per estimates of Amadeus Worldwide. Air Charters – This is a nascent industry segment in India. However it is extremely popular with leisure travelers and corporate groups worldwide. This could be an opportunity worth exploiting with a separate fleet of aircraft. However, competition is largely unregulated in this segment and can hence get quite brutal. Product differentiation – At present, Air Deccan differentiates its no frills product by offering less features at substantially low fares. However, this strategy will become generic with the entry of low cost carriers waiting in the wings. At that stage, low cost competition will each need to try and “be different”. Limited product differentiation is an opportunity, but must be approached with extreme caution. This has happened in the West and by trying to differentiate; some low-cost airlines also lose their bearing and begin adding frills like assigned seating, hot meals and in-flight entertainment to attract some of the more comfort-seeking customers. But that leaves them exposed to being undercut by a new competitor who focuses exclusively on price. Anything (like frills) that adds costs and reduces price competitiveness is a bad trade-off.

Tax holiday on aircraft leasing – The Union Budget of the Government of India announced in June 2004, announced a 5year tax holiday on aircraft leasing. This is a huge opportunity that Air Deccan can exploit in the medium term for capacity expansion.

THREATS Killer competition – The Indian skies are witnessing a bloody battle for market shares. A much anticipated fare war has broken out across Indian skies. Air Deccan is still a new, small player in the Indian skies. They are vulnerable to price cuts by large players with deep pockets. Aviation experts are betting that IA, Jet and Sahara could start a debilitating price war to push the fledgling no frills airlines off the tarmac - permanently. Almost as a precursor to the impending battle, intense lobbying with the civil aviation ministry has begun. The full service carriers are already demanding that the government increase the minimum equity needed to start an airline from Rs 30 crore to Rs 250 crore-300 crore and that the fleet sizes ought to be at least 7-10 planes, not five. It is clear that the full-service airlines are trying to erect entry barriers. After all, it could well be a matter of their survival. Each full service airline has started offering a bouquet of promotional offers, like the Air Sahara ‘surprice’ is a 30-day advance return fare that's 36 per cent less than the 30-day advance apex fare, IA's 'metro non-metro Scheme' lets travelers pay Rs 1,000 for the non-metro leg of a flight, if it includes a metro leg. In the last few months, IA has quietly introduced discounts under various heads: round-trip fares, weekend fares, special fares, etc. All domestic full service airlines continue to offer Advance Purchase (Apex) fares that reward passengers for booking tickets 30/15/7 days in advance, with fare levels increasing as the date of travel approaches. These fares are significantly cheaper than economy class fares. Some experts say the price cuts are a reaction to a normal, seasonal fall in passenger traffic But others say the fall is due to competitive pressure. The battle has just begun. And it is a major threat to Air Deccan. Oil price fluctuations – Oil price hikes spare no airline. Aviation turbine fuel (ATF) cost and other operational costs (all government controlled) are the same for all airlines, whether it is a low cost airline or not. This adds significantly to costs of carriers like Air Deccan, especially since fuel costs as a percentage of total costs are higher at 26% for low cost airlines, compared to 20% for full service airlines. (see exhibit below)

Indian Railways – Air Deccan has already pitched its fares slightly higher than AC II-class fares, but lower than AC I-class fares. In the past few years, rail fares, especially in the higher classes, have gone up. Despite that, a quarter of a million passengers travel on AC trains every day. So if the differential isn't much, a large number of them could well upgrade to air travel, giving low cost carriers the critical mass required to grow and thrive. Infact recent reports state that the AC compartments on trains are running at as low as 20% occupancy.

However, if Indian Railways shape up their act with improved service standards and introduce high speed modern trains (the first such ‘bullet train’ is proposed on the Bombay-Ahmedabad route shortly), the extensive rail network (largest in the world) can surely be a threat, at least on shorter routes where the time savings (cumulative of reporting times, travel times to & from airports, baggage delivery delays and actual flying time) are not substantial.

