Europe’s most successful no-frills carriers are making a lot of money. But as they mature, they will have problems expanding.
The McKinsey Quarterly, 2002 Number 4
Low-cost airlines are all the rage in Europe. With rock-bottom fares that entice travelers from the chillier north to places like Barcelona, Nice, and Rome, such carriers have introduced Europeans to a cheap, fast mode of transport-a tangible benefit to consumers in the fitful march toward deregulation. As bookings pour in, the low-fare carriers are making ambitious expansion plans and placing large orders for new planes. Some are even earning profits that defy the cyclical nature of the airline business. Long-protected national-flag carriers are beginning to respond to the low-cost airlines, and capital markets are paying close attention to their business strategies, which many believe foretell the future of intra-European air travel.
It is easy to see why. In 2001, while most traditional players reported losses and some succumbed to the competition, Europe’s leading low-cost carriers were more than merely profitable: Ryanair and easyJet boasted operating margins of 26 and 9.5 percent, respectively-results that traditional airlines only dream about. In June 2002, Ryanair had a market capitalization of 4.9 billion ($4.82 billion), 45 percent more than that of British Airways (BA), which has revenues that are 20 times larger.
Expectations are high among some financial analysts, investors, and industry experts that the low-cost airlines, which now hold only 7 percent of the intra-European air travel market as reckoned by the number of passengers they fly and less by revenue, can reach the penetration levels achieved by their US counterparts (Exhibit 1). Since Southwest Airlines pioneered its low-cost strategy, 30 years ago, no-frills operators in the United States have captured a 25 percent share of the passengers in domestic air travel and a 15 percent share of the revenues.
We doubt that Europe’s low-cost carriers can do equally well. As they expand full throttle from a predominantly UK base, they could indeed double their European market share in the next five years. But they are unlikely either to dominate short-haul travel in Europe or to approach the market share enjoyed by their US cousins. More likely, their longer-term growth will bump up against the ceiling of a European market in which the contestable low-cost segment is smaller than it is in the United States and well-established packaged-tour operators and national-flag carriers can block deeper inroads into the leisure- and business-travel segments. Europe’s business market is more limited, too: fewer routes have enough traffic to sustain the frequency of low-cost departures that could attract business passengers.
These considerations should limit scheduled low-cost airlines to a successful niche strategy, mainly on routes to and from the United Kingdom and possibly to and from a few other Northern European countries.
Interlopers in the skies
Before European air travel was deregulated, in the mid-1990s, the market was neatly divided. Scheduled carriers, focusing primarily on business travelers, controlled 75 percent of the intra-European market. Charter airlines held the remaining 25 percent by selling aircraft capacity to tour operators and shuttling sun-seeking package tourists from cold Northern European countries to the beaches of Southern Europe. Both scheduled and charter incumbents were shaken by the emergence of low-cost carriers that targeted leisure and, to a lesser extent, business markets.
Low-cost airlines rely on a simple business design: one kind of aircraft, one class of passenger, and more seats crammed into the airplane-as well as no airport lounges, no choice of seats, no newspapers, no food, no frequent-flyer programs, no connecting flights, no refunds, and no possibility of rebooking to other airlines. Also, there are no travel agents and expensive computer reservation systems; about 90 percent of easyJet and Ryanair tickets are booked over the Internet.
By keeping the logistics simple, no-frills airlines cut turnaround times on the ground and maximize revenue-generating air time. On short-haul routes, for instance, easyJet’s planes are in the air an average of 12 hours a day, compared with 9 hours for the most efficient traditional scheduled carriers. Some European low-cost carriers fly to and from secondary airports-located as far as 100 kilometers from city centers-thus minimizing landing and ground-handling fees. On intra-European international routes, this adds up to an operating-cost advantage per seat and kilometers flown (unit cost) of 40 to 65 percent as compared with major scheduled carriers (Exhibit 2).
Lower costs and higher seat-load factors permit no-frills carriers to offer fares 50 to 70 percent lower than those of the incumbents. The average price (revenues divided by the number of passengers) of the no-frills carriers for a one-way ticket on international intra-European routes is 50 to 85, compared with 180 to 200 for British Airways and Lufthansa. This approach attracts price-sensitive and flexible travelers, but the lack of convenience and flexibility makes the low-cost model unappealing for most passengers traveling on business.
