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Air travel is a commodity. For most travelers, price is king, and fare competition is fierce. Over the years, the vicious circle of price wars has left a trail of airline casualties. Surprisingly, many other industries manage to thrive in a commoditized environment, and airlines can learn from them. With bright minds and the latest digital technologies, a few airlines will also be able to accelerate much faster than their peers and lead the pack.
Commoditization Leads Way to LCC Market
Commoditization occurs when the market perceives products to be substitutable. When products are substitutable, customers will naturally purchase the cheapest, and businesses will fight to lower their costs. It is common for economic textbooks to use the evolution of the American airline market after deregulation to introduce commoditization. Deregulation has been directly followed by the creation of low-cost carriers (LCCs), which, with their low-cost structures and unbundled products, now control up to 60% of the aviation market in some countries. With only marginal product differences, consumer pressure has forced all players to follow the same spiral-down trends (cost cutting, product unbundling, etc.) if they want to survive.
Many companies did not survive, and more will fail. Achieving extreme cost transformations is becoming harder and harder for many airlines due to political, human, business, market base, and other reasons. Other commonly employed strategies to lower the pressure, such as attempting to reduce competition via mergers or alliances, will ultimately reach their limits soon.
The only way up, to justify higher costs and remain profitable, becomes revenue growth. Airlines have to convince people to buy travel in spite of its price, and not for its price, a mindset that has only been marginally touched upon in the travel industry today. Fueled by opportunities enabled by new airline technology innovations and increasingly growing customer expectations, this trend will transform airlines in the years to come.
Commoditization and Resistance
As air markets have opened up over the years, the most (if not only) successful business models have been in the low-cost carrier (LCC) segment. Such carriers have disrupted markets with aggressive cost structures, both creating and capturing demand from competitors. Well-managed LCCs keep growing at double-digit rates in most markets (both mature and developing). Their agile structure allows them to realize comfortable margins; and competitors, which now tend to offer more and more similar product portfolios, have historically struggled to deliver profits.
Little by little, airlines around the world thought they had no choice but to follow the LCC recipe: cut costs and unbundle products to drive fares down. While fares and revenues have generally been declining, airlines tapped into new sources of growth in the form of better pricing and segmentation of the existing product, and started to sell a massive amount of ancillary products to complement the airfare. This recipe has been applied differently by full service and low-cost carriers; full service has more segments from which to build.
“Decommoditization [will] not happen overnight, ’but we’re on a good path to get there and that is big structural change’”
Scott Kirby, American Airlines
For example, after failing a decade ago to create a separate brand, Song, to fight against low-cost carriers, Delta is the same airline that first introduced Basic Economy. Basic Economy was introduced to match low-cost carriers on price, and matches nearly all product characteristics by cutting perks that used to be free (flexibility, free seat selection, ability to purchase upgrades, etc). Delta has actively communicated that while it needs to compete against low-cost carriers, it’s important to the company to upsell customers to one of its four other products. It is yet a pity that the standard Economy and Basic Economy share nearly the exact same experience onboard.
Many airlines position themselves as full service, or even as premium carriers. Better product offerings (comfort, experience, service), disparate markets, schedules, and airports served differentiate them and are driving superior revenues. On the other hand, FSCs (Full Service Carriers) and LCCs keep converging as customers evolve. Business class, premium ground service, and premium markets, are all now increasingly served by both players. And even though superior brands drive higher willingness to pay, such differences are eroding and can change quickly.
Race to the Bottom
Major disruptions like the Internet have increased market transparency for customers and created additional competitive price pressure. Unfortunately, those factors have not been leveraged by legacy carriers to create brands that set them far apart from the competition. Some airlines, like Delta, have been more vocal about their ability to deliver a premium product (“We have said before that our product is not a commodity. We need to produce a premium product that drives brand loyalty”) after years of differentiation (operational excellence, customer care, onboard experience). But in other parts of the world - for example, in Europe or Canada - carriers have seen worse. Around the world, airlines like Lufthansa, Qantas, and Air Canada, have been giving up and transferring some of their activities to their low-cost subsidiaries as a way to remain relevant, after failing to find profitability drivers to make up for a higher cost base.
