Spinning off low cost carriers—when it does make sense?

Journal of the Academy of Business and Economics, April, 2003 by Ying Kong, Andre Le Dressay

ABSTRACT

In the last 10 years, a number of major and flag-bearer air carriers have been spinning off low fare alternative airlines from their main operation to compete with low fare rivals. This paper examines the incentives and possible indicators of success for this strategy. Using a two-stage game model, we determine that the high fare airline company will find it profitable to create its own low fare airline when (a) the factor of cross elasticity between high fare good and low fare good is relative large and (b) the existing load factor on the high fare airline is relatively high. The model also shows that total welfare as a result of this strategy can rise under some favourable conditions.

1. INTRODUCTION

"Lets face it, if you're an airline and your name doesn't begin with Southwest, you are by default a bankruptcy candidate." Jamie Baker, an airline analyst at J.P. Morgan, to The Associated Press on the restructuring going on in the airline industry.

To be fair, Jet Blue Airways, Airtran and West Jet, the disciples of Southwest Airlines, are also profitable North American airlines. Not coincidentally, all of these share common characteristics--they are all no-frill low cost point-to-point airlines. The Southwest airline case study is quickly filling up textbooks, journals and magazines as the new airline model for profit maximization. The impact of Southwest on the airline industry has been estimated at $12.9 billion in savings to consumers (1).

All airlines have four broad components in their profit functions; the product of yield and traffic equates to revenues and the product of unit costs and output equates to costs. Southwest Airlines has focused primarily on reducing unit costs to increase traffic through the lowest prices. There are five key elements in their strategy. First, utilize all the same aircraft (737s) to reduce training and maintenance costs. Second, use less expensive secondary airports near major centers to reduce transaction cost laden turnaround times and increases productivity. Third, pay high attention to customer satisfaction to increase load factors (2). Fourth, reduce booking costs through an aggressive Internet strategy. Finally, maintain lower labor costs by more closely aligning interests between labor and management (3) (Holloway, 1997).

In contrast to Southwest and its clones, a large segment of the North American airline industry is in financial free fall. Air Canada filed for bankruptcy on April 1st, 2003 to join Hawaiian Airlines and United. American Airlines reduced its costs by $1.6 billion on March 31st to just avoid bankruptcy. U.S. Airways just finished reducing its costs while under bankruptcy protection (4). Delta and Northwest are using the examples of American and US Airways as leverage for reducing costs.

There are numerous explanations for the financial crisis facing most of the North American major and flag bearer carriers. There are exogenous factors reducing traffic such as health and security concerns. There are also a number of endogenous factors relating to their comparatively high per unit costs. At this stage, the question facing the North American major and flag bearer carriers is not whether they should compete with Southwest, WestJet and other low cost carriers by reducing their costs, but how to do it and quickly.

A Consumers including business travelers are buying down and this trend is permanent. The days when CFO=s issued directives not to travel in executive class have been replaced by new directives to only travel with low cost carriers whenever they are available. We have to conform to this reality and transform Air Canada into a low cost carrier in its own right. We cannot product a product for $1 and sell it for 754 while our main domestic competitor can produce the same product for 504.@ B Robert Milton, President of Air Canada, in the National Post, March 22nd, 2003.

A number of broad cost cutting strategies have emerged (Holloway, 1997). Most of these strategies are directed at managing specific internal cost drivers. For example, as discussed above, a number of airlines are using a combination of threats based on exogenous factors and bankruptcy to gain significant concessions from labor, creditors and suppliers. Other airlines are reducing output and cutting back on routes. United Airlines just cut back a number of routes, as did KLM. Strategic alliances such as those by Northwest, Delta and Continental are being used to achieve efficiencies in ticketing and bulk purchases (Oum, Park and Zhang, 2000).

Beginning in the early 1990s, a new cost management strategy, called the spin off strategy, emerged. A number of new airlines were established either within but separate from the main airline or as standalone entities. These include Continental Lite in 1993, Shuttle by United in 1994, Delta Express in 1996, and Air Canada=s Tango and Zip in 2001 (6).

All of these new airlines were intended to directly compete with low cost point-to-point Southwest type carriers and contribute either revenues or increased traffic to their parent companies. In theory, they would lower costs by adapting as much of the Southwest model as possible. In some point-to-point markets, the existence of these low cost spin offs would provide an effective barrier to entry, and in others; they would directly compete with Southwest and/or its followers.