Faculty of Economics and Business Science Essay
Faculty of Economics and Business Science
Introduction – How the American Low-Cost Airline Industry Looks Like? In the post World War II the federal government heavily regulated period, commercial air travels in the US. As a result, the nation was reliant on a few leading airline companies. Competition was permitted only within individual states. California and Texas were the only two states that had both the geographical and demographic advantage to make air travel attractive. Since 1938, the U.S. Congress formally regulated air transportation through the Civil Aeronautics Act. This Act created a board to control the entry and exit of air carriers, to regulate fares, and to control mergers. These new findings led to the deregulation of the airline industry in 1978. Deregulation was premised on the idea that an unregulated market would approximate a perfectly competitive industry, one that had numerous carriers, no significant economies of scale, and no significant barriers to entry.
As a result, many new entrants tried to establish on the airline market, although most of them get bankrupt due to the fierce competition on prices which made a profit margin too low to stay in the game. Besides, financial crises in 1983 and 1990 made many low-cost airlines leave the market. As an example, over 200 airlines stopped operating from 1983 to 1988. However, few significant airlines were born at that time: Spirit Airlines (1964) and Southwest Airlines (1967), Sun Country Airlines (1982).
The relatively new low-cost carriers include Allegiant Air (1997), Frontier Airlines (1994), JetBlue (1999) and Virgin America (2004). In 2006 the low cost carriers have a market share of 30% in the Unites States, compared to 7% in 1990. One of the reasons for such an escalating increase could be a raising traveling demand in the US: total number of passengers in 2012 reached 800 million! We assume that such a significant market share should be understood as a separate industry. We would like to analyze the environment of the US low-cost airline industry by applying following tools: PESTEL analysis, Porter’s five forces framework and Strategic Groups analysis.
We will start with the analysis of the largest layer of the business environment. In order to investigate the macro-environment we will apply PESTEL analysis to understand to which extent the following six main factors have an impact on the whole industry. Political Factor
Thread of terrorism: The airline industry has never really recovered from the aftermath of the 9/11 attacks. This situation leads to more invasive security procedures at the airports and customers dissatisfaction even before taking a flight. September 11, 2001 has put a long-term shadow on the whole airline industry leading to significantly higher operating costs. The airline industry is highly regulated by the Department of Transportation and the Federal Aviation Administration, primarily in areas of flight operations, maintenance and other safety and technical matters. Stricter regulations on aircraft safety maintenance, for instance, are placing new burdens on operators of older aircraft. Average aircraft operating age in the industry is 11 years.
The 1978 Airline Deregulation Act partially shifted control over air travel from the political to the market sphere. The Civil Aeronautics Board (CAB), which had previously controlled entry, exit, and the pricing of airline services, mergers, and consumer issues, was phased out under the CAB Sunset Act and expired officially on December 31, 1984. The economic liberalization of air travel was part of a series of “deregulation” moves based on the growing realization that a politically controlled economy served no continuing public interest. U.S. deregulation has been part of a greater global airline liberalization trend. Economic Factor
This economic part of the airlines industry has already struggling the airlines to contend with declining passenger traffic, competition from low cost carriers, high aviation fuel prices, labor demands, and soaring maintenance and operating costs. All these factors have made the airlines to get in bankruptcies because they can no longer afford to run their operations profitably. Fuel is the airline industry’s second largest expense, exceeded only by labor. The major U.S. airlines spend more than $10 billion a year on fuel, which is approximately 10 percent of total operating expenses. As a result, increased fuel efficiency has been a top industry priority for many years. Significant changes appeared in the US economy between 1983 and 1988; the airline industry experienced a massive wave of bankruptcies, mergers, and acquisitions.
Over 200 carriers left the market, leaving nine airlines (United, American, Continental, TWA, US Air, Pan Am, Delta, Northwest, and Eastern) to share 92 percent of domestic revenue. Contrary to initial expectations, deregulation actually led to a decrease in competition. Airlines’ profitability is closely tied to economic growth and trade. During the first half of the 1990s, the industry suffered not only from world recession but the Gulf War further depressed travel. In 1991 the number of international passengers dropped for the first time. The financial difficulties were exacerbated by airlines over-ordering aircraft in the boom years of the late 1980s, leading too significant excess capacity in the market.