A cost-cutting race to the bottom may not disappear anytime soon. The consolidation moves that strengthen economies of scale and further reduce competition have reached a global level, through acquisitions and joint ventures. At the same time, long-haul low-cost carriers are becoming a reality after having conquered short-haul travel. Will it trigger the same kind of reactions? The long-haul market, with its premium demand, tends to be much more profitable. Yet, airlines are getting ready to release their no-frills, basic economy fares internationally, explaining that the competition with the likes of Norwegian demands to reduce fares.
The 2015-2020 period is also marked by apparent setbacks in many premium carriers’ strategies. Some highly-rated Asian carriers, starting with Singapore, Cathay, and Garuda, and also Malaysia, Thai, and Gulf carriers (Etihad, Qatar, and Emirates) are all undergoing major strategy or profitability challenges. Such setbacks appear after years of extremely successful operations where little restructuring or revenue innovation have been done, at times where markets and competition have been evolving rapidly. Singapore and Cathay, for example, will attempt to grow revenues and drive costs down by implementing measures that competitors have followed a long time ago (cabin densification, creation of ancillaries such as seat reservation, digital friendliness). It is unlikely they will lose their elite status, especially in premium classes - though they may move closer to average - but it surely highlights the fact that a premium company is not immune from competition.
At times where demand is strong and fuel is cheap, airline innovation has resulted in improvements of the travel experience, especially (but not only) in premium cabins (Qatar QSuite, United Polaris, Singapore, Delta, Air France, and more). And they do so to safeguard their ability to drive fares up for the 5% of passengers traveling in the front of the cabin, for whom price is not the most important factor. With (on average) only 25% of revenues coming from premium cabins, this effort deserves to be underlined. But like the efforts of some airlines to go beyond competition and standard products to differentiate themselves, we argue that this will not be enough, especially if premium demand fades during the next economic downturn. Marginal differentiation is not enough; perhaps a revolution in airline innovation is needed.
Creating a section between economy and business was a bold first step that proved to be incredibly successful. Indeed bold, because it was not a “fail safe” attempt. Changing aircraft configurations, commercial systems, catering, airport equipment - nearly all areas of the airline, in fact - as well as training staff is a costly investment.
The product is a win for all customers. Customers may be infuriated when services that used to be free are unbundled and chargeable, but results show they will also happily pay more to enhance their travel experience.
“Users of the premium economy product are also quite varied and could include business people who are trading down due to tighter corporate travel policies, enthused leisure travelers trading up to get a better travel experience but still don’t want to splurge on business class, and those frequent flyers willing to upgrade out of economy using points.” .
It is also a win for airlines, some of which reported a 70% yield increase over economy for only 30% more space, a better return than business class. Some carriers, like United, have also expressed interest in rolling out a domestic premium economy class.
Emirates, whose CEO Tim Clark has been vocal about the need for the industry to evolve leveraging data for personalization and tailored products, seems to regret neglecting to invest in Premium Economy. He has since expressed interest in declining its economy product into several flavors, from a premium seat to a no-frills product for passengers with low willingness to pay. A move that, if implemented innovatively, could be a good effort to capture even more value by better matching demand to products, using more tailored or even personalized offerings.
Airline Innovation Opportunities
Many airlines have limited themselves to offering standard seats and standard ancillaries that used to be bundled with the fare (sometimes called “punitive ancillaries”). However, more innovative decisions shed light on the diversity of airline portfolios that one can expect in the future; they will be dramatically different from the products that generate billions today. This is a portfolio that goes far beyond four product segments and standard ancillaries.
In 2010, Air New Zealand released the SkyCouch, which offers economy class passengers an option to create a bed with three consecutive economy class seats. The SkyCouch is a win-win for passengers who can travel with increased comfort on long-haul flights, and for the airline, which can price three seats intelligently, increasing revenue and product differentiation. Without a direct competitor that can offer a bed for two in the sky, Air New Zealand is free to market, price, and sell its SkyCouch to travelers the way it wants.
