Competing with Pirates

This article is a revised edition of a former publication in ManagementSite. This revised edition is dated 05-02-03.

• Introduction
• L'histoire se répête
• 'Expectations Cage'
• Business model strategy
• Strategies for traditional players
• The future
• Notes

Low-cost airlines offer tickets for as less as one third to one tenth of the prices flag carriers such as Lufthansa, British Airways, KLM, and Air France charge. At first sight, this seems to result in a crash, but on further consideration it turns out to be a huge success formula. The interesting question is: how can start-ups be successful with a low-cost strategy in spite of their often significant initial losses. The aviation industry shows it can be done. Even more so, start-ups should turn to this strategy a lot more often. In this article we also highlight the possible strategies of the flag carriers to counter the attacks of newcomers.

Introduction

The liberalisation of air services provided a significant boost for the development of no-frills airlines. America's best known no-frills airline is called Southwest Airlines. Southwest Airlines was and is an American icon. The Dallas based company is one of those responsible for the fact that the American and world-wide aviation industry looks completely different now. The success of Southwest Airlines is based on a very simple principle: transporting passengers over relatively short distances at very competitive airline rates. The traditional high-cost airlines in America and Europe alike can whistle for it now. They risk losing much of the intra-American respectively intra-European connecting traffic that feeds into their lucrative long-haul networks.

The low-cost strategy of carriers such as Southwest Airlines has a solid basis. Southwest does not occupy itself with meals, 'in-flight' films, design chairs, and various classes (and the corresponding options). All frills have been removed from the value proposition. It is also striking that Southwest Airlines does not make use of the 'hub-and-spoke' system so highly praised by other airlines. Instead, Southwest uses the 'point-to-point' flight concept, offering rates that are at least 60% cheaper than those of the direct competition. Southwest uses plastic boarding passes (re-usable) and has looked ever since its foundation for secondary airports in smaller cities and less congested airports in major cities (or in the vicinity of major cities). On top of that, a Southwest Airlines plane is on average only idle for 20 minutes at any airport compared to the average of 45 minutes for the traditional airlines. Last but surely not least: the Southwest Airlines fleet consists of Boeing-737 airplanes (just one type of airplane) and therefore the company benefits from economies of scale and economies of skills. This is the pioneering recipe of the most successful airline since the Second World War. It is this 'simple' concept of a short-haul carrier that inspired world-wide the development of other discounters imperilling the existing giants.

The Southwest Airlines success especially starts standing out in the late eighties. Whereas the major American colleagues such as American Airlines, United Airlines and Delta Airlines are losing billions of dollars, Southwest Airlines performs well in terms of absolute figures and extremely well in terms of relative figures. Southwest Airlines remains profitable throughout the Gulf crisis, a unique feat in the highly competitive aviation industry. And all this with a very modern fleet (average age seven years) - not with a fleet of dumped leftovers.

With its competitive behaviour, Southwest Airlines creates a completely new market sector within the aviation industry and is therefore a first mover player. It has cashed in on the corresponding advantage for many consecutive years. Ever since its foundation (in 1971), Southwest Airlines has refused to duel directly with colleagues for market share and margin, but opted deliberately for the development of a completely new market sector. They choose to stimulate new demand, rather than taking shares from major carriers. No market penetration, but market development [1].

L'histoire se répête

It takes some time for the first low-cost airlines to appear in Europe. In itself this is remarkable, because a lot of regional commuters have been active in Europe from time immemorial. But the regional airlines in Europe have only been nothing but smaller versions of their major counterparts for quite some time. In essence, they make use of the same business model as the national flag carriers and that does not allow them to distinguish themselves in the game of move and countermove.

European flag carriers in general and KLM and British Airways (BA) in particular, encountered quite a lot of problems in the early nineties with the rise of British Midland. British Midland, founded by Sir Michael Bishop, initially profits from less bureaucracy which manifests itself in a lower cost structure. British Midland lets the traveller share in the lower costs - the tickets become cheaper. British Midland's competitors were consequently forced after some time to reduce their prices too. The appearance of British Midland makes it increasingly clear that the flag carriers will have to concentrate more and more on the long-haul routes. Smaller no-frills airlines throw themselves on the shorter routes. British Midland is the first to jump into that gap, followed by companies such as Ryanair, Virgin Express and EasyJet.