Overcapacity – Aircraft manufacturers continue to build and deliver new aircraft, adding new capacity. In off peak periods and on certain routes, this leads to overcapacity problems. Overcapacity fuels an imminent price war in the hope of filling empty seats. Worldwide, overcapacity pressures have at times lowered ticket prices to unreasonable levels, eroding bottom lines and acting as a threat. Diminishing yields per passenger - Overall, industry-wide demand for air travel in India has increased, but fares (average per flight) have not. Although more passengers are flying, they are paying less to do so. Not only are full service airlines collecting less fare revenue from the passengers they fly, they are also flying fewer passengers than they used to. Low-cost airlines are flying more passengers at lower prices. Controlling costs and maintaining cost differentiation is absolutely critical to overcome this threat. Growing road networks – Road travel in India has the potential to get faster, more convenient and enjoyable with the completion mega world-class road projects like the Expressways and Golden Quadrilateral networks. This will reduce travel times and perhaps get leisure travelers to use the roads as an option to enjoy the route to their holiday destinations, instead of traveling point-to-point by air. Open skies policy – The opening up Indian skies to foreign carriers is being debated at great length by the Government. Should this happen, there will be an influx of global players in the domestic market. Their long years of experience in markets abroad and financial strength will be a threat to new players like Air Deccan. Government Controls - Around 35-40 per cent airline costs in India at present are government imposed. Internationally, this figure is around 15-20 per cent. Take the recent tax on leasing. Depending on where you lease from, this will hike costs by 15-40 per cent. If the government forces us to go to certain countries, our leasing costs will go up as suddenly, that country will be deluged with requests from Indian airlines to lease planes. Poor Airport Infrastructure – Airlines like Air Deccan can buy more airplanes and put them in the air. But how do they take the aircraft and people through the terminals? There are not enough gates, not enough counter space, not enough parking bays. Lack of secondary airport infrastructure - In Europe as well as the US, low-cost airlines have one more way to shave off costs - but one that is a source of cost advantage unavailable to Air Deccan or its followers in India for some time to come. Abroad, low cost airlines avoid flying into mainland airports and, therefore, don't incur high parking and landing fees. India doesn't have too many secondary airports, and this is considered a major constraint. There is however a proposal to set up no frills terminals at Juhu Aerodrome in Bombay and Safdarjung in Delhi for use by low cost carriers.

FUTURE INDUSTRY STRUCTURE The structure of the Indian domestic airline industry will change fundamentally by 2010. There will be a distinct segmentation in the Industry with the emergence of three airline categories -

1. Full Service Airlines 2. Low Cost Airlines 3. Air Charters

Network Carriers / Alliances – There will most probably be an Alliance between IA and AI. With the open skies policy, we may also see alliances with International network carriers. Some 2nd tier carriers may exit the market (poor cost situation, no strategy for future positioning) or will lose their independence (join an alliance) Most regionals will join networks or pursue a hybrid business design. Low-Cost Carriers – In the future, they will capture a significant market share in domestic traffic. After the influx of a large number of new entrants in the low cost segment, there will most certainly be a shakeout and a bloodbath. Two to three financially successful low-cost carriers will survive successfully. First mover advantage and attaining critical size will be the keys to their success. Charters – Market share losses to low-cost carriers (seat-only and charter) on domestic & regional Asian routes. Non-integrated charter carriers are in “unprotected” competition with low-cost carriers.

Leading Full Service “Legacy” Carriers

Jet, IA

2nd Tier Sahara, AI

Regional Feeders

Alliance Air

Low Cost Carriers

Air Deccan, Kingfisher

Charters Taj Air, EIH, etc.

DISTINCT CUSTOMER SEGMENTATION

New Markets will be created through distinct customer segmentation. This echoes the vision of Air Deccan’s CEO, “We want people who had never boarded a plane or dreamt of flying to fly with us.”

Customers will continue to fall into segments with regard to demand for products on offer. Not every airline will be able to satisfy every customer.