More passengers for everyone
Most passengers who fly with low-cost airlines aren’t defectors from the incumbents. Rather, lower prices encourage people to fly when they would otherwise have gone by road or rail-or not at all. Most of these passengers are on vacation; some are workers or self-employed businesspeople commuting on a regular basis.
The overall air traffic in a market typically rises sharply when a low-cost carrier breaks into it, our analysis shows. After low-cost carriers took on the London-Barcelona market, in 1997, for example, traffic rose from 600,000 passengers in 1996 to 1,500,000 in 2001. Traditional carriers flew 380,000 of those extra passengers during this period, and the low-cost entrants 520,000. The London-Milan and London-Nice routes both show similar patterns, with the scheduled carriers continuing to grow at rates ranging from 4 to 10 percent and low-cost carriers primarily flying the additional stimulated demand.
Low-cost airlines thus seem to complement both traditional and charter airlines, but there are overlaps. They compete with the charter airlines, which sell up to a third of their seats without an accompanying hotel package, for the favors of independent travelers and people who travel to holiday homes frequently. They also compete with the traditional airlines, whose weekend fares attract moderately price-sensitive leisure travelers and whose cost-conscious business passengers often may fly repeatedly on a particular route, can plan ahead, and have no need for flexible tickets.
Same strategy, different approach
Bearing these segments and economics in mind, low-cost carriers must select routes carefully to generate enough traffic to fill the larger aircraft they use. Ryanair, we estimate, can make a healthy profit if it generates traffic of at least 32,000 round-trip passengers a year on a route.1The chosen routes should be either unserved or served by incumbents at high fares, allowing the no-frills entrant to stimulate demand by undercutting them. Profitable markets must also have a large leisure- and private-travel component-the mainstay of the customer base of most low-cost carriers.
A majority of these carriers follow the same basic rules, but with some differences in approach. Ryanair, which is as cheap as it gets, operates routes from London Stansted to many secondary airports-for example, to Carcassonne and Biarritz, in southern France, and to Pisa and Verona, in Italy. Low airport fees help keep the carrier’s costs 65 percent below those of a typical scheduled airline. Ryanair can thus offer cheap fares and still make a profit if more than 55 percent of its seats are occupied.
The low-cost carrier easyJet averages three flights a route seven days a week, compared with Ryanair’s two, and it flies from London’s Luton and Gatwick to main airports in cities such as Amsterdam, Madrid, Paris, and Zurich. This approach appeals to some business travelers, and the airline contends that up to 50 percent of the passengers on its flights are traveling on business. Mainly because of more expensive airport fees, easyJet’s costs-40 percent below those of old-line international carriers-are higher than Ryanair’s. Thus easyJet needs to fill more than 75 percent of its seats to make a profit.
Regardless of the approach low-cost carriers take, they enjoy protection from business cycles, since in hard times demand for premium service tends to decline as more passengers seek less expensive travel alternatives.
Winner takes all
Success, however, is no simple copy-and-paste game. Excluding Ryanair, the European low-cost segment accumulated losses of almost $300 million from 1996 to 2001, and AB Airlines, ColorAir, and Debonair went bankrupt. In the United States, the low-cost industry-excluding Southwest Airlines-lost almost $1 billion from 1996 to 2001, and bankruptcies were rife. With easyJet’s acquisition of Go, Ryanair and easyJet between them account for more than 88 percent of the scheduled low-cost market in Europe. Southwest Airlines holds 50 percent of the US low-cost market. This pattern suggests that a winner-takes-all dynamic favors the first entrants, which can use low prices to stimulate demand and build brand power (Exhibit 3). Later low-cost entrants, with the same costs and prices, have a harder time generating the traffic needed to fill their planes.
No-frills operators may be aware that head-to-head competition among them is bad news for profitability: by the middle of 2002, they competed on only 17 routes, compared with 111 destinations with only one low-cost player. Given the saturated market and the shor tage of other options, competition is likely to intensify-inevitably followed by consolidation. An early sign is easyJet’s purchase of its UK competitor Go, which had a similar strategy; and easyJet also has an option to buy the German domestic airline Deutsche BA.