But by now, the institutional environment is changing rapidly. This is probably an important reason for the rapid expansion of no-frills air travel in Europe. All mutual air routes between the European Community countries are liberalised as from January 1st, 1993. From that moment onwards a level playing field is created for no-frills airlines. The airline rates are no longer embedded in all kinds of bilateral agreements reeking of monopoly between national carriers. Nothing much happens in Europe initially, particularly because the early nineties are difficult years for nearly all airlines. The years before and after the Gulf War are not a fertile soil for no-frills airlines.

The first company introducing 'real' discount flying on the European continent, is EuroBelgian Airlines Express (in short: EBA Express) operating from Brussels. EBA Expresss is owned by the City Hotels hotel chain. People can fly from Brussels to Vienna, Barcelona and Rome (and back!) for about 150 Euro. EBA just copied Southwest Airlines little trick. Speed and punctuality are the value propositions made by EBA. They only fly one class, serve the passengers with half the staff and only give passengers one non-alcoholic drink during the flight.

Several Southwest Airlines clones start appearing after some time in Europe. Ryanair and EasyJet set the ball rolling, followed by the cheap subsidiaries of flag carriers such as Lufthansa, Alitalia, BA and KLM. As a rule, the Southwest Airlines business model is copied: one type of airplane, no or sober meals, no papers; drinks, however, are available, but not for free, no business lounges, booking is simple via the internet and no paper tickets are issued or very seldom. In Europe too, no-frills stands for 'no hoo-ha'.

Richard Branson, owner of the Virgin Group and Virgin Atlantic Airways, is yet another example of a business man who, halfway through 1995, fell under the spell of the possibilities low-cost airlines had to offer. The continuing liberalisation is the last push he too needed. Once again, Branson's timing is excellent. Branson becomes active in the no-frills market sector in 1996. In April of the same year he takes over the Belgian EuroBelgian Airlines Express for $ 57.3 million. EBA Express has 12 Boeing 737s and in 1995 the company transports 1.3 million passengers. Ornstein, the former boss of the American low-cost airlines Continental Express and United Express, becomes CEO. Virgin Express, the new name of the low-cost company, copies the Southwest Airlines business model, exactly the way Ryanair and EasyJet do, a model in which Ornstein is quite experienced. Just like Southwest Airlines, Ryanair and EasyJet do, Virgin Express focuses on 'point-to-point' flying: flying from A to B without transfer.

'Expectations Cage'

Major 'hub-and-spoke' companies such as KLM, British Airways and Lufthansa have struggled a long time with the business model used by Southwest Airlines, EasyJet and Ryanair. It is certainly not easy for the flag carriers to combine two completely different business models. Especially the 'point-to-point' system is hard to combine with the 'hub-and-spoke' system. A lot of traditional companies have tried over the last five to ten years to bring both business models under one umbrella. It is hard to chart true success stories. Nevertheless, the urge to link both business models is strikingly strong. This has primarily to do with the amazing financial success of the low-cost companies. Traditional airlines such as United Airlines, number two on the list of the major airlines in the world, still threatened to go under a little while ago. The reason being among other things the arrival and the aggressive growth of the low-cost companies. Stephen Wolf, former CEO of United Airlines feels that Southwest Airlines has been responsible to a great extent for the continuity problems United Airlines had to face, especially from the early nineties onwards [2].

When it had become clear that the disciples of Southwest Airlines were no nine days' wonders, the establishment decided to start up its own no-frills companies as a part of its own business operations. This is how life was breathed into a pre-emptive strategy: take the wind out of the sails of the low-cost competition. As from that moment, they also start taking participating interests in airlines operating on a regional basis. The loss-making short-haul lines of the flag carriers are now transferred slowly but surely to the existing regional partners (or to new no-frills subsidiaries). Regional companies annex partners are generally speaking able to operate such low-service lines making a profit. In the mid-nineties British Airways had participating interests in Deutsche BA and TAT and had founded CityFlyer Express for the same reason. KLM tries initially from the mid-nineties to join the battle with the no-frills companies via Air UK and its participating interests in Transavia and Martinair. It has become clear in the mean time, that the existing 'traditional' regional companies do not show the required fighter mentality. The creation of KLM's Buzz and British Airways GO is an indication to that effect. Both companies did not prove to be a decisive success for that matter.