The entrance of low-cost airlines will push customer segmentation There will be a sharper focus on customer segments, especially for short routes. This is

because the short routes are a “Dual Market” serviced by airlines for price-conscious customers (low cost airlines) and for quality-conscious customers (full service airlines)

There will be stiffer competition for non-business passengers and price-conscious business passengers on short routes

FINANCIAL ANALYSIS – A COMPARISON An attempt has been made below to compare the operational profitability of low frills vs high frills airlines. Comparison has been done for the Mumbai-New Delhi route between an Indian Airlines (High Frills) flight and Air Deccan (Low Frills) flight. The main assumptions are:- • Period for which the comparison has been done is 1 day i.e. daily profitability has been

calculated. • All the assumptions about numbers are only indicative and not the actual numbers –

hence the comparison is also indicative and not exact. • Since Air Deccan does not have a separate business class, seating capacity is more as

compared to Indian Airlines. • Since the turnaround time is less for Air Deccan (AD) as compared to IA, it is assumed

that 7 flights can ply daily on the Mumbai-Delhi route for AD v/s 6 for IA. • Break-even load factor for IA assumed at 60% for full-fare seats. • Operational Expenses per seat for AD assumed to be 50% of that of IA.

• Other assumptions and profitability comparison are presented below:

Profitability Comparison: High Frills vs No Frills Airlines

Indian Airlines Air Deccan Mumbai-Delhi Flight No. of Seats 120 180 Break Even Load Factor 60% 33% Break Even Seats (Full fare) 72 59 No. of flights / day 6 7

Rs. Rs. Rs. Rs. Full Fare (Rs.) 90% 7,070 4,581,360 23% 6,500 1,883,700 7 days APEX 5% 5,275 189,900 50% 5,000 3,150,000 21 days APEX 5% 3,500 126,000 25% 2,850 897,750 Super Low fares 0% - 2% 700 17,640 Total Daily Revenue 100% 4,897,260 100% 5,949,090 Expenses Aviation Fuel 20% 610,848 26% 694,840 Salaries & Wages 27% 824,645 12% 320,695 Admin,Maint. & Insurance 26% 778,831 23% 614,666 Marketing 8% 244,339 7% 187,072 Airport Charges 6% 183,254 15% 400,869 Depre., Int. & Capital Cost 11% 320,695 17% 454,318 Food/passenger amenities 3% 91,627 0% - Total Daily Expenses 3,054,240 50% 2,672,460 Profit Before Tax (Daily) 1,843,020 3,276,630 Results of Sensitivity analysis based on % occupancy and no. of flights plying per day are as under:

Indian Airlines No. of flights per day 4 5 6 7 8

70% 249,228 311,535 373,842 436,149 498,456 75% 412,470 515,588 618,705 721,822 824,940 80% 575,712 719,640 863,568 1,007,496 1,151,424 85% 738,954 923,693 1,108,431 1,293,170 1,477,908 90% 902,196 1,127,745 1,353,294 1,578,843 1,804,392 95% 1,065,438 1,331,798 1,598,157 1,864,517 2,130,876 O

ccup

ancy

100% 1,228,680 1,535,850 1,843,020 2,150,190 2,457,360

Air Deccan No. of flights per day 4 5 6 7 8

70% 852,516 1,065,645 1,278,774 1,491,903 1,705,032 75% 1,022,490 1,278,113 1,533,735 1,789,358 2,044,980 80% 1,192,464 1,490,580 1,788,696 2,086,812 2,384,928 85% 1,362,438 1,703,048 2,043,657 2,384,267 2,724,876 90% 1,532,412 1,915,515 2,298,618 2,681,721 3,064,824 95% 1,702,386 2,127,983 2,553,579 2,979,176 3,404,772 O

ccup

ancy

100% 1,872,360 2,340,450 2,808,540 3,276,630 3,744,720 • This analysis very clearly underlines the fact that low-frills airlines are much more

profitable as compared to high-frills for similar occupancy % and no. of flights – in fact, AD can have more profitability if it operates only 7 flights with 90% occupancy (Rs.26.8 lakhs) as compared to IA operating 8 flights with 100% occupancy (Rs.24.6 lakhs)!