For the carriers that played their cards right, the low-cost approach has proved to be an excellent niche strategy. Can they conquer a broader market? The capital markets seem to think so: current valuations can be explained only by very high expectations of long-term growth and profitability. With about 200 new aircraft on the way, the low-cost carriers certainly believe they will grow. Ryanair says it operated 44 Boeing 737s during the summer of 2002, and it has ordered 100 new Boeing 737-800s, with an option on an additional 50 for delivery from 2002 to 2010. According to the company, this expansion would provide for annual passenger growth of 25 percent. As for easyJet, it operated 35 737s as of July 2002, with plans to operate 49 by 2004, and it has options on an additional 30 737s. Success means that low-cost carriers must raise their share of the overall European market for air travel to about 14 percent, from 7 percent, by 2007. Ryanair alone predicts that the number of its passengers will increase from 11 million in 2002 to no less than 40 million by 2010.
Viable new routes from London are scarce. Across Europe, low-cost carriers have withdrawn, during the past four years, from more than 30 routes-a quarter as many routes as they served in 2002. Go has quit Lisbon, Madrid, and Zurich; Buzz, Helsinki, Milan, and Vienna; Ryanair, Rimini and the southern Swedish town of Kristianstad; and easyJet, Liverpool. So how do the low-cost carriers plan to grow in the medium term? By developing smaller Continental operating bases: Charleroi (serving the Brussels area) and Hahn (100 kilometers from Frankfurt) in the case of Ryanair, and Geneva and Amsterdam in the case of easyJet.
One approach is to open routes in markets that aren’t served at all by the bigger airlines, with their emphasis on business passengers. The share of routes served by just a single low-cost carrier increased from 22 percent of all low-cost airline routes in 1999 to 33 percent in 2002; seven of Ryanair’s ten destinations from Hahn, for example, aren’t served by Lufthansa. Ryanair has reported a strong start at its Hahn base, launched in February 2002, with an average of 80 percent of the seats from that airport filled. By March 2003, Ryanair expects to carry two million passengers on its international routes to and from Germany.
Stimulating demand in Continental market segments that have little overlap with the incumbents’ routes may be enough to fill the new airplanes. But in the long term, it is unlikely that low-cost carriers can equal their penetration of the United Kingdom on the Continent. No Continental locations match London’s high levels of well-balanced, year-round business and leisure traffic or have five airports in the metropolitan area. In addition, the French and Southern Europeans travel much shorter distances to reach sunny locations and have less to gain by switching from cars or high-speed trains to low-cost airlines. The market share of low-cost carriers on international scheduled flights from the United Kingdom in January 2002 was 25 percent, while the overall European average-excluding flights from, to, and within the United Kingdom-was 3 percent. The United Kingdom will almost certainly remain by far Europe’s largest low-cost market.
Where could long-term growth come from? Our analysis suggests that it would require the low-cost airlines to take market share from the big incumbents and charter companies. But the no-frills will find it difficult to overcome the structural limitations and competitive challenges in these markets.
Low-cost charter airlines already serve a 45 billion packaged-tour market for Europeans, who, unlike people in the United States, vacation regularly in foreign countries and prefer bundled airfare and hotel offerings. The charter airline industry, run by powerful travel groups, accounts by itself for about 21 percent of intra-European air travel, or 35 percent of the relevant market if regional and domestic flights are excluded. As a result, the current penetration of all forms of low-fare air travel in Europe is higher than it is in the United States. Some 45 percent of the flights for all German holidays, for example, are still purchased as packages, and that share has hardly changed in five years.
Nonetheless, demand for packaged tours has been stagnating, while do-it-yourself vacations have become more popular. Some packaged-tour operators may yet establish their own scheduled low-cost airlines. Germany’s TUI, the biggest packaged-tour operator in Europe, has announced that it is “intensively evaluating” this market; meanwhile, Britain’s MyTravel has hired a former Ryanair marketing director to set up a scheduled no-frills service to holiday destinations.