The no-frills companies make an important contribution to the dynamics of the competitive struggle. Competition with the major giants is not direct but indirect. This has proved to be an interesting competitive strategy. The fact of the matter is that the lower rates have resulted in increased transport flows. The Southwest Airlines strategy once again proved this. Low prices have a 'pull effect'. Major companies are moreover forced to hold their provision of services once again up to the light and to start up or buy up low-cost companies. Various studies made by, among others, Dutch market research leader NIPO (Business Travel Monitor) and the independent Dutch magazine Zakenreis, have shown that service becomes increasingly less important and that efficiency, precision and punctuality take the upper hand.

The, for the passenger, time consuming 'hub-and-spoke' system is also questioned more and more. The transfer system offers the passengers a lot of alternatives (no matter how crazy your idea, there will always be a traditional airline that can get you where you want to go), but it also costs the same passenger a bundle (including the enhanced risk of delays). The rise of the no-frills companies has led to a lot of flag carriers outsourcing or selling their arrival routes. After hiving off catering, maintenance and hotels, the flag carriers are increasingly pushed back to their 'real' core business: offering mobility and this over long distances. These routes create the economies necessary to afford the expensive sales, organisation and marketing apparatus.

The strength of the no-frills airlines is at the same time their weakness: the focus on a very specific value proposition and the business model meticulously constructed around it. The high degree of focus and the distinctive character of the no-frills companies has contributed to the fact that it is very hard to copy the business model. The experience of the last thirty years has taught us that no traditional airline has succeeded in setting afoot a second Southwest Airlines. The Southwest Airlines business model may be simple in theory, but it is strikingly difficult to clone in practice.

The lack of flexibility is the other side of the Southwest Airlines business model cum suis [3]. The strategic flexibility for instance, is low. It is difficult to switch from a 'point-to-point' business model to a 'hub-and-spoke' business model. In addition, no-frills companies often have an outspoken corporate culture. The fact that they compete with the establishment creates a tremendous cohesion. That makes them inflexible from a cultural point of view. Taking over other airlines which are, for instance, responsible for (expensive) long-haul flights is a tricky business for a low-cost company and therefore not to be advised.

Low costs make or break the business model used by Southwest Airlines, Ryanair and EasyJet. If the cost advantages in comparison with the traditional players disappear, the low-cost companies are left penniless and then things look grim for them. Experience shows that after a certain time, costs rarely continue to drop, but rather tend to rise. There are limits to low costs. In time, planes have to be renewed, employees grow older (and therefore more expensive), the mutual atmosphere is often put under pressure the more the companies grow and consequently this has an impact on productivity, cheap airports tend to increase prices in time, almost without exception, and rising kerosene prices often hit the low-cost companies harder than the traditional flag carriers, which use more efficient, younger planes. The sustainability of the competitive edge of low-cost companies nevertheless remains remarkable.

This can be explained in a certain way. Traditional companies such as BA, Air France, and KLM are imprisoned in the 'expectations cage'. Passengers have certain (high) expectations with respect to the service on board of a flag carrier. If passengers can no longer enjoy a hot meal and read a national or an international newspaper, a lot of them will give up - as some BA / Air France / KLM employees will. In the mean time, the price breakers continue their advance steadily. It appears that increasing numbers of business people make use of their services. They are left in peace and quiet on short-haul flights - a modern 'first class' treatment in due form. The parade of meals and drinks does not materialise. Flying without frills has thus touched all layers of the social fabric [4].

Business model strategy

Initially, the low-cost companies did not compete with the traditional airlines. They restricted their efforts only to creating a demand where it did not exist yet: market development instead of market penetration. This is an important recommendation for low-cost start-ups: competing with low costs is not 'suicide' provided you expand ('develop') the market as a start-up. Direct competition with existing parties for existing customers ('market penetration') with a low-cost strategy is generally doomed to fail. The triangle 'market penetration - low costs - start-up' rarely results in success. Mid-2000, the low-cost airlines in Europe had a market share of about 7 per cent, but their market share has been growing fast since then (by way of comparison: the low-cost companies had a market share of about 20 per cent in the United States mid-2001).