AN ANALYSIS OF POSSIBLE COMPETITIVE SCENARIOS The following are the possible future competitive scenarios that Air Deccan may be faced with-

1. Competition within current business design : Air Deccan is currently facing killer competition from the full service airlines on common routes. The objective of the full service carriers is obvious –

(i) Defend their existing markets, and (ii) Retain a competitive edge by making their wide network a source of differentiation

and value addition. All the airlines have used price measures to combat Air Deccan, using innovative yield management systems. Apex fares are the primary weapon of competition, which at their lowest levels (30 days advance purchase) are even lower than Air Deccan’s ticket prices. Another competitive tool is to enhance frequencies on the sectors and step up customer loyalty campaigns. Jet Airways had completely revamped its frequent flyer programme, Jet Privilege, with unique world-first features and benefits. There have also been a few cases of selective pricing strategies. The full service carriers have selectively dropped fares on flights departing at the same time slot as Air Deccan, with even last minute deals (e.g. Jet’s Check Fares) that are as attractive as or even better than Air Deccan. However the competition laws, if enforced, can limit such trade practices. For competition in this format, the following are the pre-requisites for success –

(i) The yield generations must allow scope for a “leeway” to permit the introduction of short-term price measures through a competitive cost position. Quite obviously, such schemes can be used to fill seats beyond the break even capacities.

(ii) An Extended network with optimized hub and high-performance yield management from network carrier must be used as a differentiator.

(iii) The Resource availability (especially money) must be adequate to cushion the loss in revenues from the price cuts.

(iv) The schemes must be designed to effectively avoid fair-trade violations and protect the carrier’s dominant market position

(v) The quickness and effectiveness in direct marketing quotas of low priced seats is critical.

It is also essential to look at the possible pitfalls of this strategy. There is an imminent danger of starting ruinous price wars and drop in average yields per passenger flown. This is already happening in developed Western markets where airlines are seen to be flying more passengers and substantially lower prices. This most certainly leads to an extra burden being placed on profitability and earnings paving the way towards possible long term value destruction. Full service airlines may use this strategy to capitalize on their economies of scale in the short term. It is possible to for them to take on smaller low cost carriers using “shock and awe” pricing but in the long term, continued success prospects seem low. This is because there are several instances seem across the world where full service airlines have failed when they tried to pursue low pricing. It is a fact that a full service network business design is unsuitable for low cost operations.

2. Competition in low cost format : Full service airlines can compete by establishing their new self-owned low cost units. These can be in the form of independent airline offshoots (e.g. Indian Airlines plans to re-launch their wholly owned subsidiary, Alliance Air, as a low cost airline. Air India plans to launch a new low cost arm – Air India Express). The new airline can also be formed using Joint ventures with new or existing players. The key is to apply the low cost business design to product processes and cost elements. A pre-requisite to success is the speed in implementing key low cost elements and more importantly, the establishment of units with strictly parallel organization and independent management.

The primary objective of this strategy would be to defend existing markets, although using a different product. However, the carriers can establish and gain experience from their existing business designs. The probable drawbacks for the full service airlines launching such off-shoots could include-

(i) Distortion of customer perception and brand image (ii) Danger of blurring distinction from mainline airline (iii) Value destruction for the parent (full service airline) if low cost operation fails

It must be noted that worldwide, there are no successful examples to date of full service airlines running successful low cost subsidiaries. There are several examples of failures. For instance, Buzz (a no frills subsidiary of KLM Royal Dutch Airlines) and Virgin Express (the no frills subsidiary of Richard Branson’s Virgin Atlantic) have never been successful. A primary difficulty in implementation is the separation of business sectors/units on an operational level. The lack of differentiation leads to the product and service offerings on both carriers being almost identical, though the pricing of the new airline cannot support the cost structures. Manpower costs also tend to remain on par with the full service parent airline because the HR operations are centrally controlled. It is perhaps not part of the DNA of full service airlines to offer a no frills product. However, the past failures still do not predicate certain failure for future competition in this format. The model can succeed if operational differentiation is successfully implemented at all levels.

3. Withdrawal from the market : In this scenario, if low cost airlines have grown large enough to capture the critical mass, the full service carriers have an option to abandon some existing routes and transfer resources (planes, staff) to more profitable routes, unserviced by low cost carriers.

For implementing such a strategy, the basic prerequisites include: (i) The presence of lucrative alternative routes, having adequate traffic. (ii) No negative impact on remaining operations (hub quality). This is essential as the

network is a strategic differentiator for full service airlines. Abandoning routes trims the network. Hence the routes exited should be tactfully selected.