France, Germany, and Italy all have the levels of domestic traffic needed to sustain low-cost offerings, but flights in these markets are already highly competitive and priced lower than international flights. The domestic oper-ating costs, per seat and per flown kilometer, of the flag carriers are on average 25 percent lower than the cost of their international operations, because they have reduced in-flight service, switched to larger aircraft with more seats and a single passenger class, and sell more tickets through the Internet and airport ticket offices. This leaves a cost advantage of 15 to 30 percent for most low-cost carriers, but that might not be enough to win over passengers-and certainly not enough to stimulate additional demand. Low-cost carriers have as yet made no moves to enter large Continental domestic markets.
A clearer view
Given the obstacles to growth in the charter and domestic markets, the expansion of international routes would appear to be the logical long-term growth path for low-cost carriers. British Airways’ short-haul network already suffers from fierce low-cost competition; for example, the carrier lost 12 to 55 percent of the traffic to low-cost competitors in midsize markets such as London to Marseilles, Genoa, Bordeaux, and Bilbao. Meanwhile, British Midland is setting up a low-cost subsidiary. But Continental carriers have experienced little change in their route economics after low-cost competitors entered their markets, and their profits haven’t been affected significantly. While a limited, one-digit percentage revenue loss might occur in the first year of coexistence with a low-cost carrier, revenues and load factors can actually go up over time, for some of the newly generated appetite for air travel flows over to the incumbents’ weekend fares (Exhibit 4). Our analysis of routes served by both low-cost and traditional carriers in the past three years shows that while low-cost airlines overall have doubled their size as reckoned by seats offered, the incumbents, rather than withdrawing capacity, have increased the number of seats they offer by 9 percent on these routes.
As low-cost airlines consolidate in the United Kingdom and target the Continent, British as well as Continental competitors are responding. British Airways and British Midland have cut some fares on a range of short-haul routes and scrapped some conditions for the booking of low-fare seats. Both KLM and Scandinavian Airlines System (SAS) have done the same, and Lufthansa has cut fares for some seats on a number of domestic and European flights.
What scheduled incumbents fear most is that some of their business traffic could be at risk if the low-cost offering reaches a critical mass, both in daily flight frequencies and the number of destinations. This scenario is already a reality in the London area, where low-cost routes with at least three daily flights are concentrated; more than half of British Airways’ international short-haul routes face low-cost competition. It is doubtful, however, that any other region is big enough to make such a broad low-cost offering possible. In 2001, total air ticket sales through travel agents generated 14.7 billion in the United Kingdom, for example, mostly in the London area. In Germany, with a bigger population, the figure was 8.4 billion, spread among different cities.
Direct competition with traditional airlines may also be tougher than the no-frills might expect, because the mainline carriers could compete for price-sensitive business; as a matter of fact, they could cut their operating costs on international intra-European routes by 20 to 30 percent if they adopted ingredients of the domestic recipe. (To give just one example, easyJet manages to fit 35 percent more seats into its B737-300s than KLM does.) The recent decision by SAS to switch to just one class of service in all intra-Scandinavian markets is a step in this direction. The extent to which other mainline carriers follow suit will depend on their ideas about whether their traditional competitors would do so as well, and on the pain caused by their low-cost competitors. Balancing such considerations is the risk of losing corporate passengers who have become accustomed to high levels of service, to say nothing of the possibility that the airlines would collectively end up with an excessive number of planes. (Adding to the number of seats per plane would of course have the effect of increasing overall capacity, and to avoid this the airlines would be forced to retire a number of planes.)
At the same time, the low-cost carriers will be hard-pressed to maintain or improve their cost positions as they come of age. They might, for example, lose start-up advantages such as the free or discounted use of secondary airports as those facilities gained a better bargaining position when contracts came up for renegotiation.
Europe’s low-cost airlines can double their market share in the next five years, mainly by stimulating demand on the Continent. But shaping the future of intra-European air travel would require the no-frills to make major inroads into the incumbents’ customer base. Evidence suggests that this isn’t likely to happen without taking its toll on the profitability of the low-cost carriers.
Urs Binggeli is a consultant and Lucio Pompeo is a principal in McKinsey’s Zurich office.
1This estimate is based on one daily round-trip flight on a 159-seat aircraft, seven times a week, and 52 weeks a year, filling 55 percent of the seats at a given mix of seat prices.