How long can the low-cost airlines keep on growing, without this growth being at the expense of their relatively high profitability? What is the optimum number of low-cost players and what is the size necessary for those players to maximise profitability? How much room is left on the aviation market to allow the low-cost companies further growth? A lot according to the above cases, because the low-cost airlines seem to be sailing for the wind without a worry and it will still take a long time before the end of their growth comes in sight. According to the figures of the trade journal Airline Business, there is still room for manoeuvre in the United States too, where the low-cost companies are now firmly established.

It is interesting to find out whether the business model of the low-cost airlines can be 'stretched'. Can low-cost airlines also be successful in bridging long(er) distances? Not long ago, Southwest Airlines went down this road. Southwest shows that the business model also works for somewhat longer distances, although the results are less spectacular than on the short distances. Certain additional costs have to be made for longer distances. Just think, for instance, of the costs relating to catering, higher maintenance costs (due to the long(er)-haul flights), cleaning activities requiring more time and therefore more costly which makes that the plane cannot take off again after 20 or 30 minutes, etcetera. It is also increasingly important to offer passengers comfort on longer flights (good seats and more leg space).

What have the traditional carriers done so far to reign in the threat posed by the low-cost companies? They try in first instance to perfect their own 'hub-and-spoke' system via all kinds of alliances. Such alliances allowed them to compete directly with other high-cost companies by simply forcing a direct competitor out of the market through a co-operation concept. Flights and services under each other's flag are offered via such constructions and via intricate and dense 'hub-and-spoke' networks. Via frequent flyer programmes the flag carriers try and bond with the passenger eventually threatening the passenger's freedom of choice. The above initiatives of the traditional carriers have had no or very little impact so far on the cost side of the margin and that is exactly the domain where the no-frills companies are lord and master [5]. Today, traditional carriers are still not able to offer the same low-cost service at the same low price with the same margin as the low-cost companies do.

However, it is pretty hard for the traditional carriers to ignore the low-cost airlines, which fly primarily on the short distances, because the latter especially foul up the feeder function of their 'hub-and-spoke' system. For their intercontinental flights, the traditional companies depend on the supply of passengers, who often have to be flown in from everywhere and therefore have to be flown to a central hub (the hubs have to be 'fed'). Each traditional airline needs a critical mass of passengers to turn the intercontinental flights - and consequently the whole of their business operations - into a success. A properly functioning feeder function is imperative. It is, however, difficult for a traditional company to compete directly with a low-cost airline on these short distances, because their cost structure is inherently less favourable. In addition to the above, the anti-trust authorities are really on edge when a major traditional player suddenly starts selling tickets below cost price (i.e., 'predatory pricing'). Some time ago, the European Commission left no doubt that predatory pricing will never be approved by the anti-trust authorities.

The financial outlook for the flag carriers is rather bleak. How will traditional carriers have to compete in the future with such low-cost carriers? Traditional carriers have to do their homework before they take action. The first question they have to ask themselves is: what exactly is the key to the success of the low-cost airlines? At first sight, the answer to this question seems self-evident: their low costs. But what lies at the basis of those low costs?

Low-cost companies enjoy a number of cost advantages compared to their major, traditional competitors. First of all, the business model is cheaper. The value proposition is geared towards offering one core product: offering punctual flights from A to B without transfer. All frills have been removed from flying in their concept. Such a philosophy simplifies process management. Internal business processes are a lot simpler and therefore easier to manage. In addition, it takes less hands to bring simpler processes to a favourable conclusion.

This brings us to a second cost item: labour costs. Low-cost companies employ cheaper employees and incur consequently lower labour costs, an important cost factor in the aviation industry. Flag carriers have suffered from the high wages of their employees and powerful unions. A pilot working for a low-cost company often only makes half or two thirds of the salary his colleague flying for a traditional carrier earns. The ground personnel and the other flight crew members make considerably less than their colleagues working for traditional 'hub-and-spoke' companies. Some low-cost airlines furthermore manage to push up labour productivity to high levels despite the lower wages. Southwest Airlines is a perfect example. In spite of a relatively low average income, the average Southwest employee shows a considerably higher productivity than his colleague working for any major traditional airline [6]. In addition, a lot of low-cost airlines still use second hand planes and outsource many activities to very cheap suppliers.