Mergers and acquisitions are seen to be one of the most important trends in the low-cost airline industry. Many carriers make efforts to purchase small regional aircraft operating companies or even fuel suppliers of the local level. This leads to lower operating costs and will result even into higher ticket prices in the future. The expectation for the US economy for the next years is that the growth rate will increase for 1.6% to 2.4%. Growing economy means an increase in buying power of the customers. For this reason, the traveling demand is expected to increase in the future as well. Social Factor
The profile of the passengers has changed with more economically passengers and less business class passengers. Now with more information and social media the customers have high expectations in the low price sector of the tickets because the expected standards of the services have increased. Even for a low price passengers expect to have clean seats, smiling crew, no delays etc. Moreover, customers are ready to complain if the service does not meet their expectations. Technological Factor
Though it is a fact that the airline industry uses technology extensively in its operations, they are limited to the aircraft and the operations of the airlines excluding the ticketing and the distribution aspects.
This has prompted many experts to call on the airlines to make use of the advances in technology for the front office and the customer facing functions as well. In other words, the technological changes have to be adapted to include mobile technologies as far as ticketing, distribution, and customer service. Technology media now is necessary, for their promotion and for the customers that can buy their tickets in a safe and a quicly way. An example is that Southwest Airlines uses the technology extensively and it is a fact that the 75% of its profits the company gains due to the online sales. Such technologies as mobile phone applications, homepages, online reservations and others are not necessary just to be successful in the market – they are an absolutely a ¨must have¨ for the airline to even start to make sales. Environmental Factor
The social responsibility initiatives are becoming more pronounced in the airilines industry. As consumers and activists turn a critical eye towards the airlines and their corporate social responsibility. Many people do not associate noise with pollution. But in the last decades the noise produced by jets has become one of the airlines biggest environmental challenges, the one the companies have spent billions of dollars to address. Key to their noise reduction efforts has been the development and introduction of new technology over the years. The airlines have implemented a recycling program to reduce the amount of solid waste they send to landfills. These are the most commons: aluminum can recycling by flight, greater use of metal utensils and ceramic dishes, paper recycling of airline offices.
The number of lawsuits against airlines from both customers as well as workers has gone up. In other words, the regulators are being stricter with the airlines, which mean that they are now increasingly their strategies, and actualizing their strategies only after they are convinced that they are not violating any laws. For the airlines industry the customers are the priority beacuase they know thath having an airplane accident will have legal issues and can destroy a whole airiline.
The legal system became intolerant of delays, safety issues, and other aspects has only served to increase the fears among the airlines as each and every move of theirs is being checked. In the restrictions on mergers the U.S. Department of Justice approves a certain number of airline mergers, but also blocks a number of them because they fear a trend towards monopolization which would mean less competition and could lead to higher ticket prices. Airlines then sometimes file in lawsuits to defend their proposed merger and tend to succeed. Open Skies Agreement was signed in 2008, the intention of this U.S. and EU aviation pact was to allow greater access to U.S. markets by non-U.S. carriers. This means a greater competitive pressure for U.S. airlines.
Conclusion from the PESTEL analysis: Key drivers from the macro-environment include political, economic and legal factors.
In order to analyze the next layer of the environment – industries and sectors – we will use Porter’s five forces framework. This tool was developed to estimate the industry’s attractiveness. Another purpose of our analyze is to recognize dynamics of the US low-cost airline industry. Bargaining Power of Suppliers
The suppliers of airline companies are fuel supplier, foods supplier, aircraft supplier and airport facilities. It should be mentioned that the US supplier market for the airlines is quite limited. There exist only two possible suppliers for the airplanes – Boeing and Airbus. There is a large investment required to purchase the airplanes. Thus, it makes it very difficult to switch between these two suppliers (for instance, to switch from Boeing vehicles to Airbus) as the switching costs will be unavoidably high. Another issue which is worth mentioning – in the case of switching to another supplier all mechanics and pilots should be retrained according to the standards of a new supplier. In the past, low-cost carriers tended to operate older aircraft purchased second-hand. Since 2000, however, fleets generally consist of newer, more fuel efficient aircraft. These are extremely efficient aircraft in terms of fuel, training, maintenance and crew costs per passenger.