Etihad, the carrier that has been fighting for revenue growth, has experimented with even more innovative concepts. Beyond upgrades or lounge passes, Etihad has been selling available empty neighboring seats through auctions before departure. Passengers seeking extra room and privacy can bid for empty seats.
Airlines have also been keen to offer branded, quality food for purchase as they cut free meals in economy. The thinking is that passengers prefer quality food for purchase than poor meals for free. Austrian Airlines and Air France have both partnered with recognized restaurants and proposed a highly branded meal that put their home country (and their brand) at the forefront, available for customers to experience onboard.
Low-cost carrier EasyJet offers a “hands free” airport service to make the airport experience more convenient for a small fee.
Convenience is also behind British Airways’ partnership with AirPortr, a company that allows door-to-door baggage carrying.
Airlines have historically been good at creating ecosystems around their core offerings and loyalty programs. With both a wealth of data and the fact that airfare is usually the first product to be purchased when planning a trip, airlines are eager to sell much more than plane tickets. As most innovative carriers are investing in efforts to increase their reach and offering holistic travel packages to customers, it appears this trend will keep evolving. Airline innovation will not only sell more of their own products, but many of their partners’ and affiliates’ products.
Further Differentiation in the Luxury Segment
Beyond this myriad of services, one of the most interesting developments remains the creation of a unique onboard experience by differentiating the physical seat. Every frequent flyer knows how to strategically select a favorite seat (cabin, window, aisle, emergency exit, bulkhead) and airlines have created extra legroom options. However, the latest business class layouts have added even more choices and opportunities for travelers to select seats that best suits their needs onboard. Newest cabin configurations from Swiss – and more recently, Lufthansa – offer “throne seats” that solo travelers can purchase at a premium if they value space and privacy. Similarly to Economy Plus on some North American carriers, the onboard service could also be further differentiated (catering and amenities, for instance), and so could the ground service.
Qatar Airways’ revolutionary QSuite Business Class product also enables numerous different experiences onboard for working, meeting, sleeping, and relaxing, offering a luxurious experience for one to four people. While seats are still being sold as business class seats, the day where such experiences could be sold as “meeting rooms”, “twin beds”, “relaxation pods”, or even as “honeymoon rooms”, with the appropriate amenities, is not far.
The Technology Factor
Long-term Revenue Generation
Manufacturer Airbus believes the hyper-personalized travel experience will go much beyond. It recently concluded the first phase of its transpose project aimed at amenities beyond better matching capacity to route demand, experimenting modular, reconfigurable cabin sections, and offering experiences as diverse as cafes or gyms.
The latest concepts from Airbus promise cabin innovation in unusual ways:
Also, its economic analysis concludes that airlines could gain a 5% margin increase, and it predicts passengers will pay up to 20% more for such in-flight experiences. Many in the industry seem to be willing to believe these concepts will actually see the light. In any event, airlines will require much more agility than a cabin change per decade; Lufthansa Technik recently introduced a “lease your cabin” concept, which will help airlines to update interiors more often.
Today, leading carriers control the onboard experience from taste to sounds and even light; technology has the ability to multiply this effect. But most importantly, airline innovations in technology will enable personalization and revenue generation. It will create a circle in which players with diverse and/or premium portfolios will realize superior revenues, and keep investing to strengthen this advantage.
From manufacturers to airline staff, suppliers, IT and regulators, a great deal of alignment is needed for an industry to think about its future without losing focus on today’s security and operational excellence. With so many stakeholders, delivering innovative airline products remains a challenge.
The travel industry is quickly upgrading its commercial technology layer. However, most transactions are still being done using reservations systems that find their roots in the 1960s, when airlines were only selling seats to brick-and-mortar travel agents. These systems have hindered the ability of airlines to differentiate and unbundle products (making it even harder for full-service, non-digital native airlines to sell above-mentioned ancillaries, especially at times where they were under fire of low-cost carriers) and to sell innovative products. It took more than three years for the SkyCouch to be available on Global Distribution Systems, an intermediary involved in the vast majority of the travel commerce.