Most of the low-cost airlines furthermore play on the irritation a lot of business travellers and tourists show, because they are constantly 'annoyed' (especially on short-haul flights) with meals, drinks, and duty free goods. Low-cost airlines offer an 'empty' product: the flight. Everything else has to be paid for extra. Some low-cost airlines deviate from this philosophy to a certain extent, but in essence the philosophy is to 'annoy' the passenger as little as possible with services and products. If any food or drinks are offered at all, then preferably cold and not fresh snacks, because you obviously have to get rid of warm meals and fresh products on the day itself. Business Class and First Class are an utter waste, because they are not a product the passenger flying with a low-cost company wants. In addition, the above 'classes' also take up a lot of extra seat space. For that very reason, the low-cost airlines often offer a lot more seats per plane.

A last major cost saving factor is the refusal to participate in all kinds of computerised booking systems. As a rule, passengers buy their tickets directly from the low-cost companies (over the phone or via the internet) and bypass therefore the expensive intermediaries. Ergo: lower costs.

The fact that low-cost airlines are constantly seeking ways to reduce their operational costs, contributes to their strong position in terms of cost. Thinking in terms of and working with low costs is a way of business life and therefore an integral part of the business culture. The low-cost companies manage to realise a first mover advantage in the field of cost management and reduction. The sustainability of this advantage in everyday practice shows that low-cost companies are experts at this 'cost management'. As a rule, the flag carriers seem to be months or years behind when it comes to implementing innovations and new developments. Traditional players are not able to respond with a price dumping strategy ruthlessly forcing the low-cost carriers out of the market. 'Brussels' simply does not allow it in Europe. The abuse of a dominant position going against the 'general interest', geared towards the individual consumer, is absolutely forbidden.

Strategies for traditional players

What are the strategies available to traditional carriers to play the competitive game with the low-cost companies? A first alternative for traditional carriers would be the 'cloning strategy'. However, experience shows that the traditional players have a lot of difficulty to make a low-cost business model profitable. The multibusiness corporation concept - running several different businesses grafted onto different business models, alongside each other - has not yet been properly introduced in the aviation industry [7]. Multibusiness enterprises see an enterprise as sum of business units that need to be positioned in a competitive manner vis-à-vis the competition. The traditional players do not have the cost mindset and the competitive skills to make a success of this strategic scenario.

A second strategy traditional carriers could deploy is co-operation instead of competition between the low-cost and the flag carrier. The low-cost company would then primarily take on the feeder function and the transport of the price-conscious passenger, whereas the flag carrier would occupy itself with the long distances. In this scenario, the flag carrier would have a guaranteed cheap and reliable feeder function, whereas the low-cost carrier can count on a definite number of passengers and facilities (to be agreed upon properly in mutual consultations) and the marketing knowledge of the flag carrier. The disadvantage of such a co-operation concept is that the passenger must not have any objections to different service levels (no service whatsoever versus proper service). The flight schedules will furthermore have to be co-ordinated meticulously. Both parties will also have to act according to the letter of the agreement and not be forced with the lapse of time to launch into the operations of the colleague-partner [8].

A third strategy the traditional carriers could turn to is getting a grip on the slots and the gate capacity of minor airports which would then be soon out of capacity and consequently no longer available to low-cost carriers. In other words, the traditional carriers make their networks 'denser' and fly from a greater number of primary and secondary airports to several destinations. This would allow them to kill two birds with one stone: the low-cost companies no longer have access to an important source of their competitive edge (cheap secondary airports) and the passenger has a choice of several destinations at the same time. This strategy requires networks of alliances to compete against other networks or single operating carriers i.e. expanding the 'hub-and-spoke' systems [9].

A fourth strategy consists of participating or taking over new low-cost companies. Again, this entails a few unavoidable risks. To start with, the anti- trust authorities will have to agree to such a strategy. Secondly, both parties will have to be able to link up both in terms of infrastructure (IT/IS, route networks, etc.) and culture. They must at any rate not repel one another. Thirdly, in case of bad performance of the newly acquired company, there is the danger of deterioration of the existing brand. In other words if the low-cost carrier fails, it may influence the reputation of a flag carrier.

