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 WEAKNESSES

Cost differentiation A fixed-cost perishable product

First mover advantage Limited sectors
Brand Equity Questionable on-time performance
Promoters having lack of financial muscle
No previous industry experience

OPPORTUNITIES THREATS

Un-serviced Hinterland Killer competition

Air Charters Overcapacity
Product differentiation Diminishing yields per passenger
Tax holiday on aircraft leasing 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

Leading Full Service

“Legacy” Carriers
Jet, IA

2nd Tier Regional

Sahara, AI Feeders
Alliance Air

Low Cost
Charters
Carriers
Taj Air,
Air Deccan,
EIH, etc.
Kingfisher

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.
 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.

z The entrance of low-cost airlines will push customer segmentation

z 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)
z 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
Occupancy

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
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
Occupancy

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
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 –

z Airlines must consistently pursue their business design.

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