Airlines are also highly dependent on Boeing’s and Airbus’s innovation strategy – especially low-cost carriers have little bargaining power to negotiate with the suppliers and order special custom-made vehicles (for example, airlines cannot make an order to Boeing/Airbus to produce special airplanes with more seats/less fuel costs in order to maximize airline’s profits). Thus, the power of the suppliers makes the airlines to adopt their strategies to a new fleet and the other way round! Fuel market is quite monopolized as well (PDVSA, Venezuela; Petrobras, Brazil). Moreover, price of aviation fuel is directly related to the cost of oil. It implies difficulties to the airlines as oil market is very unpredictable and tend to increase. For this reason airlines prefer to sign long-term contracts with the fuel suppliers in order to negotiate fuel prices for the future as well. Foods suppliers do not cause any specific difficulties for the low-cost airlines due to two main points.
Firstly, many low-cost carriers do not serve a warm/cooked food for the passengers. Secondly, foods suppliers have little bargaining power as their market is highly competitive as well. This makes it very easy for the airline to switch to another foods supplier. Large airports charge very high prices for renting or buying the gates. Thus, they are seen as a big challenge for the airlines. On the other hand, regional airports have little bargaining power as they are heavily dependent to make their profits from a regionally dominant airline. It is worth mentioning that it is very important for the low-cost airlines to dominate on the regional level.
But in this case, low-cost carriers do not challenge fees of regional airports – they rather compete with other low-cost airlines to get the airport gates. Conclusion: In general, bargaining power of suppliers in US low-cost airline industry is very high, although there can be some differences between the national and regional level of operating. Regional low-cost airlines are not so much dependent on airports’ bargaining power, but even this issue does not affect the whole picture of the industry. Bargaining Power of Customers
Customers seem to be very price sensitive. According to the survey conducted in 2010, 36 percent of travelers ranked price as their top consideration while choosing a airline. The second most valued factor, with 32 percent respectively, is particular schedules and routes the airline can offer to a passenger. Surprisingly, on-time performance and star rating all gathered seven percent or less. Thus, customers’ behavior towards prices makes low-cost carriers participate in a fierce competition on low prices for the flights and invite special sales offers and promotions to gather new customers. The next problem which low-cost companies face is low switching costs for the passengers. The opportunity to compare prices from different airlines online allows the customers to make a best-choice decision. According to the survey mentioned above, only less than two percent of travelers mentioned brand loyalty to be a crucial factor of choosing an airline to fly with.
Increase in customers’ awareness about building the prices also puts some limits on the airlines’ strategies: modern travelers know exactly how much their flight tickets should cost! They are aware that most low-cost carriers try to promote online sales in order to shorten their costs by not renting offices and not establishing call centers with call agents. Today’s customers also understand that online check-in allows the airline to cut its costs for renting check-in desks at the airports etc. As a result of this awareness, customers become more suspicious about the price and have higher expectations for the services. Conclusion: Price became for the customers the most crucial factor to decide what airline they want to use. No switching costs and customers’ awareness define as well that customers possess a huge bargaining power towards low-cost carriers in the US. Threat of New Entrants
Deregulation law of 1978 had a great impact on the whole US airline industry. The idea of deregulation changed the airline business into a perfectly competitive industry with numerous carriers, no significant economies of scale, and no significant barriers to entry. After plenty of mergers and acquisitions in the airline industry in the 1980s were executed, over 200 carriers left the market. Thus, US deregulation created a more concentrated airline market with no specific barriers for the new entrants on the other hand. Historically, it has been seen very prestige to owe an airline – for this reason a lot of investors tried to enter the industry despite of its low attractiveness. Most of them, however, left the market as the airlines declared themselves being bankrupt. In general, airline industry has one of the highest turnover rates – over 60% of all new entrants leave the market in the first five operating years. There is a high capital investment required to enter the industry.