The latest IATA standards, built to enable an ecommerce-style travel shopping, are experiencing notable traction. Leading carriers, starting with the Lufthansa Group, are fighting hard to make this a reality. Ultimately, these standards will allow airlines to sell as many unique products as they want, in an Amazon-like experience: transparent, personalized, and simple. Product transparency is critical to lure passengers into paying the premium that the product provides, and for airlines to offset their costs. Airlines also have tremendous experience in pricing and revenue management, and will quickly figure out strategies that ensure new products can be sold as profitably as possible.
Zodiac believes that passengers will sleep in plane bellies (cargo hold) by 2020, which is not far away. That said, new onboard products will require a massive investment and are a challenge to deliver. For example, United’s Polaris business class seats and lounges were launched in 2016 and are far from being available network wide. The 2015-2020 period marks half a decade in which airlines’ returns have exceeded the cost of capital (and a decade of profitability), unlocking some investment opportunities. Airlines are also getting bigger, which brings additional research and development resources.
Commercial departments understand the importance of the digital experience and stand ready to better express the value of their premium products to make sure passengers pay the right price. Planes and equipment manufacturers have reached critical sizes and understood the importance of innovation and transformation. For Airbus, it will be a powerful competitive advantage against emerging manufacturers.
And for airlines, the beginning of a new world in which customers may be presented with the product they desire to satisfy their travel experience every time they interact with a brand. Such products may have much less competition, and allow the airline to drive increased margins. But airlines need to aim much higher. They must build strong brands that eliminate competition; and uniqueness is one of the strong characteristics of today’s most successful brands. Uniqueness is nearly impossible to achieve when all products are marginally similar, but becomes a real possibility once product portfolios are revolutionized and overcome the state of commodity. Companies that combine this with other business techniques that made today’s top brands incredibly successful – including precise product positioning and marketing, and a reputation of exceeding customer expectations in service delivery – will manage to become the next Apple of the air.
Flying Real Estate
Airlines like Emirates are starting to think in terms of “flying real estate” rather than seats, an indication that defining an airplane with three or four cabins will probably soon be a thing of the past. It does not mean that airplanes will feature casinos or swimming pools, but that revenue-generating customer choices will compete against each other to maximize overall profitability, as they would in a store.
For Emirates, there’s little incentive to start a new discount airline, like Eurowings. But Clark noted Emirates has a huge fleet of double-decker A380s, with a “fabulous bit of real estate,” giving Emirates plenty of room to experiment.
“Yes, we are a full-service carrier,” he said. “We have some very big airplanes. We have the capability of slicing and dicing our product offering, and technology allows us to put in all processes to make that work. Is it doable? It’s doable now — if I wanted to.”
Tim Clark, Emirates
Finally, regulators are and will be challenged to a faster pace and more complex evolutions. One can believe that if the business case is obvious, the industry will be compelled to adopt the latest evolutions quickly.
The Opportunity Exists; Which Airlines will Seize it Best?
The airline industry has suffered from commoditization and it will only get worse. Trade barriers are erased for global concentration to drive down costs, and at the same time, long- haul, low-cost travel becomes viable. After two decades of extreme competition, full service carriers feel stuck, unable to lower their cost structures, and new approaches are urgent.
Innovative products today seem to be fluid to an infinity of versions, just as there is a vast number of potential customers to purchase a personalized and incomparable product from a strong brand. With such products, customers have the opportunity to purchase the experience they want, instead of comparing the prices of commodities.
Economy class will not disappear any time soon, but there will be plenty of opportunities to both satisfy travelers and create margin. Brands that succeed at making their travel experience genuinely different in a sustainable fashion will reap revenue benefits comparable to today’s most lucrative businesses. These businesses manage to reap 80% of the profits of the market in which they operate.
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