Franchising is a fifth strategy to compete with low-cost carriers. This is a risky strategy because outsourcing the bulk of the provision of services goes hand in hand with taking risks in terms of quality of the services provided, punctuality of the services provided and control over the franchisees. If things go wrong in the mutual relationship between a franchiser and a franchisee there is only one party to blame: the flag carrier. A smear on the flag carrier's reputation is the additional consequence. However, this does not deter most national carriers. British Airways was one of the first airlines to understand that the BA product could be subcontracted to parties with a more efficient business model. Said parties may, among other things, use the BA computerised booking system. In exchange, BA gets a previously agreed fixed fee. Something can be done about the high overall costs structure in this way without such being at the expense of the brand name. In 2000, the seven BA franchisees transported already almost 3.8 million passengers on their own to 80 destinations [10].

Strengthening and (re)building the core business is the sixth possible strategy for the traditional carriers [11]. Their branding in terms of safety, comfort on long-haul flights, possibilities of flight connections is still worth a lot for business and other travellers interested in some of the frills making live on board more comfortable and exciting.

An obvious strategy (number seven) is treating the customer like a king. Today, a passenger still has to be grateful all too often that he/she is 'allowed' to fly with a flag carrier. That requires a change of mentality, a mental salto mortale. Only the odd flag carrier - think Singapore Airlines - knows how to offer its passengers the necessary high-quality services and overall service. Pampering passengers is an extremely serious trade.

The future

The key to a future sustainable competitive edge - and the sweet fruits to be reaped afterwards - is optimising the relationship with the customer. It is a true relief to fly with the no-frills companies because they do exactly what the customer expects them to do: no hustle, check in and go. If the flag carriers fail to please the customers, the end is nearing fast. That means that they have to show a real interest in the customer and his/her latent or manifest needs and wishes. Traditional carriers exist by the grace of the customer. Perhaps it was never the case in the monopoly era of days gone by, but the liberalisation of the aviation markets (and the corresponding rapid rise of customer-oriented and therefore very successful low-cost airlines) once again shows that this will be the situation in the future once and for all.

Alarm phase 1 has been called. Indeed, the low-cost companies are now beating the living daylights out of the traditional carriers. Worse still, the low-cost players are 'playing ' with their plaything, the traditional carriers. Although the game may last a long time, every game has to deal with the terror of the time factor. It would not be the first time that the illustrious champions of days gone by lose the game because of a lack of time. Making up lost ground turns out to be a pretty difficult task in practice. For the sake of completeness: there is no such thing as injury time in the aviation game. And there are plenty of injuries by now.

P.K. Jagersma is CEO of eXistenZ Investments, a global investment company, and Professor of International Business at Nyenrode University and Professor of Strategy at the Free University of Amsterdam. D.M. van Gorp is Assistant Professor of International Business at Nyenrode University and Director of the Nyenrode Institute for Competition (NIC). The core of this article has been published in P.K. Jagersma's new book, 'KLM - Waarheen vliegt gij?', Holland Business Publications.

Notes

1. For an elaboration of this strategy see: B.J. Nalebuff and A.M. Brandenburger, Co-opetition, Doubleday, New York, 1996.
2. In Fortune (August 22nd, 1994), Wolf observes that the $ 1 billion dollar UAL lost in 1992 would have been a profit of $ 700 million had it not been for the competitor from Texas.
3.  See for an excellent discussion of the subject 'flexibility ': H.W. Volberda, Building the Flexible Firm. How to Remain Competitive, Oxford University Press, Oxford, 1998.
4.  The influential Dutch magazine Zakenreis (issue 930; January / February 2001) wrote some time ago that more than half of all Virgin Express passengers are business travellers.
5. For a detailed discussion see: P.K. Jagersma, Global Strategy, Inspiration Press, Brussels, 2000.
6. Fortune, "Is Herb Kelleher America 's Best CEO? ", May 2nd, 1994.
7. See: P.K. Jagersma (ed.), Multibusiness Corporations , Inspiration Press, Brussels, 2001.
8. See: P.K. Jagersma, Global Strategy, Inspiration Press, Brussels, 2000.
9.  See for example: P.K. Jagersma and D.M. van Gorp, "Alliance Management: The KLM/Alitalia Case", to be published in 2002/2003.
10. These data are from British Airways.
11. See also: C. Zook and J. Allen, Profit from the Core: Growth Strategy in an Era of Turbulence, Harvard Business School Press, Boston, 2000.