Moreover, investors cannot change the existing prices in the industry. Most costs for the airline are built from its fixed costs (renting or purchasing fleet, renting airport gates, fuel costs, salary paid to the personnel, trainings). This makes it very difficult to reduce the costs when needed – fixed costs cannot be reduced in the emergency case. Restricted slot availability makes it even more difficult for the new entrants to find suitable airports. Especially in the low-cost sector of the US airline industry it causes extremely high challenges for the new entrants to have enough basis to set low fares for the flight tickets.
By setting very low and competitive ticket prices a new entrant should take a risk to stay unprofitable for the first operating years as a new company has a lot of debts from the investment and no customer base to make enough profits. On the other hand, as we analyzed before no close customer relationship is possible within a low-cost airline industry. Hence, if a new entrant is able to catch customers’ attention by setting low fares this airline can expect the profits in a short time. Conclusion: Although the new entrants will face a fierce price war immediately after entering the market, there are some key factors (low prices, different routes) that can save the company from going bankrupt. Nevertheless, the thread of new entrants in the industry tends to be low.
As mentioned before, the low-cost carrier market in the USA is highly competitive due to heavy pressure on prices, margins, and hence on profitability. Besides, the industry is characterized by the following specifics: Most cost advantages can be copied immediately.
Low chances to participate in the competition for the national market as the two major low-cost airlines (Spirit Airlines, Southwest Airlines) have avoided direct head to head competition by choosing different routes to serve. Existing rivalry is competing on the regional and local level. Not much differentiation between services. Price is the main differentiating factor. The pricing policy of the low cost carriers is usually very dynamic, with discounts and tickets in promotion. A new tendency towards prices: the prices steadily rise thereafter to a point where they can be comparable or more expensive than a flight on a full-service carrier. Conclusion: highly competitive environment.
Threat of Substitutes
Historically, airlines have satisfied the demand for a speedier travel experience with faster aircraft. Travelers choose air for a variety of reasons; chief among them are costs and time. But in the future airlines can be on the edge of losing this advantage if high-speed rail will be improved. In this case more travelers will re-evaluate this alternative, and many will quit flying because of the reasons they dislike air travel: check-in/security hassles, lost productive time, lower-than expected reliability on in-time departure and arrival, and negative environmental impact. Rail is not a complete substitute for air travel in all markets because longer distances magnify the effects of slower travel speeds.
But for travel distances of less than 1,200 kilometers, high-speed rail can be seen as a viable choice. It is worth saying that after the Deregulation law in 1978 the American railway was quite “abandoned” as most travelers switched to the air travel due to the low fares offered for the tickets. Thus, American railway has hardly introduced new rail destinations and can be barely seen to be a substation for the air travel today. Nevertheless, the situation can change if investment in the improvement of American rail destinations will be made. Buses are not a substition for the US low-cost carriers as their prices (even for the regional destination) are comparable to the prices for the flight tickets. Conclusion: Low-cost carriers are not threatened by the substition by railway/buses.
The summary of the Porter’s five forces analysis can be represented by the following graph:
Conclusion from the Porter’s five forces framework: The U.S. low-cost airline industry is not an attractive industry to enter because of the heavy competition, large turnover rates and high fixed costs which results in one of the lowest profitability of all industries.
Now we came to the most immediate layer by which the companies are surrounded – layer of competitors and markets. We will conduct the analysis of this layer by dividing the airline industry into particular Strategic Groups. We decided to define Strategic Groups by following terms: by geographic coverage (national, regional, international) and by customer satisfaction (measured in the airline industry by a scale from 1-1000 points). Conclusion to the Strategic Groups: The most direct competitors of low cost-carriers are very often other low-cost carriers. There is a strong competitive rivalry both within the strategic group of low cost carriers like Southwest Airlines and JetBlue, but also there exists a competition between strategic groups. For instance, a big low cost-carrier Southwest also competes with Delta Air Lines who is the largest legacy/major U.S.airline who operates in both a domestic and an international network. According to our research, critical success factors for the low-cost airline industry include: ticket fares, waiting times for flights, safety measure, customer-oriented service and comfort, special sales offers (for example, frequent-flyers programs), airport fees, number of destinations, costs of airplaines, fuel price conditions, online ticket booking, high-frequency flights.