(iii) Loss of a low percentage of premium traffic from sectors abandoned The objective here is to avoid losses by overstepping a ruinous competition. The focus pf the full service carrier must remain on maintaining yield and profitability. Possible Pitfalls that must be considered are an adverse impact on the size and reach of the network, loss of critical mass and a reduction in customer loyalty due to a smaller route network offering. It is most critical to bear in mind that market re-entry into the routes that have been abandoned, after a period of absence, will become more difficult. Such a competitive position must be taken only as a “Last resort” option. A careful evaluation of the overall long term business strategy must be taken before a decision is taken.

4. Competition between low cost carriers : With the successful run of pioneer low cost carriers, it is imminent that more players will enter the market. Currently, there are several players waiting in the wings to start no frills operations in India, following the success of Air Deccan. Competition between carriers pursuing this business design will inevitably be intense. Low cost Carriers will compete by building routes, innovative pricing and creating reputations for safety and on-time performance. Maintaining strategic Cost differentiation is critical to long term success. This is because the most the cost gap between competing airlines, the more flexibility will be available to offer price cuts and gain market share from the competition. To succeed, low cost carriers will need to speedily implement key low cost elements in their business design. An extended route system will most certainly be a key differentiator as passengers would not need to look at different carriers to reach different destinations. Building the network will require more airplanes and related manpower. Resource availability becomes critical to achieve this goal. Air Deccan has promoters who do not have deep pockets. However, the airline is in the final stages of negotiation with banks and financial institutions to tie up funding their future expansion plans. The primary objective for low cost airlines competing within their own segment is to survive and capture critical mass. The focus must be on growing large enough to ensure that the competition cannot harm without maiming themselves. It is easy to compete with a small carrier offering limited seats. But if a low cost airline grows large enough to offer a larger number of seats, the smaller low cost carriers and full service airlines will not be in a position to turn customers away by offering price cuts and selective pricing. One of the major pitfalls to guard against is attempting to differentiate a low cost carrier by adding frills, thus losing strategic cost advantages. Every frill or service adds to cost and reduced the strategic cost gap, thus curbing the flexibility to offer innovative price deals. There are several examples in the West where low cost airlines were faced with hyper competition within their own sector. They tried to “be different” and in the process, lost their strategic positions. One of the examples is Debonair which started offering a two-class product, with a frequent flyer programme and positioned its product as “low cost-high frills”. Debonair went bankrupt in 1999, shortly after pursuing this hybrid strategy.

In India, Air Sahara is planning to reposition its product as a ‘low cost-high frills’ offering. Possibility of success seems remote, especially since increased competition is reducing the average yield per passenger and costs are on their way up. It is doubtful as to how Air Sahara can afford to offer a high frills product at a substantially lower fare and still make a decent margin ti sustain its operations. Vijay Mallya’s Kingfisher Airline also has plans to launch an airline with such a “hybrid” business design. Around the world, it has been observed that low cost airlines pursuing a generic business design have emerged as the most successful. The moment they have started adding frills, they have lost their source of competitive advantage by narrowing the strategic cost gap.

5. Competition with other transport service providers : The low cost airlines have pricing models aimed at capturing critical mass from surface transport providers, like luxury buses and the Railways. For instance, recent reports have pointed out that the Rajdhani Express and other premium trains and AC class compartments across the board are running at less than 20 to 25% capacity. This is significant as these low load factors are reported in the Diwali – Winter time period which is the peak season for travel within India. The Time V/s Price comparisons are the key to positioning in this market. If safety concerns are adequately addressed, it is not difficult for low cost airlines to capture huge passenger loads away from these surface transport providers. The main objective is to capture Critical Mass and to create a new Market segment. Primarily, low cost airlines offer tickets at prices lower or equal to premium trains/AC class fares thus allowing people who have never dreamt of flying to use their services. When looking at the competitive scenarios and charting out its future strategies, a MAJOR LESSON that Air Deccan must learn from the experiences of low cost carriers in the Western World is –

Airlines must consistently pursue their business design.

Hybrid (e.g. low-cost for network carriers, high frills for low-cost carriers) will not be capable of surviving.

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